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Is Rio Tinto plc A High-Risk Trade Following Its Joint-Venture With Savannah Resources Plc?

Rio Tinto (LSE: RIO) has not appeared on my personal wish list for a very long time but it could be worth considering its shares right now, analysts argue.

Are they right?

Strategy

The iron ore producer is teaming up with Savannah Resources (+80% in early trade) in Mozambique, it emerged today.

Unsurprisingly, Rio’s stock was flat following the announcement.

The deal is not a game-changer for Rio, of course, but there remains a doubt that its shares may deserve the attention of value investors right now — at least its depressed valuation may suggest so. 

Rio Tinto’s iron ore strategy has backfired so far — the same holds true for BHP Billiton — but management is only partly to blame for a very poor performance in recent times. After all, even Glencore, whose management has often accused both rivals of little understanding of certain basic market dynamics concerning supply and demand, has struggled over the last 12 months. 

Landscape 

At Rio and its rivals, operational hurdles have come at a time when downwards pressure on most commodities has emerged as the inevitable price to pay for a global slowdown and a shaky recovery whose prospects are highly uncertain, given that nobody can firmly assess whether the growth rate of Chinese GDP is sustainable at 7% a year. 

Signs of stress are apparent, and combine with lofty valuations in other cyclical sectors. 

As expected, the CRB Commodity Index — a commodity futures price index that is useful to determine at which point in the commodity cycle we stand — still trades at multi-year lows.  

A tough trading environment means that Rio’s strategy may take many years to pay off, or it could just be plainly wrong.

Valuation 

Like disposals, targeted joint ventures could be the way forward… although one of the most appealing features of Rio could be a takeover by Glencore, which was rejected in October. A tie-up would make a lot of sense right now — but that’s not enough to buy Rio stock, I’d argue. 

In research published earlier this month, analysts at commodity house Royal Bank Of Canada (RBC) argued that applying “a 1.0x (8%) P/NAV multiple and a 13.0x multiple to our 2016E EPS forecast, we arrive at our price target of £27/share“.

RBC’s estimates are broadly in line with the average price target from brokers, according to Thomson Reuters. Rio’s shares currently trade at 2,700p, which is not far off their five-year lows (and is some 40% below their post-crisis highs). 

Consensus estimates have fallen by 26% over the last 12 months: I doubt they have bottomed out. 

It is important to note that the NAV and EPS multiples could improve when commodity markets improve and Rio Tinto can progress further in advancing its growth projects and enhancing the returns in underperforming assets. In our view, management success here should lead to multiple expansion relative to its peer group,” RBC analysts opined. 

So, Rio Tinto remains a ‘cyclical macro play’… but one whose declining net debts, reduced capital requirements and cash flow position may be a threat to its dividend yield, which is north of 5% on a forward basis. 

All in all, Rio Tinto carries too much risk, and there's better value in growth/yield stocks that do not look expensive at all right now -- a few of them have been included in a FREE report published by our team of analysts. 

It's easy to argue that their defensive characteristics, combined with attractive valuations and outstanding yield prospects, render these five shares a very attractive investment proposition at this point in the business cycle. 

In fact, if you are looking for a more balanced investment than Rio, I suggest you click here right away to learn more about affordable shares. But don't hang around -- this report is free only for a limited amount of time!

Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.