This Is Why I’m Staying Away From BHP Billiton plc And Rio Tinto plc

It has been a tough year for Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT). Year to date Rio’s shares have slumped 16.6% and BHP’s shares have fallen 20.3%.

Such declines are bound to attract bargain hunters. However, even though I would describe myself as a value investor, I’m staying away from Rio and BHP. 

You see, one of the toughest parts of value investing is learning how to avoid value traps. Indeed, value traps are difficult to spot and finding them isn’t an exact science. More often than not, investors find themselves being sucked into a value trap without realising it. 

Now, I’m not saying that BHP and Rio are value traps, (although there’s evidence to suggest that BHP is) but the two companies do lack pricing power, which makes them almost impossible to value on a long-term basis. Pricing power allows firms to set the prices of goods sold. This enables them to maintain steady profit margins even during periods of economic stress. Further, pricing power usually translates into high, stable returns on capital. 

Market forces

BHP and Rio both produce commodities, the prices of which are ultimately decided by the market. Without pricing power, the two companies are at the mercy of market forces. And this means, that to accurately value these two miners, investors need to know how to market is going to move during the next few weeks, months and years. 

Unfortunately, it really is impossible to know where commodity prices will be 12 months from now. So to accurately value BHP and Rio, investors need to do a certain amount of guesswork. 

Guessing game 

Even the City’s top mining analysts, who know the sector inside out, are struggling to predict accurately the commodity market. For example, this time last year analysts were expecting BHP to report earnings per share of $2.69 for 2016 and $3.01 for 2017.

Current forecasts are significantly lower than those published 12 months ago. City analysts now expect BHP to report earnings per share of $0.78 for 2016 and $1.03 for 2017, 71% and 66% lower the initial predictions. Similarly, the City has reduced its full-year 2015/2016 earnings estimates for Rio by 56% and 56% respectively. 

The point here is that the future is extremely uncertain for miners. As a result, it is almost impossible to produce an accurate valuation for the companies.

At present, BHP and Rio are trading at forward P/Es of 25 and 13.3 respectively, but as noted above, these figures are only based on current spot commodity prices. If commodity prices fall further or increase, these forecasts will be out of date.

That said, BHP and Rio might make good income investments. Rio currently offers a dividend yield of 6.5% and BHP supports a yield of 7.8%. Although, without any pricing power it’s difficult to say how much longer dividend payouts will be maintained at present levels. 

So if you brought either Rio or BHP for income, it could be wise to sell up and look for other income opportunities elsewhere.

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Rupert Hargreaves 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.