Billionaire David Einhorn's Investor Letter: Short Iron Ore

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Why Einhorn hates the iron ore industry. Billionaire David Einhorn and his hedge fund Greenlight Capital underperformed the broader market in 2012, posting a 2012 total net return of 7.9% (check out the top performing hedge funds). Now Einhorn is gearing up for 2013 and per his 4Q letter to investors, one of his investment ideas continues to be short the iron ore industry. 

So will the bet be fruitful? Since inception in 1996, Greenlight has managed to return an annualized 19.4% net of fees, so at least digging into this thesis is worthwhile. So what are the best ways to bet against the iron ore industry?

Einhorn said this in his letter concerning his 'short iron' thesis...

Our bearish thesis on iron ore is new, and we have shorted a number of stocks in the sector. Our view is that after a decade-long bull market, supply is now exceeding demand. On the supply side, the miners have spent billions preparing to expand supply, which is poised to grow about 15% in each of the next couple of years. At the same time, iron ore is used to make steel, and global demand for steel is currently growing at just a couple percent per year. 

The major iron ore producers includes BHP Billiton (NYSE: BHP), Vale (NYSE: VALE) and Rio Tinto (NYSE: RIO) are all heavily exposed to the iron industry which is heavily dependent on the broader economy. Other stocks to avoid, assuming you agree with Einhorn, include U.S. Steel (NYSE: X) and Cliff Natural Resources (NYSE: CLF)Worth noting, it was reported that Einhorn was short U.S. Steel 'off and on' in 2012.

These iron ore companies also face a number of other risks related to geopolitical and nationalism concerns, government regulations, natural disasters and currency fluctuations. 

BHP Billiton upped its exposure to the iron industry late last year by selling off its diamond business. Vale has guided toward negative production volume growth in 2013, which is in large part due to demand decline in Brazil. Vale also faces significant fluctuations in currency prices and is feeling pressures from depreciation of the Brazilian Real relative to the U.S. dollar. 

At the Sohn London Investment Conference, famed short seller Jim Chanos (check out his profile) also targeted Vale as an overvalued stock, calling the company a 'value trap'. He went even further to say that the iron industry itself is overvalued. Chanos argued that Vale is too dependent on China’s demand for iron ore, where demand will likely slow due to construction of their own iron ore plants. 

Rio Tinto has been struggling of late, with large write-downs that have strained earnings. The recent write-down includes $14 billion, $3 billion for Coal Mozambique and $10 billion for its aluminum assets. 

Two companies with a large short interest already include: 

<table> <tbody> <tr> <td colspan="1" rowspan="1"> </td> <td colspan="1" rowspan="1"><strong>Short Interest (% of float)</strong></td> </tr> <tr> <td colspan="1" rowspan="1">Cliff Natural Resources</td> <td colspan="1" rowspan="1">18.90%</td> </tr> <tr> <td colspan="1" rowspan="1">U.S. Steel</td> <td colspan="1" rowspan="1">25%</td> </tr> </tbody> </table>
 
The big issue for U.S. Steel, well two big issues, one being they have fixed iron ore costs. Thus, as iron ore price fall, U.S. Steel doesn't necessarily benefit, rather competitors get a competitive advantage. The other big issue for U.S. Steel is their underfunded pension liability. The under funding has been said to be upwards of $5 billion, which is about 1.5 times the company's market cap. 
 
Recently quarterly results for Cliffs may rule it out as a short candidate, for now, since the stock plunged over 20% on the news. Cliffs posted fourth quarter results that showed EPS (excluding one time charges) of $0.62, compared to a $1.30 gain for the same quarter last year. Other big news was that Cliffs was cutting its quarterly dividend by 76% to $0.15 per share from the previous $0.625 per share.
 
Don't be fooled. With Einhorn shorting the iron ore markets, should investors? It definitely appears that there might be good reason to. All three of the major iron producers outlined above face economic and industry headwinds, so a potential short on one of these stocks might be worth considering. Vale has an incalculable PEG given its expected five year earnings are expected to decline 18% annually, where BHP and U.S. Steel have a PEG ratio above 2.5 (see Einhorn's newest picks).
 
<table> <tbody> <tr> <td> </td> <td><strong>Price to Earnings to Growth</strong></td> </tr> <tr> <td>BHP</td> <td>2.6</td> </tr> <tr> <td>Vale</td> <td>n/a</td> </tr> <tr> <td>Rio Tinto</td> <td>1.3</td> </tr> <tr> <td>U.S. Steel</td> <td>2.9</td> </tr> <tr> <td>Cliff Natural</td> <td>1.77</td> </tr> </tbody> </table>

 See what else we found in Einhorn's letter: Part 1 (saviors of 2012), Part 2 (big bets for 2013), Part 3: (Marvell Technology) Part 4 (Computer Sciences). 


mhargra has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus