Two blue-chip miners to buy now

We've been encouraging readers to pour money into the mining sector for quite some time. But now that BHP Billiton (BLT) is looking to hook up with Rio Tinto (RIO) to form a mining uber-giant, we feel we have to take another look at things.

Sure, this is a landmark moment but is it a good one? Or is it perhaps a Time Warner/AOL kind of moment one that signals the point at which a boom suddenly becomes a deflating bubble?

The good news is that we think not. The Time Warner/AOL deal showed that when it came to technology companies, big very often didn't mean better. But here, as Edward Hadas points out on Breakingviews, it does: a deal between BHP and Rio would result in $1bn a year in cost savings and would give the combined group control of more than a third of the global iron-ore market, allowing them to extract better terms out of big clients such as China.

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But the deal makes sense in a wider context as well. Mining firms have been blowing a bundle hunting down new reserves a combined total of some $7.5bn last year alone thanks in large part to the huge cost of getting your hands on the right equipment and expertise during boom-time conditions.

With that in mind, the sensible choice for miners is not to focus on digging stuff up, but to buy up other companies that have already done so. "And if the name of the game for BHP and Rio is resources in the ground," says Stephen Pope of Cantor Fitzgerald Europe, "Why pussyfoot with junior or medium-size miners when you can go to the top?"

This is especially the case given that the big miners are veritable "treasure-troves of scarce industrial resources", says David Fuller on Fullermoney.com. They control the main supplies of everything from the steel that China and India need to build their new cities, to the aluminium car manufactures require to put cars on the roads. There's nowhere else that developing countries can turn to to make this happen.

As former head of BHP Billiton, Charles Goodyear, was fond of telling investors and journalists, the China-led boom in commodities is on a par with the Industrial Revolution and the rebuilding that occurred after World War II. "This story will run for decades," says Fuller.

We're inclined to agree albeit with a note of caution. If you started buying Rio and BHP five years ago when we started tipping them, now might be a nice time to bank some profits. Note that even if you didn't buy Rio until February, you would still have doubled your money the shares rose 30% last week alone. The canny play now might be to look to other possible consolidation targets in the sector.

With sovereign wealth funds and state-controlled mining firms circling, miners in democratic countries may soon find themselves buying up other miners in order to maintain their grip on the industry, rather than because it's the most economic way to secure more resources, says Fuller. We look at some of the better mining prospects below:

Two promising miners to dig into

One miner on David Fuller's list is Xstrata (LSE:XTA). The fourth-largest copper producer in the game, Xstrata has grown through a series of shrewd acquisitions spending $22bn in a buying spree last year says Fuller. But the firm isn't big enough to avoid a takeover. With exposure to seven major commodity markets, Xstrata is a tasty target for some of the big players looking to diversify their interests, say mining analysts at Austock Securities. Like other big miners, Xstrata makes a shed load of cash, but it remains cheap on a forward p/e of 11 a discount to the UK mining sector average of 15.5.

Copper companies will also be targets, says Robert Guy Matthews in the Wall Street Journal. One smaller player to watch, says John Meyer, head of resources at investment bank Fairfax, is Kazakhmys (LSE:KAZ). Kazakhstan's biggest copper producer has slipped a little of late because a flood at one of its mines cut production. But its earnings still grew 22% to $1.3 bn over the last year. Given the steep copper price and the way the Chinese government is sweating over control of copper supply, it should rapidly make up ground. The firm is valued on a forward p/e of 7.8.