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1 Metric You Need to Know Before Investing in Miners

Joshua Bondy
March 17, 2014

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.

Iron ore
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%. </