Money flows for the mining sector

AS the market waits for the Fed to make up its mind on further quantitative easing, money looks sure to keep pouring out of the dollar and into commodities. This boom, averaging 20 to 30 per cent since July, has significantly boosted the mining sector, which was doing pretty well already thanks to growing emerging market demand. As a result mining companies are now flush with cash. While the upward trend alone should spark the interest of the spread better, looking a little closer at how the companies are using their new capital could provide some tempting clues to the source of the next big rally.

The choices presented to the trader look interesting as we head towards 2011 because certain mining companies have chosen opposing strategies for their new-found cash. Some have gone for high-profile hostile bids such as BHP Billiton for Potash and Vedanta’s pursuit of Cairn Energy.

Others such as Vale have chosen to return the cash to shareholders.

Credit Suisse launched a report last week arguing that mining companies choosing to buy back shares or seek out or expand into developing country green field will be the most profitable since these options are high-return and low-risk strategies. They predict an extra 3 per cent average internal rate of return over those that choose to invest in mergers and acquisitions (M&A).

Standard & Poor’s Equity Research’s Johnson Imode says it is not that simple. He argues that M&A is not necessarily a bad choice for mining companies: “It makes strategic sense for BHP Billiton. It is more of a question of how much they pay, rather than whether or not they should.” BHP Billiton is currently offering a price of $130 a share for Potash Corp. Imode says this would be exceptionally good value. The market continues to price it at around $145-50 per share and Imode says paying much more than this would be a mistake.

Imode also warns of potential curveballs that could rock a company’s rally off course. While there is plenty of opportunity in new frontier mines in Mongolia and North Africa, questions remain about such countries’ political stability.

In politically safer territory, the Australian mining hub is under threat from a hefty 30 per cent mining tax, which could squeeze out smaller mining firms and have an adverse effect on big companies such as Rio Tinto who are primarily based there. But Australia’s own brand of political instability could hold off the tax in the near-term. The new coalition government, while in favour of the tax, continues to bicker over the precise amount to be charged, stalling the process. Traders would be advised to get in and out of companies heavily reliant on the Australian market before the tax is introduced.

While there is plenty to tempt traders into mining stocks, choosing the best company is a matter of weighing your attitude towards M&A and watching out for political troubles in mining hubs new and old.