The savvy yabby (or, how I “know” when to adjust iron ore exposures)

The iron ore futures price's pause for breath around US$100 dollars a tonne has left the market hunting for clues on the direction for the iron ore complex. The majors may well be finding their feet with support around the cost of entry, but the juniors in the complex likely have some rough sledding ahead of them. Here we apply the "cost of entry" signal described in our post "The role of sentiment in iron-ore stocks", to estimate where the typical investor is likely to have their break-even. These levels mark where "Get-Evenitis" is likely to set in.

The cost-basis signal on an individual stock estimates the average entry price for investors. When a stock is above that level the average investor has a paper profit. When the stock is below that level the average investor has a paper loss. These levels affect investor sentiment, and can easily overwhelm the valuation signal in the short to medium term. I use this approach to help me understand what other investors are likely thinking, and feeling, about their investments.

Whatever I may think of an investment, it is the crowd that sets prices. So, I pay close attention to how the crowd is travelling on their investments. If there is a falling price, but large unrealised paper gains, there is a temptation, at the margin, to sell and take profits. 

On the other hand, if there is a rising price, but large unrealised paper losses, then there is a temptation to hold back and wait for break-even, only then to sell and "get out even".

Cost-basis analysis, in the form I have developed it over the years, will not itself tell you exactly what to do. But it can help an investor stand back from their own situation and obtain an objective view on how other investors are likely responding to their own investments.

In my experience, the cost-basis signal is most useful are on the entry and exit from conditions of widespread positive sentiment (bull market), or negative sentiment (bear market). The tool can help us to better understand the whys and wherefores of market psychology.

To kick-off, let's reprise the grandad of this space BHP Group (ASX: BHP)

Last week, the cost basis was at $37.69, and it has now moved up $0.01 to $37.70 while the actual stock price fell to close on Friday 24-Sep-2021 at $37.72. The reason why the cost basis rose is that there was new trade at prices higher than the old cost-basis. 

Since we now sit at breakeven, and the negative news flow on falling iron ore prices has abated somewhat, we would expect BHP Group (ASX: BHP) to firm this week. It has other businesses that are doing well, such as oil and gas, and produces a lot of metallurgical coal, along with copper and nickel. Since there is no more profit to take, on average, some investors will likely step in and top-up holdings.

The story is different for the marginal producers such as Mount Gibson Iron (ASX: MGX).

This stock fell very sharply on falling iron ore, due to the higher marginal cost of production. The cost basis is significantly above the present price. A good rule of thumb for bear markets is that the selling pressure usually starts to abate at around a -40% unrealized loss. The ratio to apply is therefore 0.6x times cost basis. That figures, in this case, as current price is around 0.6 times $0.70, or $0.42. 

For students of technical analysis, you can see there is a big support level around here, and so we anticipate the stock will now consolidate. However, we should be careful as to renew a bull market trend the stock needs to break above $0.70, where it would likely encounter significant selling pressure. This is likely to be a slow workout.

For another junior in bear territory, we look at Deterra Royalties (ASX: DRR).

This is in marginal bear territory - but improving. Note that the stock price did not rise that much through high iron prices as it is an income stock related to mine royalties. One would need to go examine those royalty streams for sensitivity to iron ore prices, but it looks like that is actually low, on past form. This looks like a good one to pick up for yield. Fundamentals are key for a position like this, where it seems to have gotten caught up in the storm.

Moving along to our remaining bear stock let's look at Fenix Resources (ASX:FEX).

This is one of the newer generation high-grade Direct Ship Iron Ore (ASX: DSO) plays. You can see it is beaten up, with the 0.6 times multiple point being at around $0.18 (0.6 x 0.29). But the way up was steep and so is the way down. With a stock like this, which we don't own, we would take the opportunity to do some fundamentals homework, see if we want to own some, and then watch the order book to see where the buying interest is coming in.

For a brighter bull story, consider Champion Iron (ASX:CIA).

This is the Bloom Lake Canada mine restart. Look for investors to keep taking profits. You know the drill. Do your fundamental homework, see if you like the project. Take careful note of management reports on their cash cost, and sustaining cost. Compare that to the iron ore price and estimate margin. See if the earnings multiple implied by that looks favourable to the current cost basis estimate of $3.92. If it does, to you, then be patient and monitor the flow of orders in the limit order book to see if they are coming in positively to your thesis.

Finally, we have my personal favourite Grange Resources (ASX:GRR).

This screened up as one of the better value stocks in our universe. You can see that we are a long way from a cost basis, so we may have a bargain opportunity in the offing. This setup is the reason I named the indicator I used "the savvy yabby". It lies in wait for tasty morsels.

Let us see what happens.

Remember to always seek independent advice, to diversify your portfolios, to seek counsel if you feel disoriented by market conditions, and to pay close attention to managing the risk of permanent loss of capital by spreading bets to favor firms with strong balance sheets, while allocating that capital you can afford to lose entirely to the more speculative bets.

Disclosure: the author owns shares in BHP Group.

If you like this approach to markets please follow me.

(Image Credit: Photo by Victor on Unsplash)

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