In cyclical industries, the wheel turns in the same old way and often companies make the same old mistakes. During the mining downturn five years ago, a stand-out case was Rio Tinto (RIO). It was left to rue the day it splurged A$3.9bn (£2.1bn) on a prospective coal mine at the high point of the previous bull market.
But the memories of the last downturn have remained fresh this time around. With metal prices rising into the early part of this year, miners prioritised handing cash to shareholders and stripping out costly assets instead of searching for the next multi-decade project.
New mines now getting green-lit have been on the books for years. The juniors and midcaps look on anxiously. Only distressed projects such as Woodsmith in North Yorkshire or very early development projects get picked up rather than the shovel-ready options the industry used to go for.
Alongside the dividend focus, majors such as Rio and BHP (BHP) have held on to the cost-focused practices of the downturn when free cash was in short supply. When metal prices, namely iron ore and copper, were at historically high levels earlier this year, the tighter operations meant profits soared. Rio’s free cash flow margin in 2020 was a full 10 percentage points ahead of where it was in 2011 and it is likely to climb higher this year.
The question is when the wheel will turn again. In August the iron ore price dropped from US$200 (£146) to below $130 a tonne.
Short term commodity price moves should not determine an investment strategy, but analysts had forecast price weakness in the second half due to the Chinese government’s moves to slow steel production. This drop-off could mark the end of the stimulus boom times. China consumes over 60 per cent of global iron ore supply, so it is the key price driver. The current prices should show the first half was the peak. Broker Liberum has estimated that sector earnings have fallen around a third since July based on spot prices.
But that is the big picture. Looking at individual companies, there’s not much to complain about, though investors targeting yield have a tricky decision. Yields for both BHP and Rio exceed 10 per cent. Anglo is behind the pack at 6 per cent but its policy allows for buyback top-ups, with which it handed $1bn to shareholders after its interim results. Glencore (GLEN) trails all three. The shifting sands of the commodities space mean this won’t be the case forever: base-metals-focused Glencore and Anglo look best set for the next year or so while the iron ore giants will see profits dip if analyst forecasts for the prices of their key products are correct.
Both iron ore majors have dividend policies that pay out from underlying earnings: 50 per cent in BHP’s case and 40 to 60 per cent for Rio. But there are greater headwinds in the short term from Rio’s development plans, especially its Oyu Tolgoi mine's underground expansion. Further out, both companies are expanding in new areas. For BHP the focus is potash and for Rio it's lithium, though both revenue streams are a way off.
BHP is our short- and medium-term pick for income, despite its lower yield than Rio. This is in part due to BHP's lower reliance on iron ore for earnings. The restructuring to come in the next year will take away its exposure to oil but thanks to the merger of these interests with Woodside Petroleum (AU:WPL), investors can keep their exposure to hydrocarbon cash flows. Analysts also expect this year to be the peak for Rio’s payouts at 1,165¢ while BHP’s will climb again next year. This is to be taken with a pinch of salt given the recent iron ore price tumble, however.
The miner's abandonment of its dual-listed structure will also remove constraints on franking credits, which are an Australian tax policy that means the dividends aren't taxed twice. This will result in franked distributions being paid directly "to all BHP shareholders", the company said.
See our other Income Majors: