Mining stocks have a bad reputation with some investors. But if you approach this sector in the right way, I believe miners can be a good source of dividend income.
Despite environmental concerns, the world won’t stop needing materials such as iron ore (for steel) and copper (for all things electrical) any time soon. These two natural resources would probably be my top picks for the 21st century, as modern infrastructure and technology simply can’t be built without them.
One big digger I’d buy
A company that shares this vision is FTSE 100 mining group Rio Tinto (LSE: RIO). Rio has sold its coal mines and is now focused on iron ore, copper and aluminium.
In each of these areas, the company has large, good quality assets. The benefits of this approach are clear. In 2018, Rio generated free cash flow of almost $7bn from sales of $40.5bn. That represents a free cash flow yield of 17%, which is an exceptionally good figure.
The company’s profit margins are currently being boosted by strong iron ore prices and some disruption at other major producers. But chief executive JS Jacques is keeping tight control on costs and spending. Having reduced Rio’s debt levels to minimal levels, Mr Jacques is returning most of the company’s spare cash to shareholders.
In 2018, dividends and share buybacks totalled $13.5bn, giving a total shareholder return of about 14% on the current share price.
Returns are likely to be more modest this year. But analysts still expect Rio shares to provide a dividend yield of 5.7%. I suspect more share buybacks are likely as well.
What about the risk of a crash?
It’s no secret that the mining sector is heavily cyclical. Periodic downturns are a fact of life.
The sector crashed in 2015 and I suspect it will happen again at some time in the next 10 years. But I don’t see this as a reason to avoid diversified miners like Rio, which are financially strong and prioritise shareholder returns.
I’d be happy to buy Rio for income today. I’d then plan to buy more during the next downturn, in order to lower my average purchase price and boost future returns.
I wouldn’t do this
As a general rule, I stay away from smaller miners, such as Tanzanian gold firm Acacia Mining (LSE: ACA).
The biggest problem with such companies is that they tend to rely on a handful of assets, often in a single country.
This leaves them heavily exposed to political risk and operational problems. Acacia is a good example. Today’s first-quarter results revealed that the firm is still no nearer to a settlement with the Tanzanian authorities relating to a major tax dispute.
In the meantime, the group’s gold production fell by 13% during the first quarter, due to a ground fall and various other technical problems. Although Acacia remains profitable and may seem cheap, the eventual cost of settling with the Tanzanian government could be high. All of the firm’s revenue-producing mines are in Tanzania, so it can’t afford to walk away.
I believe that gold miners can be a good long-term investment. But Acacia faces unknown risks and has all of its eggs in one basket. At 150p, the shares have risen by 50% from last year’s lows of under 100p. In my view, that’s enough. I’d stay away.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.