One would be hard-pressed these days to find a more unloved group of stocks than those in the beaten-down mining sector. While the broader S&P 500 index has racked up an impressive 15% gain this year through mid-August and has been hovering near record highs, the S&P 500 Metals & Mining index has tanked by almost 20% in 2013. And that dismal performance marks the third straight year of negative returns for mining stocks, which fell by 7% and 29% during 2012 and 2011, respectively.
There are some very compelling reasons for the plunge. Commodity prices have been slammed by a growth slowdown in China, which accounts for about 45% of the world’s base-metals consumption. And prices for gold and other precious metals have also been hit over speculation that the Federal Reserve will soon start tapering back its massive stimulus efforts, which have stoked inflation fears and helped prop up commodity prices.
The bloodbath in mining stocks has led many industry experts to declare the sector oversold, and some high-profile investors, such as hedge fund manager David Einhorn of Greenlight Capital, have recently been upping their stakes in mining companies. The sector has even been showing some signs of life lately: The Metals & Mining index has bounced about 10% since the beginning of July, aided largely by an unexpected rise in China’s exports that could signal a stabilization of demand for commodities.
But even if metals prices stage a rebound, there’s no guarantee that mining stocks will follow suit. Gold prices, for instance, shot up by about 160% between 2007 and 2012, but the NYSE Arca Gold Miners index, which tracks 30 gold-mining companies, rose by a mere 15% over the same period. “Miners went on a spending spree and used their profits to develop more mines,” says Morningstar analyst Samuel Lee. “The capital expenditures were huge and are ongoing.” And for many companies, that implies a serious drag on future profits.
For that reason, analysts recommend that investors looking to do some bargain hunting focus on miners with below-average costs, strong balance sheets, and an ability to generate profits even if commodity prices stay low moving forward. The following four companies, each specializing in a different segment of the mining industry, fit the bill.
Shares of Freeport-McMoRan, the world’s largest publicly traded copper producer, have plunged by some 30% over the past two years, thanks to a decline in copper prices from a record of $4.60 a pound in 2011 to about $3.30 today. Barclays analyst David Gagliano expects copper prices to slide to $2.90 a pound in 2014, but that’s still well above Freeport’s forecasted cash cost — the cost to Freeport of operating its mines — of about $1.30 a pound. “Freeport-McMoRan is the most undervalued and underappreciated long-term growth stock in U.S. metals and mining, even after assuming lower copper prices,” says Gagliano.
Gagliano estimates that Freeport has the potential to generate average earnings growth of around 10% to 12% annually over the next several years, and he also expects the company to fortify its balance sheet by cutting about $5 billion from its debt over the next three years. In the meantime, the stock is paying a hefty 4% dividend yield.
Eldorado Gold of Vancouver is one of the most efficient mid-tier miners. In 2012 its cash costs averaged about $550 an ounce, far below the industry average of nearly $700 an ounce. Indeed, even after the 30% drop in gold prices over the past two years, the company is still generating substantial cash flow. And management recently announced its decision to defer some of the company’s development projects — a move applauded by analysts, given the shaky outlook for gold prices.
At a recent price of about $9 a share, Eldorado’s stock is currently trading at a discount to its peers based on its net asset value (the projected value of the company’s mining operations less its liabilities). But Raymond James analyst Phil Russo, who has an outperform rating on Eldorado’s stock, contends that the company “should command a premium multiple given its low operating costs, strong balance sheet, and proven track record.” Russo believes the stock could trade up to $11 over the next six to 12 months, or more than 20% above current levels.
Shares of Vale, the world’s largest supplier of iron ore, have fallen by more than 25% so far this year, on fears that steep declines in iron ore prices could whack earnings. Research by Goldman Sachs indicates that iron ore prices could potentially drop from the current level of about $135 a ton to as low as $80 a ton in 2015. But thanks to Vale’s low-cost operations in Brazil — its cash costs have averaged about $35 a ton in 2013 — the company’s iron ore business should remain solidly profitable at those lower iron ore prices.
Vale also stands to benefit from the weak Brazilian currency, since the bulk of Vale’s costs are denominated in Brazilian reais, while the majority of its revenue is received in U.S. dollars. Goldman analyst Marcelo Aguiar, who has a buy rating on the stock, notes that at the current price, Vale is “heavily discounted” relative to its peers and believes the shares could rise by about 25% over the next 12 months. And that’s on top of the company’s rich 4.9% dividend yield.
Finally, shares of coal miner Teck Resources have plummeted by more than 25% so far this year. About half of Teck’s sales and earnings come from producing metallurgical coal, which is used in steelmaking, with the remainder derived mainly from its copper and zinc operations. Prices for metallurgical coal have fallen precipitously over the past two years, from $300 to $160 a metric ton, as growth in China’s steelmaking industry has slowed down. But with total costs of about $115 to $120 a metric ton, Teck has nonetheless remained a profitable producer.
To further curb costs, Teck has also delayed several projects and instead focused on returning capital to shareholders through share buybacks and a dividend yield that currently stands at 3.4% — moves that CIBC analyst Alec Kodatsky says “the market has underappreciated.” Kodatsky believes Teck’s stock could reach $41 a share over the next 12 to 18 months, an increase of almost 50% over the current price.
After a long run of underperformance, it appears that certain mining stocks are now poised to deliver some healthy returns, especially for investors willing to dig for low-cost producers.
A former compensation consultant, Janice Revell has been writing about personal finance since 2000.
This story is from the September 16, 2013 issue of Fortune.