Put Away The Shovel

Put away that shovel. Mining stocks are getting hurt as investors anticipate a profit squeeze between rising investment costs and falling commodities prices.

The DJ Basic Resources STOXX index, which includes some of the world's main metals companies, including BHP Billiton and Rio Tinto, is down 26% in the past three months. That has left commodities companies trading at historically low multiples of expected earnings, suggesting either the shares are undervalued or investors believe miners' run of profit growth can't continue.

The latter looks most likely.

Even if commodities prices don't fall further, rising costs could be enough to squeeze profit margins and slow earnings growth -- even if the volumes shipped by the biggest companies continue to rise.

The latest interim results from BHP, run by Marius Kloppers, showed signs of the pressure. Operating margins were two percentage points lower at its Escondida copper mine in Chile compared with last year, and BHP saw deterioration of nine percentage points at its Olympic Dam copper and uranium mine in Australia.

Rival Rio Tinto, facing a takeover bid by BHP, also demonstrates how cost pressures are affecting capital investment. Inflation alone accounted for about half of the increase in its capital spending from 2003 through 2006, according to Lehman Brothers. Since then, Rio Tinto is likely to have found it is getting even less from its capital-expenditure dollars. Its capital spending was $5 billion in 2007, up 25% from 2006.

The rising cost of fuel, transport and equipment as well as hiring and retaining engineers explain the squeeze on miners' margins in some areas.

Miners can't expect higher commodities prices to come to the rescue, either, as consumption slows. Sector consolidation ought to offer safety from a price war or overinvestment. But this strategy, born during the boom, has yet to be tested in a downturn. Forcing more price rises on weakened customers looks unsustainable.

Goldman Sachs reckons half the world economy is in or facing recession. Even China might not spend so heavily on infrastructure in the short term. Some see a post-Olympics slowdown, if not a pause, resulting in the reduction of metal inventories.

With investors able to invest directly in commodities through exchange-traded funds and other vehicles, they don't have to dig into mining companies themselves to retain long-term exposure to metals. Mining stocks now trade on an average of around seven times bullish 2009 earnings estimates, compared with more than 12 times forward earnings at points in the recent past.

The sector looks cheap. But given the potential margin squeeze, only deceptively so.

Those Who Hesitated Have Lost Even More

A year into the credit crunch, banks should have learned a lesson: It pays to be first.

The small number of financial firms that acted early to repair balance sheets must be glad they bit the bullet when they did. It was easier and cheaper to raise equity capital in the early phases of the crisis. In January, when Citigroup raised $12.5 billion from selling convertible preferred shares, its stock was just shy of $25. At Monday's closing price of $17.61, shareholders would potentially face far heavier dilution.

Firms jettisoning troubled mortgage assets today would likely get worse prices than at any time in the crisis. Bonds backed by Alt-A mortgages and jumbo prime mortgages are trading at record lows, according to Credit Suisse, while subprime loans are only slightly above their mid-July trough.

E*Trade Financial looks lucky to have unloaded $3 billion of toxic mortgage assets to hedge fund Citadel in November. Market participants were aghast at the $800 million Citadel paid, because it implied a hefty 75% write-down. But a fire-sale discount today could be even larger.

Admittedly, firms that were quick to take bold steps did so because they had to. Others should have taken the cue from their sicker brethren. In fact, in today's markets, even hitting the wall first could end up being an advantage. Bear Stearns's shareholders should now feel lucky they got $10 a share, as should debt investors who were made whole.

Today, shareholders might get nothing. The Fed is open to the idea of structuring investment-bank bailouts so that shareholders get wiped out completely, according to a speech Friday by Chairman Ben Bernanke. And debt holders might also have to take losses.

It isn't too late to act.