BHP and Rio downgraded, but the sector still has upside, fund managers say

Commodity prices may have bottomed, but investors hoping the big miners shares' have further to rise are likely too late to the party, according to analysts and fund managers.

A day after Fortescue Metals Group chairman Andrew Forrest declared the mining downturn had bottomed at a National Press Club address, Citi joined fellow investment bank UBS in calling the top for the nation's biggest miners, downgrading BHP Billiton and Rio Tinto to "sell".

The ASX 200 Metals and Mining Index is up 42 per cent year to date, compared with the broader market which is up around 5 per cent. But UBS points out much of this rally can be attributed to a curb in supply rather that a lift in demand, and analysts led by Glyn Lawcock moved BHP and South32 to "neutral" and Whitehaven Coal to "sell".

The rally may be running out of steam, but it does not mean prices will tumble to the sort of levels seen in January, when BHP Billiton plumbed a 12 year intra-day low of $14.06.

Contango Asset Management chief investment officer George Boubouras said supply issues, particularly in energy and bulk commodities, will likely create a cap on the outperformance of local resources stocks. 

"Most people will have missed it [the rally], the probability of upgrades from current levels is limited. People will be looking to accumulate on any downside," he said. 

Contango increased its stake in BHP earlier this year but has sold out of the position in recent months. The fund also moved overweight in energy stocks including Oil Search and AWE during the first quarter. 

Citi analyst Clarke Wilkins said he expects the share prices in BHP Billiton and Rio Tinto to pull back "significantly" towards year's end and in early 2017 citing cooling demand from a pullback in Chinese stimulus. 

"With commodities the key driver of the stock performance outside company specific catalysts, where commodity prices go from here become critical for sector performance," he said. 

Mr Boubouras said the prospect for earnings to move much higher from here was limited. "Quite clearly BHP, Rio and Fortescue are making good profit at current prices," he said. "But what is the future profit? We don't see much scope for coking coal upgrades or upgrades from sustainable iron ore prices, given the supply dynamics," he said.

Other fund managers see much more upside for the sector. Garth Rossler, managing director of Maple-Brown Abbott said the firm was "pretty bullish" on resources stocks. 

"If the current commodity prices hold then I think you could see [share price] upgrades of 100 per cent in some cases in the sector," he said. 

Tribeca portfolio manager Ben Cleary also sees further upside for the sector. The long-short fund has sat long in the sector since the duration of the year, holding at a time when the sector was "unloved, unheld and cheap".

The upside is contingent on commodity prices holding, supported by inflationary pressures including a rise in production costs with oil doubling in price from its lows, the US dollar stabilising and rising service provider prices.   

"We don't think current spot prices of coking and thermal coal are sustainable but equally we don't seem them pulling back to the lows we saw earlier this year," he said.

"A profile similar to iron ore is more likely in our view where prices rallied then pulled back but held approximately 30 per cent above the lows." 

Shaw & Partners senior analyst Peter O'Connor described the nine month rally as a "once in a decade event".

"It is very much a flipside of what we had last year, which was a de-risking event." 

But the rate of outperformance will slow, he said. The slowing reflects a normalisation that reflects a lower growth around 2 to 3 per cent after the end of China's economic boom. 

October and November were also seasonally weak months for commodities, and the US election and December's US Federal Reserve meeting, where it is expected to lift interest rates, will also keep some investors on the sidelines. 

But with stocks posting new yearly highs and higher lows during sell offs, expect to see some buying on weakness, he said, although much of the exuberance of the past nine months is unlikely to continue. It was not too late to buy the likes of BHP, he said.

"Will we see BHP at $30? Absolutely. This quarter? Probably not," Mr O'Connor said.

The fundamentals on the biggest mining stocks on the S&P;/ASX 200 Index still showed value, he said, and Shaw & Partners has a "buy" rating on  BHP, Rio, OZ Minerals, Alumina and Iluka, citing value on price-to-net present value and price to book ratios. 

"Earnings across the board are moving higher, cash flows are moving higher … the sector is the most attractive financially in as long as I can remember in terms of leverage," he said, noting 17 of 25 big miners had no debt. 

"The companies that do have debt [including BHP and Fortescue] have a clear pathway to retire that debt," he said. 

However there are stocks that have been in the momentum trade, and Mr O'Connor has a "sell" rating on Whitehaven Coal, South 32, Fortescue Metals Group and Newcrest Mining.