What Is Priced into the Major Miners?

Market optimistically expects spot prices and capital restraint to continue to underpin high returns. We have been bearish on the resources space for a few years, and to date, our more pessimistic view has not played out. The Australian mining companies have performed very well in recent times, against our expectations. From lows in January 2016, the S&P/ASX 200 resources index has roughly doubled, as have the share prices of BHP and Rio Tinto. After plummeting 75% within two years, Fortescue's shares have subsequently tripled from 2016 lows. Based on our work on the sensitivity of our fair value estimates to commodity price changes, we estimate the market is factoring in current spot commodity prices in perpetuity, which we view as overly optimistic. Moreover, for Rio Tinto and BHP, this implies average unadjusted returns on invested capital of about 16% for our forecast period, nearly double our estimated cost of capital for those companies given their lack of moat. The market also discounts the potential for further bouts of capital misallocation. We continue to view shares as overvalued. At current share prices of about AUD 34 per share for BHP, AUD 85 for Rio Tinto, and AUD 4.70 for Fortescue, the shares trade at 48%, 77% and 27% premiums, respectively, to our fair value estimates.

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