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Could Rio Tinto plc Survive A China Crisis?

Rio Tinto (LSE: RIO) (NYSE: RIO.US) has enjoyed a storming six months, rising 30% to 3364p since June, three times the growth rate of mining rival BHP Billiton. That’s Rio’s reward for a strong production performance, with its all-important iron ore shipments beating expectations. It is also new chief executive Sam Walsh’s reward, for his well-received strategy of cutting costs and tightening purse strings, after predecessor Tom Albanese was sacked for his wayward acquisition strategy that ended up in a costly $14.4 billion of write-downs.

Rio was helped by a recovery in the iron ore price, which hit a low of $110.40 a metric ton last May, but has since rebounded more than 20% on stronger demand from China. But Rio is in a delicate position, heavily exposed to a single metal, and a single customer. Walsh appears to have the right strategy, but I worry he is at the mercy of events beyond his control. Commodity prices are already under threat from QE tapering, but my biggest concern is China.

Chinese bear

Most people’s biggest concern seems to be China these days. Bank lending has doubled since the financial crisis, while its shadow banking system is roughly equal in size to the US and Japanese banking systems combined. Bank of America recently warned that markets are too complacent about the dangers and told clients to take out default insurance against Chinese debt. China is also in the grip of a property bubble. It also seems to be threatening war with Japan.

Which raises an interesting point. Should an unquantifiable macro risk deter you from investing in an otherwise healthy company? On most measures, Rio merits your attention. It has exceeded production and cost-cutting targets. Management has a progressive dividend policy, with a 15% increase in the half-year dividend to 83.5 cents per share. Despite recent share-price growth, you can buy it at a modest 11 times earnings. Forecast earnings per share growth is 14% in 2014, which would lift the yield to a prospective 3.5% by December. All very nice.

Either/ore

With China responsible for 60% of global iron ore demand, any meltdown would scorch Rio. Today’s news that Chinese PMI production fell from 52.5 in November to 50.9 in December, its lowest level since August 2011, is a worry. Walsh recently admitted that the iron ore price may be soft this year, as production continues to rise, but declared that this was still a good business to be in. I would second that. A China crisis may strike, but the country’s journey towards urbanisation and industrialisation still looks unstoppable to me. I would buy Rio Tinto today. And I would buy more if the China crisis did come to a head. 

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> Harvey owns shares in BHP Billiton. He doesn't own shares in Rio Tinto.