Jun 26, 2009, 5:54 p.m. EST

Canada miners could get bulldozed if China stalls

By Ryan Williams, MarketWatch

NEW YORK (MarketWatch) -- Canadian mining shares, which have made a steep run this year, look vulnerable to another correction, with analysts saying the stocks have run ahead of fundamentals, especially if China doesn't deliver an expected jolt to global growth.

"The optimism that has been attached to metal flows into China is that the Chinese economy won't just act as a leader, it will help to pull the whole (world) economy up," said John Mothersole, senior economist at IHS Global Insight, a Lexington, Mass.-based researcher.

"While China is important on global stage, it can't do all the heavy lifting," he said.

The S&P/TSX Capped Diversified Metals and Mining Index /quotes/comstock/11t!ittmn (CA:ITTMN 621.71, +6.04, +0.98%) has had a more than two-fold jump this year as investors have bet global industrial production will rebound, with China leading the way as the world's biggest consumer of base metals.

By contrast, Toronto's broad S&P/TSX Composite Index /quotes/comstock/11t!isptx (CA:ISPTX 10,390, +33.91, +0.33%) is up 17% in the same period.

But the swift advance for the metals sector has positioned some copper and nickel companies for a sharp fall if China, seen as the engine for global economic growth and the driver for double-digit rebounds in several metals, doesn't return to its formerly hot growth pace.

Ahead of fundamentals

Since hitting the sector's 2009 lows on Feb. 2, shares in small to mid-sized miners, such as Inmet Mining Corp. /quotes/comstock/11t!imn (CA:IMN 41.80, -0.74, -1.74%) , Quadra Mining Ltd. /quotes/comstock/11t!qua (CA:QUA 9.20, -0.15, -1.60%) and FNX Mining Company Inc. /quotes/comstock/11t!fnx (CA:FNX 8.45, -0.17, -1.97%) , have jumped between 93% and well over 100%.

These smaller players have easily outpaced the near 15% gain and 13% loss in big global gold miners such as Goldcorp /quotes/comstock/13*!gg/quotes/nls/gg (GG 36.06, -0.71, -1.93%) /quotes/comstock/11t!g (CA:G 41.54, -0.80, -1.89%) and Barrick Gold Corp. /quotes/comstock/13*!abx/quotes/nls/abx (ABX 35.03, -0.23, -0.65%) /quotes/comstock/11t!abx (CA:ABX 40.37, -0.23, -0.57%) , respectively.

Chris Cotterell, a base metal stock analyst at BMO Capital Markets, says the market capitalization of copper miners Inmet Mining Corp. /quotes/comstock/11t!imn (CA:IMN 41.80, -0.74, -1.74%) and Quadra Mining Ltd. /quotes/comstock/11t!qua (CA:QUA 9.20, -0.15, -1.60%) , and nickel producers FNX Mining Co. /quotes/comstock/11t!fnx (CA:FNX 8.45, -0.17, -1.97%) and Western Areas NL /quotes/comstock/11t!wsa (CA:WSA 5.25, +0.20, +3.96%) are more exposed to a potential sell-off in the underlying metals they produce.

"Those companies which trade at a premium (to net-present-value) could fall more than their peers, partly due to leverage to prices they have -- based on lower grades or higher cost mines," wrote Cotterell in emailed comments.

Net-present-value is derived by calculating all projected future cash flows of firm then discounting them by a nominal interest rate. If a company's price per share trades at a premium to NPV, it means investors have bid-up its shares to a point past what it is theoretically worth today.

It's one metric that analysts are using to separate winners and losing from the latest boom in commodities-related stocks.

According to Cotterell's analysis, the market capitalization of Inmet and Quadra are about 150% and 100% of their respective net-prevent values.

Enthusiasm for a China recovery has also propelled shares of nickel producers FNX Mining and Western Areas to what may be risky levels, according to a report issued by Cotterell.

They currently trade at about a 10% premium net present values, making them more prone to a devaluation compared to Martinrea International Inc. /quotes/comstock/11t!mre (CA:MRE 6.35, +0.13, +2.09%) , trading at a 40% discount to NPV.

Faith in China

If China fails to act as a buoy for the global economy, "they (base metal miners) all will correct," said TD Securities analyst Craig Miller.

In the short-term, but not in the long-term, the base metals markets are putting too much faith in a China-induced recovery, he said.

Which fuels doubts, at least for now, that stocks and commodities have gotten ahead of themselves.

IHS is bearish on base metals, including spot nickel and copper, up about 69% and 73% respectively in the last six months, at least until mid-to-late 2010.

"In our mind base metal prices appear to be a little ahead of fundamentals," IHS' Mothersole said. "What seems to be priced into commodities right now is a v-shaped recovery. That is something we do not see."

The doubters

After a near cataclysmic fall following the failure of Lehman Brothers, developed economies rushed to buttress industrial production. With a $586 billion stimulus package, China was no different.

Thanks in part to this massive capital infusion, which helped prop-up import demand, producers of base metals -- copper, nickel, and the like -- rebounded on hopes industrial production would come back to a normal range.

The key to future prices is, however, based on whether imports are used right away in production or sit in inventory.

"There are big surplus issues that are not being addressed, so the fundamental correction that markets need to make is not being made," said Mothersole.

For example, at least 90 large freighters full of iron ore were idling off Chinese ports, where they faced waits of up to two weeks to unload because port storage operations are overflowing, the New York Times reported June 11.

But for all the recent exuberance in base metals, and a possible fall to the downside, Canada, with a less beleaguered banking system and well diversified export portfolio, may still be an attractive outlet for capital.

"I like Canada as an investment," said Jeffrey Saut, chief investment strategist at Raymond James.

"Canada's got the dirt, they've got the stuff," he added. "And it looks like they are more fiscally responsible than the U.S."

Ryan Williams is a reporter for MarketWatch, based in New York.