After fleeing in 2008, investors return to red hot mining shares

Red hot mining shares are set to keep outpacing other sectors as the top beneficiaries of a growing belief that the global recession will be short.

LONDON (Reuters)  - 

Mining shares have turned red hot this year after a disastrous 2008 and are set to keep outpacing other sectors as the top beneficiaries of growing optimism that a global recession will be shorter than feared.

Signs of a recovery in China -- one of the top consumers of raw materials in the world, emerging appetite for risky assets and resilient metal prices have prompted investors to jump on the mining bandwagon this year.

But analysts advise caution and suggest not picking up the shares of small exploration companies, preferring large diversified basic resources groups.

"The recovery in risk appetite has been associated with a belief that the worst of the recession is over," said Andrew Bell, head of research at Rensburg Sheppards.

"But this is still an economically risky environment and not a time to concentrate your portfolio in small exploration stocks. You are still in an environment where diversification, financial strength and access to finance are going to work."

The DJ STOXX European basic resources index has topped the gainers list this year by jumping 44 percent, an impressive performance especially after its 65 percent plunge in 2008, when it was the worst performing sector.

In contrast, the DJ STOXX European utilities index and the telecom index are down 10 percent and 9 percent respectively in 2009, while banks, the best sector this year after mining, are up about 24 percent.

Rio Tinto, Eurasian Natural Resources and Xstrata have almost doubled this year, Lonmin has jumped 63 percent, Antofagasta has climbed 47 percent and BHP Billiton has gained 16 percent.

Part of the rebound in the sector is linked to a recovery in key metals prices. Copper, which fell 54 percent in 2008, has gained 48 percent this year, though it is still 49 percent lower from a peak in mid-2008. Zinc, platinum and nickel are up 26, 23 and 10 percent respectively so far in 2009.

"High above the raging torrent of recession, metals have benefited from a number of bridges across troubled water, enabling them to steal the show," Royal Bank of Scotland said in a recent note.

RBS said the "bridges" included monetary and fiscal stimulus by governments, hefty supply cutbacks and 'cash-for-clunkers' schemes boosting auto sales. Relatively new investment vehicles such as exchange traded funds and more interest from hedge funds also helped miners to soar, analysts said.

Investors are now willing to pay a premium for miners: the basic resources index trades at 16.2 times one-year forward earnings, according to Thomson Reuters data, 41 percent more than the broader market.

CHINA FACTOR

Analysts said metals prices are likely to remain underpinned by new infrastructure projects in countries like China, although any setback to the Chinese economy could hurt the sector badly.

The economy appears to be gaining momentum, with the China Purchasing Managers' Index rising to a nine-month high in April. Another survey pointed to a recovery in Chinese manufacturing.

"If demand picks up, particularly from resource-intensive countries like China, then we are going to find that prices of metals go up," said Peter Dixon, economist at Commerzbank.

"And as long as they rise at a faster pace than the production cost, this is positive news for corporate margins."

Analysts said the sector could prove to be a good pick over the next 12 months and advised that it is the time to move away from 'expensive defensives' to 'cheap cyclical stocks'.

Improved price and demand outlook for metals would encourage companies having idle mining capacities to raise output.

Rio Tinto is seen as a substantial gainer from a rise in metals demand as it has got idle capacities in iron ore and aluminium, analysts said, but added its planned $19.5 billion tie-up with China's Chinalco could force some investors to remain cautious.

Investors have speculated that Rio might have to amend the deal after its shares climbed above the conversion price on the first of two tranches of convertible notes that would be issued to Chinalco under the deal agreed in February.

FOCUS ON DIVERSIFIED FIRMS

Analysts remained in favour of large, diversified companies and said that aggressive measures taken by miners to tackle the financial crisis by cutting jobs, scaling down production and restructuring operations have raised investor confidence.

"I am optimistic. I think that the sector will be a good pick in the next 12 months. But I hesitate to recommend the small, illiquid companies with very large family holdings," said Iain Armstrong, analyst at Brewin Dolphin.

Two top picks are sector leaders BHP and Rio.

BHP's world class assets and its strong balance sheet should also be positive, analysts said, adding Rio's iron ore business has growth potential and most of its operations are in countries with lower geopolitical risk.

Barclays, along with a number investment banks, is positive on the sector, with an upgrade on Rio and Kazakhmys and rising its target price for major miners by 8-48 percent.

"While we expect mining shares to be volatile and the sector to have occasional pullbacks, we recommend that investors increase their exposure to the mining sector in general," said Christopher LaFemina, an analyst at Barclays Capital. (Editing by Jon Loades-Carter)

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