The best of the iron ore stocks

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Brokers are often thought to be a bit optimistic because they rarely have a ‘sell’ on a stock. So, in my opinion, if the collective wisdom – or consensus view – of brokers is weak for a particular company, there is little point in investing in it. That does not mean any good consensus view will turn out to be good – but it does mean that the brokers are not aware of any problems with the company or its market.

Iron ore options

Investors can access Reuter’s broker survey results here, and then type in a stock code, then click the appropriate stock name, and then the ‘analysts’ tab. The table on that site looked like that below for each of four iron ore stocks (RIO is slightly diversified outside of iron ore) (I repeated the exercise four times and displayed the data differently to aid comparison).

Table 1: Reuter’s survey results of broker forecasts for four stocks on 7th April 2014

Source: Reuters

The column headed ‘Current’ contains the latest data and for RIO it shows that there were 16 brokers (=3+9+4) in the survey: three said ‘buy’ (1 point), nine said ‘outperform’ (2 points), four said ‘hold’ (3 points) and there were no underperforms or sells. The average score (3×1 + 9×2 + 4×3 + 0x4 + 0x5)/16 = 2.06 is a very strong consensus result.

But not all consensus recommendations are the same. A similar score of 2.06 could have been achieved with a different distribution of ratings. For example, by changing one of the ‘holds’ to a ‘buy’ and another to a sell gives the same mean rating but I would be more concerned with the presence of a ‘sell’.

By looking at the ‘1 Month Ago’ column for RIO, I can see that there has been no recent change in the ratings. But ‘2 Months Ago’ I can see that one analyst has since joined the coverage but, more importantly, two analysts have downgraded their strong ‘buys’. If we compare the two month and three month ago columns, there was an upgrade to a ‘buy’, so I do not find these more recent changes to the data to be a significant problem. RIO looks like a well-backed stock.

Although all four stocks have their stock prices heavily influenced by the same iron ore price, the cost structure and diversification of mines are quite different. While Fortescue’s rating at 2.19 is not much different from RIO’s 2.06, the recommendation histories are quite different. In particular, two analysts have an ‘underperform’ on the stock and one once had a ‘sell’. That would rule out Fortescue for me when compared to RIO. The other two stocks clearly have inferior ratings.

In the case of Mount Gibson, some are calling into question the longevity of its mining strategy. Atlas and Mount Gibson are not in the top 100 so they didn’t make the watch-list I worked through in my previous posting a fortnight ago. So RIO is the standout from these four for me.

Portfolio update

With a small universe of stocks – which I strongly advocated in my previous posting – the task of reviewing these ratings is not arduous. Since I have an automated system (for which I pay a lot!) I check my ratings and various other statistics first thing each day. I would need a good reason to buy a stock for the first time if it has a rating of 3.0 or bigger (recall bigger is a worse rating).

When a stock’s recommendation climbs above 3, I monitor it closely. I might sell or I might choose to hang on for a while, depending on how it fits in my portfolio. For example, I have held CBA for some time and its recommendation slipped above 3. However, I believe that slip to be due to its stock price rather than any inherent problem. Since it is a long-run dividend play in my SMSF, I continue to hold on.

These ratings have played a central role in my portfolio construction methodology since I started creating portfolios for clients (and myself!) a few years ago.

I have updated my watch-list portfolio from two weeks ago by including the latest recommendations in Table 2. One should not expect much change in the consensus recommendation in a two-week period but it can be noted from Table 2 that some did.

Table 2: Updated broker recommendations for the watch-list

Source: Thomson-Reuters Datastream

Goodman Group (GMG) is the standout improver with a very promising 1.50 rating. But I find any stock that has improved by, say, -0.4 or -0.5, very worth looking into further. On the downside, NAB took a beating and drops out of the watch-list for now with a reading of 3.31 and GPT goes with it.

Of course, there are countless news articles on current hot picks. I avoid most of them because I don’t feel the need for more information that is readily available from Thomson Reuters. And I don’t want to deviate from the rigour of my personal strategy. However, if I were holding NAB or GPT I would seek out analyst’s reasoning for the changes to determine whether I should sell or hold. Equally I would want to follow up Goodman Group’s story. After all, it is my life savings that go into my portfolio and so I will not follow any metric blindly.

And finally, it is so important to select stocks that fit together – in that they help diversify risk. Since to me Fortescue is more or less a smaller version of RIO, I have two reasons to exclude Fortescue – size and rating. In due course, the relative strength of the two recommendations might reverse so it is perhaps wise to keep Fortescue in my watch-list even though it isn’t (and hasn’t been) in my portfolio. I have always held some exposure to RIO.

In a fortnight’s time, I will discuss managing expectations for different styles of portfolios, such as yield and index-tracking

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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