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Missing: The Crucial Buy Signal For BHP Billiton plc, Rio Tinto plc And Anglo American plc

With big dividend yields and modest P/E ratings, the big London-listed mining companies such as BHP Billiton (LSE: BLT) (NYSE: BBL.US), Rio Tinto (LSE: RIO) (NYSE: RIO.US)  and Anglo American (LSE: AAL) look so attractive through the lens of traditional valuation methodology right now.

But wait. We could be sleep walking into a value trap if we buy these firms, because the oh-so-crucial buy signal is missing — proceed at your peril!

But look at the value

Self-respecting value hunters and income gatherers will no doubt pore over the figures for the big miners at these levels, and why not? They look cheap:

Year through 2015

Share price now

Forward P/E rating

Forward dividend yield

BHP Billiton

1385p

11

5.7%

Rio Tinto

2991p

11

4.8%

Anglo American

1162p

10.5

4.7%

Compared to the FTSE 100’s combined P/E rating around 15, and its dividend yield of 3.5% or so, the big miners look like good value on traditional valuation measures.

The trouble is that comparing the miners to the indicators of the whole index is not a good idea, as that method is a poor indicator of comparative value.

The miners are different beasts

Before thinking of the miners as value plays or as income propositions, we should first think of them as cyclical enterprises. Cyclicality is everything with big commodity producers. The products they deliver are characterised by low differentiation, little added value, and the firms have very little pricing power.

Being a commodity producer means being in as commodity style a business as it’s possible to be in. Apart from geographical location to end market, and slight variations in the quality of the raw materials from individual sites, there’s nothing between one firm’s offering and another. The big miners must sell into a market that determines its own price, and that price moves up and down according to variations in supply and demand, which alter according to macro-economic gyrations.

The whole set-up tends to turn traditional value indicators on their heads for cyclical companies such as the miners. That can lead to a situation where big yields and low P/E ratings occur near the end of up-legs in the wider macro-cycle — when it looks like we should buy according to traditional valuation measures, we might be better off selling.

Wait for the buy signal

As macro-cycles unfold and economies improve big mining profits tend to rise year on year. However, a bust seems to follow every boom, and when it does profits fall hard, taking the miners’ share prices down hard, too.

The stock market is smarter than we realise much of the time and figured out cyclicality long ago — it tends to adjust valuations downwards as the macro-cycle grinds on, in anticipation of the next profit collapse. Yet even with this valuation-compression effect, we still seem to get a big share price plunge after hitting peak profits. That means that when the miners’ P/E ratings are low and their dividend yields are high we could be close to share price collapse — when we see the biggest value in the traditional sense, we are in the most dangerous place with the miners and other cyclical firms.

So where are we now?

Mid-cycle like this, it’s very hard to tell where we are. The severity of economic cycles varies and one bottom might be lower than another, but with the miners and other cyclical firms, I would at least wait for an uptrend in the share price as the crucial buy signal before committing. Preferably, a definite share price collapse should precede that uptrend to show that the bottom might be in.

Right now, the share price charts of BHP Billiton, Rio Tinto and Anglo American show a downtrend, and I fear that buying now could expose us to further valuation compression, which could nullify, or even reverse, any income gains from the dividend, even though earnings may rise further over the coming years. Then there’s the unknown location of the share price abyss that follows peak earnings lurking somewhere ahead…

The miners are for trading, to try to catch the 'up leg' after a cyclical bottom. Long-term buy-and-holders, value hunters and yield gatherers beware! Instead, these five shares make good candidates for further research. They are strong, well placed in their sectors, and exhibit far less cyclicality than the miners.

The Motley Fool analysts identified these London-listed market leaders as enduring long-term investments. You can download this wealth-building report now, free from obligation. Click here.

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.