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Many investors might be surprised to learn that they are materially underweight BHP. It now accounts for over 11.3% of the S&P/ASX 200 index – by far Australia’s largest company. It is more than 50% bigger than the Commonwealth Bank and five times the size of competitor Rio.
BHP’s surge in weighting is a function of the recent unification of the Australian company with the separately listed UK company. Effectively, the former UK entity is now included in the Australian share market indices. But it is also a function of BHP’s increase in share price – the higher it goes compared to the rest of the market, the higher the weighting.
There is nothing wrong with being “underweight” BHP. It is a perfectly reasonable position to take if you want to limit your exposure to the resources sector, or believe that Rio or Fortescue or one of the other miners will perform better. However, when a stock is so big, underweight or overweight positions increase the risk of portfolio underperformance (or outperformance). That’s why many institutional funds have been buying BHP to get closer to market weight – in the competitive investment management game, the business risk of underperformance is too big for some.
Outside its index position, there are many reasons to like BHP. Firstly, it has world-class mining assets and is a low-cost producer of iron ore, copper and metallurgical coal. It now claims to be the lowest-cost producer of iron ore of any of the major miners.
The surge in commodity prices fuelled by the demand from global economic growth is going straight to its bottom line. In the first half, BHP reported record earnings with EBITDA up 33% to US$18.5bn and NPAT up 77% to US$9.7bn. This translated to a ROCE (return on capital employed) of 42.9%.
It is re-investing in two commodities it believes will be part of the low carbon future – nickel and potash (the latter used in fertilizers).
BHP’s offshore oil assets will shortly be ‘demerged’ into Woodside, with BHP shareholders receiving Woodside shares and owning 48% of the entity. When the transaction completes in late June, BHP shareholders will receive approximately 178 shares in Woodside for every one thousand shares they own in BHP. Using Friday’s closing prices implies that the value of the demerged assets is about 11.2% of BHP or $5.60 per share.
For shareholders, the rewards have been phenomenal. On 28 March it will pay an interim dividend of $2.08 per share, fully franked, putting it on a prospective yield of 7.7% for this financial year.
Looking at what could go wrong for BHP, apart from a fall in commodity prices or mining accident, another major ‘risk’ is that BHP makes a major acquisition. I am being a little facetious because mines are wasting assets and mining companies need to replenish their reserves. However, the big miners have a history of embarking on major acquisitions at the “top of the cycle” – so any acquisition would need to be carefully reviewed. And certainly, BHP can make one because gearing is down to just 3% and net debt is only US$6bn.
The major brokers are cautious on BHP seeing it as fully valued. According to FNArena, the consensus target price is $45.94, some 8% lower than where it closed on Friday. The range is a low of $42.00 through to a high of $53.00.
While this position shouldn’t be discounted, care is required when interpreting broker valuations of miners because so much of the valuation is determined by the broker’s long-range forecast of commodity prices. The brokers are understandably cautious on this – with most working on a long term assumption of the iron ore price being about US$80 to US$90 per tonne, well below the current spot price of over US$140 per tonne. Further, two of the major brokers are on ‘research restrictions’.
The table below shows target prices and recommendations.
In terms of forecasts, the brokers have BHP trading of a price-earnings multiple of 9.9 times FY22 earnings and 13.5 times forecast FY23 earnings. Next year’s dividend is forecast to drop, putting BHP on a prospective yield of 5.5%.
I am not advocating that you rush out and buy BHP today. I liked it when it was trading in the high thirties back in October – to buy it now at $50.00 is a reasonable call.
But I am advocating that if you are underweight the stock, you look to take action in the short to medium term to bring your position closer to market weight. I think there are big risks in being underweight.
All prices and analysis at 07 March 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.