The Investment Column: There are still good reasons to bet against a meltdown in mining

Click to follow

China's industrial revolution and continued robust economic growth in the West combined to keep demand for commodities at record levels in 2005. Commodities prices, then, were at multi-decade highs and the mining sector was the stock market's best performer. Even the diversified giants such as Anglo American, BHP Billiton and Rio Tinto - each now worth over £25bn - managed spritely share price rises in excess of 50 per cent, and there was even a Kazakh copper mining company in the FTSE 100 by the end of the year.

Heady times, then, but what of 2006? Surely this will be the year that commodities prices finally come off the boil and, even if they don't, creeping cost pressures across the mining industry conspire to dent profits and share prices.

It is still worth betting against this armageddon scenario, for a number of important reasons.

Global stockpiles of metals and minerals continue to be at historic lows. There is no reason to expect a sharp slowdown in China and every reason to think that infrastructure investment in other emerging markets - particularly India and eastern Europe - might accelerate in 2006, further fuelling demand. Meanwhile, because cash returns to shareholders were boosted so much last year, investment in new mines continues at a level that seems unlikely to match rising demand from these global economic powerhouses.

Also, most analysts factor in much lower commodities prices than currently prevail when setting estimates for mining company profits this year and beyond, so the year is set to be characterised again by above-forecast results and increased dividends. This gives the leeway that will be necessary to companies faced with undeniable wage inflation and the shortages of plant and equipment that have been driving up the costs of extraction.

There are six mining stocks in the FTSE 100 now, and all of them were chased higher by optimistic investors yesterday. The best performer was the newest addition, Kazakhmys, which is one of The Independent's tips for 2006. It mines copper in Kazakhstan, a former Soviet republic sandwiched between Russia and China and with an increasingly prominent role in supplying the region with commodities. The stock was underpriced at flotation and there are plans to dramatically increased production.

Xstrata has the advantage of a big exposure to coal, which looks set to be a lucrative product this year, but it also harbours ambitions to turn itself into a major global player through acquisitions and might bid too much. On balance, it is a hold, as is Antofagasta, a Chilean copper miner which could succumb to a takeover bid this year.

Of the big three, Anglo American is the most expensive on a multiple of projected earnings but does have a higher dividend than Rio Tinto, and could outperform. Our favourite of the trio is BHP Billiton, which has the most diverse portfolio of assets and is the only one with oil and gas exposure. Buy.

Seek out exploration companies that are poised to start producing

Ask any mining sector specialist in the City if 2006 will be another great year for the little exploration companies which have flocked to AIM, or whether it will be the year when the chickens finally come home to roost and you will get the same answer: both.

Many of the exploration companies floated in the wake of the commodities boom since 2002 will find themselves out of cash this year and those who have little progress to show will not be refinanced. While mining never matched the dot.coms as an investment mania, last year's scandals dented enthusiasm and it must be likely that this year's fad will be elsewhere, perhaps in biotech.

Investors should keep an eagle eye on the notices of director share sales, particularly in the spring, when directors' lock-ins are most likely to expire. Follow any who head for the exits.

As for what to buy, investors should look for companies with projects moving into a production phase this year or next. Griffin Mining, which has been patiently preparing its mining project in Caijiaying in China for seven years, is now producing zinc there and working out what gold prospects it is also sitting on. It could perform well again in 2006. And we like a recent flotation, Titanium Resources, which is reopening an old rutile mine in Sierra Leone.

For gold bugs, Peter Hambro Mining will be an attractive play on a gold price that is climbing because of fears over inflation and because of investment by Middle Eastern families flush with oil money.

It goes without saying that small mining companies are among the riskiest punts on the stock market, but some are more risky than others. For those with money to punt, one final tip is Metals Exploration, which is attracting comment in the City for its gold exploration work in the Philippines.