Given the afflicted state of the commodity sector, most investors will be quietly relieved with the “mixed bag” of results just posted by Rio Tinto (LSE: RIO). It certainly spared the iron ore miner yet another handbagging by stock markets, its share price broadly flat at time of writing.
Chief executive Sam Walsh says “efficient production, rigorous cost control and sound allocation of capital” have helped the company generate substantial free cash flow in challenging times, confirming my view that this is a good company in a bad sector. Don’t blame it on Rio. Its strategy of ramping up production to offset falling prices, with Q3 production up 14% year-on-year, may be controversial but is hard to argue against. What’s the alternative?
Copper Crowned
Copper production is less important to Rio but the 24% drop in mined copper to 115 kilotonnes, still hurts. Although Rio insists it is still on target to hit full-year guidance.
So, nothing earth shattering. Investors will be cheered by Walsh’s claim that the balance sheet has been strengthened by cost cutting and his promise to deliver strong shareholder returns in future. But we all know that what Rio Tinto investors really want to see is an increase in commodity prices, and they aren’t getting that while the flow of Chinese bad news continues.
What they are getting is a soundly run company trading at just 7.72 times earnings, and yielding 5.37%. That yield isn’t set in stone: another year or two of slowing China and falling metals prices will eventually sink it.
Chinese Arithmetic
It is a similar story at BHP Billiton (LSE: BLT). It yields a staggering 7.16% — who would have imagined that five years ago – after plunging 25% in the past year. Over five years, it is down 44%. Such long-term underperformance shows exactly how much it hurts when a super-cycle turns against you. Contrarian buyers who bought into commodities too early will regret acting in haste.
With Chinese imports falling by a massive 20.4% in September, it really feels too early to call the end of the downswing. It also seems to early to talk about buying BHP Billiton, which trades at a relatively pricey 14.68 times earnings. Morgan Stanley was recently talking up a 19% upswing in commodity prices by 2017, but that looks like a leap of faith from where we are now. I am all in favour of contrarian purchases but I have learned the hard way that it takes time for all the bad news to flush out.
Not My Bag
The problems afflicting China’s shadow banking system, the unfathomable depth of its bad debts and fallout from its runaway property boom have barely begun to be exposed. Yet another bout of stimulus may cover up the cracks, but this trick is getting harder to pull off.
My worry is that all the overheated talk about a commodity supercycle has given investors unrealistic expectations, and they see the current slowdown as abnormal, when I see it more as the new normal. China won’t post double-digit GDP growth again. Its breakneck pace of infrastructure growth is neither repeatable, or desirable. And I don’t see who else will pick up the slack.
Buy BHP Billiton and Rio Tinto for their stunning income, and hope it can be sustained. The future still looks like a mixed bag to me.
