As any Facebook addict will attest, the world is riven with a sense of 'FOMO'. For investors, ‘fear of missing out’ is better known as opportunity cost; retrospectively, the returns you would have made had you been there when everyone else was at the party, taking selfies and doubling their money. Onlookers of Rio Tinto (RIO) know the miner’s party has been an ongoing bash for 17 months. Consequently, they may well think that all the fun has been had; fun, that is, from the gains that Rio has made via deleveraging, cutting costs and a small commodity price boom. But even with its share price close to its five-year high, we think there is a strong case for the diversified miner’s role in a defensive portfolio.
Super low costs
Good dividend yield
Balance sheet strength
Iron ore sensitivity
Reliance on China's growth
Here’s one good reason why: unlike the last ascent of the commodities cycle, when Rio chased headlines, blockbuster deals and volume production, the focus this time around is on creating shareholder value. First-half results for 2017 were testament to this: a $2bn (£1.6bn) annual cost savings drive was completed early, $2.5bn of gross debt was wiped out, and the board again showed its selective approach to major growth projects.
This has juiced operating cash flows, which, with debt repayment no longer sucking up cash, adds weight to Rio’s commitment to regularly pay 60 per cent of underlying earnings in dividends. As we detailed in our Income Majors feature in July, a large part of this has been buttressed by an accelerated share buyback programme, which in the current financial year should retire $1.5bn of stock.
Buying shares isn’t always smart after an 18-month rally, but there’s greater cause for optimism this time. True, the iron-ore division, which in the first half of 2017 contributed 71 per cent to underlying profits before exploration and interest charges, is expected to fade next year on lower prices. Yet, arguably, lower earnings assumptions are baked into Rio’s rating of six times enterprise value to cash profits; and if the share prices does weaken, Rio's bosses have signalled they will buy in stock.
Prospective investors worried that the share price is banging into decade-long technical highs should also consider the currency effect. A glance at Rio’s New York-listed depository receipts, denominated in dollars, shows a valuation still a fifth off its 2014 highs, when the down-leg of the commodities cycle was very much in train. The miner is not expensive compared with recent years.
Another obvious concern lies with the mining industry in general, and Rio's reliance on Chinese economic policy specifically. First off, the quality of Rio’s assets mean it should generate a lot of cash even if coal, iron ore, copper and aluminium prices drop heavily. But mindful of volatility – and the possibility of a slowdown in demand for base metals – we’ve deliberately selected bearish forecasts in the table below.
| RIO TINTO (RIO) | ||||
| ORD PRICE: | 3,602p | MARKET VALUE: | £66.4bn | |
| TOUCH: | 3,601-3,602p | 12-MONTH HIGH: | 3,719p | LOW: 2,254p |
| FORWARD DIVIDEND YIELD: | 4.7% | FORWARD PE RATIO: | 17 | |
| NET ASSET VALUE: | 1,845p | NET DEBT: | 16% | |
| Year to 31 Dec | Turnover ($bn) | Pre-tax profit ($bn) | Earnings per share (¢) | Dividend per share (p) |
| 2014 | 47.7 | 9.55 | 503 | 135 |
| 2015 | 34.9 | -0.73 | 249 | 143 |
| 2016 | 33.8 | 6.34 | 284 | 134 |
| 2017* | 37.1 | 10.12 | 403 | 164 |
| 2018* | 32.6 | 6.42 | 271 | 170 |
| % change | -12 | -37 | -33 | +4 |
| Normal market size: | 750 | |||
| Matched bargain trading | ||||
| Beta: | 1.34 | |||
| *Macquarie forecasts; £1=$1.28 | ||||
