Brave investors should consider mining and metals again

After years of losses and share declines, base metals producers may have reached rock bottom and be poised for a rebound

Workers at a metal smelting plant

Steel will be oversupplied for years, but copper and nickel are another story. (ImagineChina/Corbis)

To say the mining industry has had a bad couple of years would be an understatement. Since January 2013, the S&P Global 1200 diversified metals and mining index has fallen 57%. It’s not hard to pinpoint the cause: China’s economic slowdown has dragged demand well below the supply for base metals. Prices are now beneath the cost of production at many mines, and cumulative losses are piling up.

Nonetheless, the drop in share prices has been so severe and so prolonged that a few financial firms believe now’s a good time to get back into industrial metals. On Oct. 7, Morgan Stanley released a report saying the worst is over, and it put an Attractive rating back on the sector.

It’s a contrarian idea, to be sure. But the question now is not whether the market will rebound but when, says Matthew Miller, an equity analyst with S&P Capital IQ. “It’s an industry that’s hugely out of favour based on short-term fundamentals,” he says. “It’s going to improve in the future.”

One cause for optimism is global economic growth. The International Monetary Fund projects global real GDP growth of 3.6% in 2016 and 3.9% the year after, which will help eat into the oversupply. At the same time, major suppliers are cutting back their output. Glencore PLC (LSE: GLEN), for example, announced in October that it would slash its zinc production by a third. The surplus supply of copper, about 300,000 tonnes this year, should shrink to around 100,000 tonnes in 2016 and become a shortfall in 2017, says Miller.

While it may still be a while before producers’ stocks see gains, Steve Land, a portfolio manager with Franklin Equity Group, says they’re coming. The supply picture has already been factored into share prices, though uncertainty around demand is still keeping stocks depressed.

Long term, though, demand looks robust, says Land. China’s move from an export economy to a domestic-focused one will still require commodity inputs, even as a tapering of infrastructure spending weighs down coal and iron ore. Globally, the markets for copper and nickel look attractive; the former will find its way into a host of electronics, buildings and water grids, while the latter is used in stainless steel, a key input for the still growing aerospace, automotive and home building industries.

When buying companies, look at the end user, advises Miller. Companies that sell to consumer-driven industries, such as auto and aerospace, will experience increasing demand. As well, be mindful of debt. Many of these firms overspent on past projects. The ones with extended balance sheets will have the hardest time recovering. Avoid companies that have more than 3.5 times net debt to EBITDA, says Miller.

Large, diversified operations, such as BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE: RIO), are also appealing; companies exposed to coal and iron ore, less so. These steel­making inputs still have years to go before demand catches up to supply.

As with any turnaround play, investors will have to be patient. Wait too long to get back in, though, and you could miss the initial easy-money upswing. “Things can happen quickly,” says Land. “The same way China has caught the market by surprise over the past two years on the downside, it could accelerate quicker than people think.”