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How Will Rio Tinto Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at global mining company Rio Tinto (LSE: RIO) (NYSE: RIO. US).

Track record

With the shares at 3,266p, Rio Tinto’s market cap. is £46,139 million.

This table summarises the firm’s recent financial record:

Year to December 2008 2009 2010 2011 2012
Revenue ($m) 54,264 41,825 55,171 60,537 50,967
Net cash from operations ($m) 14,883 9,212 18,277 20,030 9,368
Adjusted earnings per share 656.2cents 357.1c 713.3c 808.5c 503.1c
Dividend per share 112.35c 45c 108c 145c 167c

1) Prospects

Rio Tinto is a huge diversified mining concern dual-listed on the London and Australian stock exchanges. But that won’t help it escape from the curse of cyclicality within the industry.

Commodity prices oscillate as they please, dictating the profit result for companies like Rio Tinto, and that major factor is completely outside the directors’ control. The firm is currently battling against the pincer movement of weaker output prices and stronger input prices. The squeeze in the middle is digging into earnings, which were down 18% with the firm’s half-time results in August.

In a recent third-quarter update, Rio reported production up across most of the commodities it produces, but it remains unclear whether that is enough to halt, or reverse, the slide in earnings.  We’ll be much clearer on that issue when the company releases its full-year results in February.

City analysts following the company are optimistic that production will increase enough to lift earnings next year and beyond. In the meantime, investors will cherish the dividend payout. Watch out for possible P/E compression, which could drag on the share price as the macro-economic cycle unfolds.

2) Risks

Commodity companies such as Rio Tinto have no pricing power and their fortunes rise and fall with the fluctuations of commodity prices in the general market. If commodity prices take a dive, Rio’s profits will follow unless extra production can offset the decline in revenue.

Meanwhile, the costs of labour, transport and machinery can rise, as recently, and at the most inconvenient times, such as when commodity prices are falling. The inevitable casualties are profitability and the level of the share price. In my view, investors should time investments in cyclicals such as Rio Tinto very carefully.

3) Valuation

A forward dividend yield of around 3.9% looks attractive, but is it? City analysts following the company expect earnings to cover that payout around three times.

To buy into that income stream will cost investors a forward P/E multiple of around eight, which sounds low; however, cycles hit their peak with low P/Es and high yields. I can envisage the P/E going lower and the yield, higher, which inclines me to worry about total investor returns.

What now?

Cyclical companies such as Rio Tinto make me nervous at this point in the general economic cycle, so I’m unlikely to invest, despite what looks like quite a rosy outlook in terms of Rio Tinto’s business and its likely profit recovery.

With so many variables, the total-return outcome for Rio Tinto investors looks uncertain so, in pursuit of potentially steadier returns, I'm enthusiastic about five companies with strong economic franchises and, seemingly, well-defended operating niches analysed in a well-researched Fool report.  

I recommend the five shares for your own due diligence and research. Each firm operates in a less cyclical environment than Rio Tinto and they deserve consideration by investors aiming to build wealth in the long run. To download the report click here.

Kevin does not own any Rio Tinto shares.