Have you ever heard of the Herfindahl–Hirschman Index (HHI)? A concentrated industry has a high HHI and is more likely to be an oligopoly. In this case what is bad for consumers is good for investors. A high HHI means more stable pricing, more resilience during a downturn, and higher margins -- ingredients for a good long-term investment.
Over the past 10 years, BHP Billiton's (NYSE: BHP ) segmented EBIT margin has taken big swings. While copper's EBIT margin was higher than iron ore's EBIT margin for a period, since 2008 iron ore has consistently been superior. Its EBIT margin has stayed far above 50% for the majority of the past decade, while its aluminum, manganese, and nickel segment's EBIT margin has plummeted far below 25%.
The HHI helps explain these trends. Iron ore has a higher HHI than aluminum, manganese, nickel, and copper. This high degree of concentration lets BHP Billiton use the seaborne iron ore trade to stabilize the company and generate big profits.
The other side of the HHI coin
Investing in a miner in a high-HHI industry is a great first step, but you must make sure that you are on the right side of the market. Molycorp (NYSE: MCP ) mines rare earth metals, one of the most concentrated industries in the world. The problem is that Molycorp is a relativity small miner with a $1.2 billion market cap, and China owns the majority of the world's rare-earth metals.
Reports from January show that China boosted its rare-earth exports by 161.8% year over year. China's export boom helped send Molycorp's quarterly margin plummeting to its recent level of -156.2%. With a total debt-to-equity ratio of slightly more than 1, Molycorp is stuck between a rock and a very hard place.
Seaborne iron ore and market share
Taking an industry's HHI together with a company's market share gives a clearer idea of pricing power and margin stability. In 2012 BHP Billiton's market share in the seaborne iron ore trade was 16.9%, while Vale (NYSE: VALE ) controlled 25% and Rio Tinto (NYSE: RIO ) had 17.9%.
All three companies have very similar EBITDA margins. BHP Billiton's iron ore EBITDA margin in the first half of fiscal 2013 was 61.4%, Rio Tinto's 2013 adjusted EBITDA margin was 67.1%, and Vale's 2013 adjusted EBITDA iron ore margin was 61.2%.
The biggest difference between these companies is their degree of diversification. Vale is the most exposed to iron ore with it directly accounting for 58.6% of 2013 net operating revenue; Rio Tinto comes in second with iron ore accounting for 47.6% of 2013 revenue; and BHP Billiton comes in third with iron ore accounting for 32.4% of the first half of fiscal 2013's revenue.
Diversification is still important
If you want steady long-term returns, then diversification is a critical part of the puzzle. Even the best and most secure markets can be hurt by unforeseen instabilities.
BHP Billiton's decision to make iron ore around one-third of its revenue helps to stabilize its dividend and overall return. The iron ore market is concentrated and especially resilient, but it can still go through a downturn. A downturn could help BHP Billiton in the long run, as it would help push out high-cost marginal suppliers.
Molycorp's recent losses make it even clearer that maintaining a degree of diversification is critically important for any miner. If you are looking for a stable investment, then BHP Billiton is a good option. If you are looking for more exposure to a highly controlled industry, then Vale or Rio Tinto are better options.
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