'Gushing cash': iron ore miners a yield favourite

A soaring iron ore price has made the major iron ore miners an attractive option for yield-hungry investors, with alternatives scarce in the Australian sharemarket.

The investment case for Rio Tinto, Fortescue Metals Group and BHP Group is hard for investors to overlook as dividend cuts and earnings downgradesdominate the rest of the market.

"The major mining companies are in a really strong position," said Yarra Capital Management's head of Australian equities, Dion Hershan.

The major miners appear to be an attractive option in the current market.

"These businesses are literally gushing cash and they have very attractive valuations in a market where it's really hard to find value.

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"And they're only firing on few cylinders because most commodities are quite weak at the moment."

Iron ore prices rocketed through $US100 a tonne in May after Brazil's iron ore supply chain was temporarily disrupted by the COVID-19 pandemic, and the metal is up nearly 40 per cent since the start of the year.

Sturdy demand from China has also allowed the major miners to keep selling through the pandemic.

The China Iron and Steel Association reported that daily crude steel and pig iron output in the first 10 days of June had exceeded levels from the same period a year earlier, a sign demand for iron ore remains healthy.

While BHP Group and Rio Tinto are still trading lower year-to-date, they are both outperforming the S&P/ASX 200, while Fortescue Metals Group has risen almost 20 per cent so far this year.

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A big factor keeping the major miners supported is the prospect of dividends.

Most of the sharemarket has been hit hard by COVID-19, scrapping, postponing or reducing their dividend payouts to shareholders in order to stabilise their balance sheets.

A wave of equity raisings has seen investors hand far more over to companies than they have handed back. But the miners remain one of the few sure-fire bets for investors, with cash still pouring in from strong iron ore prices.

"We think the yield prospects are some of the strongest in the market," said Plato Investment Management senior portfolio manager Peter Gardner.

Katana Asset Management's Romano Sala Tenna says the big miners do not offer compelling value. Tony McDonough

"They're basically taking iron ore out of the ground at $US10 to $US15 a tonne, so they're getting great margins at these levels.

"Fortescue's gross dividend yield is around 17 per cent, Rio's is around 10 per cent and BHP just a bit lower. If prices stay at current levels, they look very cheap."

Despite the promise of strong dividends in a yield-starved market, some investors remain cautious on the sector.

"They're not compelling value," said Katana Asset Management portfolio manager Romano Sala Tenna.

"BHP is down 6 per cent from its peak but the banks, like NAB, are down 32 per cent. So yes, they're down a little bit and their values are OK, but they're not compelling."

But he said the sector still looked appealing when compared with the rest of the market.

"The risks are probably evenly balanced at the moment because there's as much upside as there is downside, and it's probably one of the least worst sectors to be in," he said.

"The miners are well positioned and you can easily make a case why commodity prices could recover from here. Large-scale infrastructure projects are also being pushed ahead, so that's good for the miners."

The potential for a trade spat between Australia and China could derail the outperformance of the major miners if Beijing chooses to use iron ore exports as a weapon against Canberra.

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Dr Gardner was sceptical China would use such a tactic, given the country's reliance on the bulk commodity for its own economic growth.

"China, when they put pressure on Australia, they normally choose areas where they can find alternatives," he said.

"We make up two-thirds of seaborne supply so there's really nowhere else to go, so we don't really see that as a risk."

Rio Tinto has also faced significant backlash after it destroyed 46,000-year-old rock shelters used by ancestors of an Indigenous group in Western Australia, and is now facing a Senate inquiry.

Fund managers are still backing the Anglo-Australian company despite expressing their displeasure.

Yarra Capital's Dion Hershan: "These businesses are literally gushing cash." Jessica Hromas

"It's inexplicable what they've done, especially for a company that's supposed to be tuned into these issues," said Mr Hershan.

"There's going to be renewed caution on the sector, which frankly is common sense."

The investment case remains largely intact for sell-side analysts.

Macquarie has an "outperform" recommendation on BHP, Rio and Fortescue, saying they all remain on track to achieve guidance.

"We remain positive on stocks with iron ore exposure due to strong cash flow yields and earnings upgrade momentum," Macquarie analyst Hayden Bairstow noted.

"Fortescue and Rio are our preferred large-cap exposure. BHP’s near-term earnings risk [is] heightened by weak coking coal and energy prices."

JPMorgan analysts were more upbeat on the diversified miners, forecasting Brazil would be able to recover from its COVID slump, weighing iron ore prices.

"Overall, we remain positive on BHP Group [and] Rio Tinto due to attractive price to net present value, but downgrade Fortescue to 'neutral' following its material outperformance," said analyst Lyndon Fagan.

"We still see Fortescue offering strong yields, but as we expect Brazil iron ore
exports to recover in the second half of 2020, we believe lower iron ore markets could weigh on Fortescue."