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Iron: Not Shiny or Slick, But a Hot Commodity

There’s a lot of talk these days about commodity stocks and their potential. The fashionable investment strategies seem to focus on gold — either physically via the SPDR Gold Trust ETF (NYSE:GLD), or via miners like Barrick Gold (NYSE:ABX) and Goldcorp (NYSE:GG) — or oil via majors like Exxon Mobil (NYSE:XOM) or small-cap energy service stocks like Hercules Offshore (NASDAQ:HERO).

But don’t count out other commodity stocks right now — particularly those that traffic in iron ore.

The big players in this space include focused mid-cap play Cliffs Natural Resources (NYSE:CLF) and diversified mining blue chips Vale (NYSE:VALE), BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO), among others.

So why iron?

  • It’s Highly Traded: The strong baseline demand for iron ore means the market is always humming for this commodity. About 2 billion metric tons will be mined in 2012, according to The Economist, and the size of the commodity market for iron ore is surpassed only by crude oil.
  • It’s in Everything: Iron and steel (which is really just iron with impurities removed) are ubiquitous. It’s used in skyscrapers, cars, dishwashers and everything in between. Roughly 95% of global metal production focuses on steel and iron.
  • It’s Not Just Baseline Demand: Consider the building boom in China and India alone as these emerging markets urbanize and more apartment buildings and commercial real estate are needed. More construction and more durable-goods sales abroad mean growing demand for years to come, even if the macroeconomic picture isn’t all that grand at present.
  • Inflation: By Ben Bernanke’s own admissions, central bank policies right now are designed to focus on maximum employment and support asset values … with inflation an afterthought, and a modest rate of inflation actually desirable. The same inflationary pressures that could drive up gold and oil will drive up iron ore prices, too.

Of course, the risks are obvious: As a base metal, iron is subject to the painfully cyclical nature of the global economy. Just as copper and aluminum prices have been soft and held back related stocks, major iron stocks have felt the pain of the global slowdown. Cliffs Natural Resources and Rio Tinto are both off more than 50% from the peak commodity prices of mid-2008, and all iron stocks are significantly in the red during the past six months vs. a tiny gain for the S&P 500.

But if you want to play commodity stocks and you have concern over overhyped gold or highly volatile crude oil, consider investing in iron ore.

The dividends are pretty plump, for starters. Vale’s payout is admittedly volatile and only comes by twice a year, but the stock is yielding more than 5% right now — plus, the dividend is very sustainable at a sub-40% payout ratio of earnings. And Cliffs recently nearly tripled its dividend, from 28 cents a quarter to 62.5 cents, giving it a nearly 7% yield — with a payout ratio that is significantly smaller than Vale!

Also, the negativity has been baked into valuations. That’s not to say that stocks can’t move sideways for a while if demand remains weak or we see another downturn, but it’s hard to imagine these stocks getting gutted again for the deep losses they’ve incurred over the last few years. Cliffs has a forward P/E of about 9, Vale is under 8 and RIO is under 7.

Lastly, the upside potential is pretty dramatic based on historical pricing. Consider this chart from The Economist. Iron ore prices have crashed in the past year or so but are showing signs of life. If and when demand picks up, it’s not unrealistic to think that iron ore producers could command prices 50% higher than they do now.

I suppose it’s possible oil could hit $150 a barrel or gold could hit $2,500 an ounce, too, in the near future. But sky-high iron ore is at least equally possible — if not more so.

I’m closely watching diversified miners like Vale and Rio for many reasons. I believe money will rotate into materials stocks sooner rather than later on hopes of a recovery in the next few years. After all, look at homebuilders — stocks like PulteGroup (NYSE:PHM) and Toll Brothers (NYSE:TOL) didn’t soar recently, after the recent talk about a housing recovery, but instead added the lion’s share of their gains steadily during the past 12 months as the picture has increasingly brightened.

You don’t want to wait for signs of a cyclical recovery to get into materials stocks, because it will be too late. And if you want to get into materials, there are few better commodity investments right now than iron ore.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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