Why the mining sector is booming, not bubbling

Many analysts are starting to believe that mining stocks have entered bubble territory. But here at MoneyWeek, we can point to several reasons why mining is booming not bubbling - and will do so for a long time to come...

At MoneyWeek, we are great fans of the mining sector. When we look at commodities, we see high demand and constricted supply, something that we can't help but believe means rising prices and a boom in the mining stocks for some time to come.

Not everyone agrees. Indeed, according to James Montier, a strategist at Dresdner Kleinwort Wasserstein, the global mining sector is far from being a buy. Instead, he says stocks "appear to be on a bubble path".

Investors, says Montier, are "in love with the China can grow to the sky'/supercycle story" and they shouldn't be. Why? Because they are in danger of confusing "simple stories" with serious investment process and so buying into a "craze", regardless of "the price they end up paying".

Montier is well known for his work on behavioural finance and it is true that many a bubble is thought of as a boom until it eventually crashes, when suddenly everyone refers to it as a bubble.

But there is a way to tell the difference between the two. Something is a bubble when stock prices have moved far beyond anything that can be justified by the fundamentals (this was the case in the tech boom, when no one understood the fundamentals anyway) and it is a boom when prices are rising fast, but given the underlying conditions, those price rises make sense. To us, the current situation looks more like the latter than the former.

David Fuller, writing on Fullermoney.com, agrees. You have to see rising miner prices in the context of the "secular uptrend" in commodities the world is experiencing, says Fuller. China is still growing at around 9%, India at not much less and the rest of Asia around 5%, so the demand for resources will increase every year, for a "very long time".

Still, that doesn't mean that investors should buy indiscriminately in the sector. As the FT points out, the Aim-listed exploration and production firms deserve a little more scrutiny than they have been getting after their "phenomenal" three-year run. Note that many of the explorers in particular will never have assets amounting to much more than muddy holes in the ground; that fund managers are already becoming more discerning about which ones to back; and that many of the smaller companies that raised cash early in the boom are running out of money and feeling "increasingly nervous" about where they might get more from.

Another concern is that costs (for labour, energy and equipment) are going "through the roof" for many commodity producers, says Dailyreckoning.co.uk, and cutting into profits so much so that, according to consensus forecasts, profits at basic materials companies in the S&P 500 will actually come in 8% lower in the first quarter of 2006 than in the previous quarter. 

Some of this may suggest that we may be seeing a medium-term peak for some mining shares, but it's worth noting that these same rising costs prevent new projects being developed, something that will keep supply tight and prices up over the long term.

Finally, on the issue of whether the metals market is in a bubble or not, we'd ask you to look at the p/e ratings of the various diversified miners listed in the UK. Most are barely in double figures and that's with earnings estimates based on assumed commodity prices that are well below today's levels. This wasn't, and isn't, a bubble, says MoneyWeek editor Merryn Somerset Webb in The Sunday Times. "Instead, so far, it's barely the beginning of a real boom. Most bull markets in commodities last 15-20 years. This one has been going for a mere five."

The best miners in the sector

One firm making hay while metals prices boom is BHP Billiton (BLT, 1,009p), the world's largest mining company. The firm recently reported a 45% increase in first-half pre-tax profits to $6bn, says The Fleet Street Letter, and now intends to return £1.15bn to shareholders through a share buyback programme over the next 18 months. With its shares trading on a forward p/e of only 12 times, BHP is the "best vehicle" to cash in on the commodity boom. Buy below £10 if you can, says the newsletter.

Another fine firm in the sector is general miner Xstrata (XTA, 1,739p), says The Mail on Sunday. In addition to benefiting from record metals prices, the group is doing well out of the "strong rebound" in coal prices to the extent that about a quarter of this year's operating profits should end up being derived from coal. The shares trade on a p/e of only 12.9 times.

Finally, for those looking for diversified exposure to the smaller companies in the sector, it might be worth looking again at the Aim-listed RAB Special Situations (RSS, 126.5p), up 25% since we last tipped it in June 2005. The company runs the RAB Special Situations fund, which invests largely in oil and mining firms, such as Falklands Oil & Gas, and Oxus Gold.

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