Do Rio Tinto plc & Inspired Energy plc Make A Great Investing Combination?

Could big-cap Rio Tinto plc (LON: RIO) and small-cap Inspired Energy plc (LON: INSE) work well together?

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Sometimes I find it a good idea to blend a few big-cap shares with smaller, higher-risk and potentially higher-return shares in my portfolio.

A steady big cap can deliver solid dividend gains and maybe a little capital growth to stabilise the foundations of my investment strategy, while a growing small cap can spice up returns when the underlying business clicks.

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With such a strategy in mind, I’m looking at Rio Tinto (LSE: RIO) and Inspired Energy (LSE: INSE) to see if they can make a great combination when held together.

Performing well

Inspired Energy ticks the box for excitement and strikes me as a good candidate for the small-cap side of this investment strategy. The firm describes itself as one of the largest energy consultants in the UK, and reckons it provides a range of essential energy advisory services and intelligent energy solutions to the industrial and commercial sector. The company’s business involves buying strategies, market intelligence, negotiation and extensive contract management solutions, based on client-specific needs.

Inspired Energy seems to be something of a sales-driven organisation working on commissions. That kind of service is essential for time-strapped organisations that want to outsource their energy procurement needs. Service firms such as Inspired Energy can become experts about what is available in the market — perhaps to a level that one-off buyers would find difficult to achieve on their own.

The business model is certainly performing well for Inspired Energy. Revenue, profits and cash flow have all grown well:

Year to December

2011

2012

2013

2014

Revenue (£m)

1.53

5.26

7.62

10.84

Profit after tax (£m)

(0.85)

0.64

1.42

2.47

Net cash from operations (£m)

0.02

0.71

2.03

1.6

City analysts following the firm expect earnings to grow just 1% this year with a 19% surge during 2016. Meanwhile, at today’s 12.62p share price, the forward dividend yield runs at 2.8%, and those earnings should cover the payout more than three times. That’s a healthy level of cover, which suggests to me that the directors see plenty of potential for further growth, otherwise they might return more free cash to investors through the dividend rather than reinvesting it into the business.

Inspired Energy’s forward price-to-earnings (P/E) ratio sits below 12, which seems undemanding if growth is set to continue. To me, the company is well worth further research.

Ramping up production. Is that risky?

Big miner Rio Tinto continues to ramp up production even as commodity prices fall. The firm earns around 90% of its profit by producing iron ore, and the recent third-quarter results release revealed iron ore production up 11% on the figure achieved nine months previously. However, when I look at the long-term price chart for iron ore, the high prices of the last ten years look like a bubble.

People often say that the cure for low commodity prices is low commodity prices — meaning that low prices encourage producers to shut down production to reduce supply. When supply reduces and demand remains stable, prices should rise. Rio Tinto seems to be doing the opposite, though. The firm’s chief executive said:

“We continue to deliver efficient production, rigorous cost control and sound allocation of capital. This approach is ensuring that our tier one assets generate substantial free cash flow even during a challenging economic environment.”

I hope he is right, but what bothers me is that iron ore’s current price of around $52 dollars per metric ton is still almost four times the level it was at the end of 2003, just 12 years ago. To me, there is considerable scope for the price of the base metal to halve from here and maybe stay there for decades. If that happens, it could wreak havoc with Rio Tinto’s ability to turn a profit and the share price could fall a heck of a lot more from here.

I hope I’m wrong, but I see Rio Tinto and the other big mining outfits as risky propositions right now. So Rio Tinto doesn’t make it as a ‘defensive’ big cap to complement this particular two-pronged investment strategy.

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