How To Value Red Gold

–How do you find out what the best value mining stock in Australia is? You have to read the report that came across our desk this moring (in draft stage)about Rio Tinto (ASX:RIO) and BHP Billiton (ASX:BHP). It’s the third in a series of analytical reports prepared by our friend Greg Canavan that we’re calling the Sound Investments Series.

–Greg’s taking a value investor’s critical look at the Aussie market and revealing what you need to look for in each industry to find the best value. The first of his reports on the retail industry was published last week. Later today we’re going to publish the second report on banking. To view both reports and be notified directly when the other reports are published, go here and enter your e-mail address and follow the directions.

–Of course, if you don’t mind being a little late to the party, you can always just follow the Chinese money and buy what they’re buying. Yesterday’s big news was the $1.2 billion offer by Hong Kong-based Wah Nam for Brockman Resources (ASX:BRM) and FerrAus (ASX:FRS). The offer values Brockman at $923 million and FerrAus at $230 million. Both share prices jumped over 25% on the news. Iron ore (red gold) could be the new gold (gold gold).

–There are two things to take away from this news. First, it pays to be early. Brockman has graced the pages of Diggers and Drillers twice. The first time was in March of 2008 when it sported a cash-to-market cap ratio of 239% and was number two on our list of the most “cash greedy” resource stocks on the market (Cape Lambert Iron Ore was first at the time). The second time it featured was in February 2010, post-Lehman Brother collapse, when Dr. Cowie again went trawling for cashed up resource stocks.

–Cash isn’t automatically the balance sheet item you covet the most on a resource stock. Having a great resource base, or proven reserves is even better. But in a market where financing was hard to come by, companies that had the cash to ride out the market were in a strong position and benefitted.

–The second take away is that it pays to get the primary trend right. In the case of iron ore, you have two primary trends, if that’s possible (it’s probably not, but bear with us). The first primary trend is that China’s fixed asset investment (extremely metals intensive, especially steel) is growing. Bloomberg reports that urban fixed asset investment in China rose by 24.4% in the January-October period.

–Boom baby, boom.

–The second and more recent primary trend is something that was true in 2008 but neither urgent nor important. That truth? Rock is not paper. Neither is it scissors. Iron ore, a kind of rock, is growing in value relative to paper money issued by the State, which is declining in value relative to things which have to be mined and not printed.

–The Fed’s QEII moves have kicked off a low-level kind of capital flight out of U.S dollar assets and into emerging markets, including the iron ore stocks mentioned above. While this is welcome news in Australia for anyone who already owned those stocks, or is thinking of speculating soon, the capital flows are leading to big worries by the BRIICs countries.

–For example, outgoing Brazilian President Lula told reporters at the G-20 that the real problem is the developing economies aren’t consuming enough. Lula! (really the original but far more successful Obama!) said, “There is a visible contradiction: on one side we have the emerging economies, including Brazil, taking measures to increase their consumption; and on the other side, the rich countries, which are not consuming – they don’t want to buy, they only want to sell…If everyone sells, who is going to buy?”

–Lula added that the world is headed towards bankruptcy if the rich nations don’t increase consumption. He wants them to do what they’ve been doing for the last 50-years; spend their way to prosperity through debt-based consumption of goods exported by emerging market countries like Brazil.

–Perhaps Lula did not get the memo/e-mail/SMS/twitter: a lot of the so-called rich nations are already bankrupt, or about five minutes away by tram.

–He does have a point though. The Fed is effectively exporting inflation, as long as other countries try to match dollar devaluation with devaluation of their own currencies. Consider China, where consumer price inflation hit a 25-month high of 4.4% last month. The rising dollar prices of imports like copper and iron ore are gradually pushing up consumer prices and, probably, wage demands.

–In fact, Shanghai-traded copper is currently trading at a premium to copper traded on the London Metals Exchange. In Shanghai, a tonne of copper will cost you around $10,577/tonne. In London, it’ll set you back $8,966/tonne. Chinese copper consumption (derivative of fixed asset investment in commercial and residential real estate, which is arguably bubbleicious) is set to be 7.5 million tonnes this year, or 40% of total global demand.

–It tells you something when copper demand is so torrid China (quick, ditch the dollar as fast as you can!) that it’s cheaper to buy the metal in London and have it shipped to Shanghai than to buy it locally. But with industrial output growing by 13.1% a year, Chinese demand for copper has been pretty steady.

–Keep in mind that supply is creeping up as an issue. The strike at Chile’s Dona Ines de Collahuari mine—with 500,000 tonnes per year being 10% of Chilean production—is putting pressure on already thin copper inventories in warehouses. So Alex was right in January when he said copper was a steal at $7,365 a tonne.

–Incidentally we just got a note from the Dr. He’s in Africa again, checking up on of his copper recommendations. He’ll be back in Australia next week . You’ll hear all about his trip soon.

–In the meantime, commodities may have, through no fault of their own, been exposed to a counter attack. The beleaguered, Fed-weakened dollar is actually getting some relief from a weaker euro. The chart below shows that the Euro currency index is down sharply in the last few days. And though we are no chartist, the fact that the index is in danger of crossing its 50-day moving average (the blue line) does not look bullish.

–We were first alerted to the bearish euro action by our own in-house chartist Murray Dawes. He pointed out that sovereign debt woes in Europe were showing up again in the form of a blowout in Irish bond spreads. With Ireland back in crisis, the euro bulls are in danger of getting hulk-smashed.

–“Everything is correlated to the U.S. dollar at the moment,” Murray said when we ducked our head in his office to hear it directly. “Basically, if investors and traders think the Euro is stuffed, it’s bullish for the dollar and you get a rally in the dollar. This obviously has a direct affect on commodity prices and risk assets.”

–Murray, who was looking a little haggard (but who wouldn’t be when you deal in a world where Ben Bernanke forces us all to become short-term speculators) is translating the daily global action into daily local trading recommendations. He’s been very busy.

–He doesn’t trade every day, mind you. But with capital flows leading to whip-sawing movements in currency values and commodity values, we’re glad to have him in our corner looking at entry and exit points on blue chips. Stay tuned this weekend for a new video presentation on what Murray is up to lately.

–Several readers asked us if there were any plans for another “Doomer’s Ball” this year. In past years, we’ve invited readers to a casual night of drinks and finger food at a Melbourne venue to celebrate another year of reckoning and fellowship. We’re happy to organise something this year, but should probably do so quickly if there’s any interest, so folks can make plans. If you’re keen for a party, let us know at and we’ll proceed accordingly.

–And speaking of get togethers, the Gold Show got us to thinking that maybe it’s time for a big investment conference here in Australia. It’s one of our big goals for next year. And we’re already in discussions with possible presenters in Sydney. In fact a couple of them agreed in principle to the project, as long as we could deliver a rhyming couplet at the end of this week’s DR. Anon…

Go thee, noble yellow metal, to your higher highs
And expose in hardest fact the house of paper money lies

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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