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Vale, China And Iron Ore: A Recipe for Long-Term Success

Saturday - 11/24/2012, 10:19am  ET

Vale  has been on my radar for several reasons lately. First, Vale produces iron ore and fertilizer products, thus it is an economically sensitive company. Second, iron ore is used primarily for making steel products used in construction and manufacturing. Since China is a major consumer of steel, and demand from that country has recently weakened, investors have become concerned over whether or not Vale can offer any real gains for its investors heading into 2013. Should we be concerned?

One big question is whether or not the weakness in demand from China will last as its population continues to expand. China’s slowing economy has hurt mining companies. The country recently took major steps to improve its economic growth and made it clear that economic growth is the number one concern. The country recently introduced a series of stimulus packages aimed at increasing economic growth. A massive stimulus program was announced near the end of the summer. A large part of this stimulus is concerned with investing in infrastructure, which requires massive amounts of iron ore and steel produced by Vale.

Meanwhile, Brazil has slashed interest rates to 7.25%, a record low. Rates were at 10.5% earlier this year when the government began cutting rates to boost economic growth.  As we go forward, I anticipate the Brazilian economy will start to see positive results from these rate cuts, and Vale will benefit directly from this. Over the next several quarters, the effects of the rate cut could start to positively impact the Brazilian economy.  Not only will borrowing be cheaper, but as the low rates increase demand across sectors in Brazil, Vale will be in a good position to grow.

Vale looks undervalued at current price levels. Vale currently has a price to earnings ratio of just under 8, but Vale also pays a dividend yield of 3.60%, which is significantly above average. The stock is trading at just above $17, which is slightly above its 52-week low of almost $16. I believe that much of this low price is due to unease over the slowdown in the world economy.  

One concern I have in the short-term is high inventory problems. Rio Tinto , a major producer of iron ore, is not slowing production even during a time of low iron ore prices.  While this is a good sign looking forward to the future, as it indicates confidence in the global economy and the belief that demand will pick up, it can be bad for Vale in the short-term. There is a supply imbalance right now that continues to put downward pressure on iron ore prices.  In the short-term, because of this imbalance, Vale might see short-term declines. However, positive news that should drive confidence in iron ore prices in the short-term is BHP Billiton’s  announcement that it is dumping iron ore expansion plans.  Had BHP continued with these expansion plans, iron ore prices would have declined further due to oversupply.

The average stock in the S&P 500 Index trades for about 13 times earnings, while Vale trades at less than 8. I expect Vale will see strong gains in the future. Some investors have been concerned by ongoing tax disputes which are specific to Vale, but this issue is overblown and will not have much impact on the company going forward. 

Looking at the mining sector as a whole, Vale is a very good buy. I believe there is far more value in Vale’s share price than in Rio Tinto or BHP Billiton. Companies invested heavily in coal, like Teck Resources (TCK) are also suffering from declining prices. But there is not the same level of confidence that coal prices are going to see a significant increase like there is surrounding iron ore prices. Similarly, mining companies invested heavily in copper are not going to see the type of demand for copper as we will see for iron ore. Freeport-McMoRan  will see some good growth going forward as I expect copper prices to rebound somewhat.  But copper does not mirror global growth in the way iron ore does. As the Chinese economy is expected to heat up, iron ore is going to see very significant increases; these increases will far outpace those of copper. For this reason I recommend investing in Vale before investing in companies like Freeport-McMoRan.

This article was originally published as Vale, China And Iron Ore: A Recipe for Long-Term Successon Fool.com

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