The best mining stocks to buy today

China is heading for a hard landing, and that spells disaster for most miners as demand for commodities slumps. But some parts of the sector are still worth buying, says John Stepek.

China has been an accident waiting to happen ever since the financial crisis blew up.

You can't base your country's entire business model on exporting cheap goods and then expect to keep prospering when the rest of the global economy is falling off a cliff.

So what China did was to pile even more money and resources into expanding its infrastructure. But rising inflation, shoddily-built projects, and soaring property prices saw the government crackdown on credit availability.

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Now it seems clear that China is having the hard landing that the bulls always said was impossible.

And a hard landing for China spells disaster for the mining sector...

The trouble with mining

We've been bearish on China for quite some time. As a natural result, we've been bearish on mining stocks too. China is the biggest driver of commodity demand. If China's economy slows, commodity demand drops, and so do prices. If commodity prices fall, miners run into trouble.

That's how it's played out so far. We suggested you sell out of industrial metals miners back in June 2011. The FTSE 350 mining index has lost more than 25% of its value since then.

There's probably more to come. The problem with mining is that it's a cyclical business. It's as boom and bust as they come. The trouble is that mining projects take so long to develop, whereas commodity prices move pretty quickly.

At the bottom of a commodity cycle, when prices are low, no one is investing in new capacity. Miners are barely making money as it is. So when prices rise, there's no rush to open new mines.

As prices continue to rise, interest picks up. Some projects that were uneconomic, become viable. But supply still tends to lag behind demand, because no one wants to commit to making big investments while they're still not sure that demand will continue.

Eventually of course, prices get a lot higher, everyone decides that the demand will be never-ending, and you get a lot of investment in projects that are only viable at high prices.

At that point, any drop-off in prices becomes a real problem. Because miners are still geared up to expand, based on commodity prices being at stratospheric levels. So you end up with revenues being unable to cover costs.

It looks as though we're at this point in the cycle. The bulls are increasingly being forced to stake their hopes for the sector on a fresh bout of stimulus' from China, or on a Chinese consumption boom, which would boost certain metals at the expense of others.

But from where I sit, it's pretty clear that this particular supercycle is over. It doesn't mean the global economy is going to collapse, or that China will never build another road or city again. But the best times for the mining sector, for this business cycle, are over.

Why asset allocation matters

That's why I see no compelling reason to hold most mining stocks. We've always said that one of the most important parts of your investment strategy is your asset allocation. You make money by being in the parts of the market that are going up, and avoiding the ones that are going down.

Rather than spend your time looking for the best stocks in sectors that are in a downtrend, you'd be better off hunting for a mix of stocks in sectors that are in an uptrend. So with fundamental conditions for miners clearly deteriorating fast, the best bet for most investors is just to avoid or get out of the sector altogether.

The one area in the industrial sector I'd perhaps exclude is the mining of coal used in power generation. Getting the right energy mix in the years to come is going to be tough, and we may find we're more reliant on coal than we'd like. We'll be looking at this in more detail in future issues of MoneyWeek magazine.

But beyond that, there is one area of mining I'd definitely say you should keep in your portfolio: that's gold miners. Gold miners have had a pretty miserable time for the past few years. But unlike industrial metals miners, demand for their product gold isn't collapsing. In fact, gold miners could benefit from the rest of the industry's woes.

Why? A key problem for all miners has been input costs. The same demand that pushed up commodity prices also drove up raw material costs for miners. On top of that, demand for mining equipment, and skilled staff, drove up wage and machinery costs too.

But as projects get delayed or cancelled, that'll all change. As the FT reported earlier this week, "one sliver of positive news from the miners was that rampant cost inflation, which has eaten into earnings and pushed up the cost of big development projects, seems to be abating."

Anglo American, for example, "expects costs to rise by about 2% in the second half of [2012] down from 4% in the first half, and 8% in 2011".

That's got to be good news for gold miners. If cost pressures ease up, but the price of gold stays strong or rises further, that should lead to higher profit margins. My colleague Merryn Somerset Webb looks at some other reasons why now looks a good time to buy here: The future is bright for gold miners.

Also, we'll be launching a new newsletter looking at precious metals miners in the very near future. It's from Simon Popple, who picked out some of his favourite precious metals stocks in a recent MoneyWeek cover story.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.