Why it’s time to avoid mining stocks

One of the joys of investing for yourself is you don’t have to buy everything! 

“What goes up must come down” – Isaac Newton.

In finance, some things will go up…

but must come down.

Commodities are one such thing.

When there is a favourable supply-demand imbalance, market prices go up.

And when prices rise, exponential supply enters the market as previously unfeasible projects get approved for construction.

But unless demand growth can match supply growth, prices will fall.

Economics 101

Exploiting the run up in commodity prices can be a fantastic way for Australian investors to make over-sized returns. Indeed, some of the best mining companies are listed right here on the ASX and boast some of the world’s most economically viable resources.

Parlaying small amounts of capital on investments in iron ore, oil, copper and coal was a fantastic strategy for investors…until the GFC.

Figure 01. Major commodity prices continue to fall

Source: Indexmundi.com

As can be seen in the graph above, major commodity prices have been on their way down in recent years after a ferocious fall and subsequent bounce during the GFC.

Gold prices are much the same. Indeed, if it weren’t for a falling Australian dollar, shares in gold miners would be plunging – further than they have already, and many would’ve already gone bust!

Avoid bad investments

Peter Lynch, the former legendary money manager at Magellan, is famous for saying:

“In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”

Six from 10 is hardly a tall order. However, to keep a respectable stock-picking average requires investors to do two things:

  • Avoid losers; and
  • Pick ‘good’ stocks

It’s a simple formula, but one many which investors choose to ignore – to the peril of their returns.

Just ask yourself, how many of your friends have owned these next five stocks over the past five, or 10 years.

Figure 02. Average annual compound shareholder returns of major miners

Data sourced from Morningstar.

Despite an unprecedented China-fuelled mining boom, Australia’s major miners have produced poor returns for shareholders.

In fact, if an investor held a diversified mining portfolio of Rio Tinto Limited (ASX: RIO), BHP Billiton Limited (ASX: BHP), Newcrest Mining Limited (ASX: NCM) and New Hope Corporation Limited (ASX: NHC) over the past decade, there’s no guarantee they’d have outperformed the market.

Survival does not equal outperformance

Given their excellent resources, efficient operations and low break-even prices, there’s little doubt any of the miners above will go bust in the current price environment.

However, survival does not equal outperformance. And if you’re picking stocks for yourself, outperforming the market should be your only goal.

Hazy outlook

Unfortunately, the outlook for a majority of commodities is bleak – to say the least. Indeed, we recently noted here and here that an investment in Australia’s biggest miners is anything but clear cut.

While holding on for their generous dividends may be enough to see current shareholders through the lull in prices, as well as rebound in share price over time, it might be best to avoid buying shares in the sector altogether, for now.