At first glance, FTSE 100 miner Rio Tinto (LSE: RIO) looks like an attractive stock. It’s got a high dividend yield, a low-looking valuation, escalating profits and modest levels of debt. And those attributes combine with positive director comments to make the share appear a potential winner. And it may prove to be.
Why I’m cautious about Rio Tinto now
However, I’m cautious about Rio Tinto right now. My first consideration when appraising a company in the mining sector is cyclicality. And I’m mindful of the advice written by Peter Lynch, who once excelled in managing the Fidelity Magellan Fund. He cautioned that cyclical stocks can be at their most dangerous for investors when they look at their most attractive. And that usually occurs after a long period of strong earnings.
And I think Rio Tinto is in that zone now. Earnings have been riding high since dipping into negative territory during 2015. In today’s full-year report, the company posted underlying earnings per share 21% higher than the prior year. And net debt fell from $3,651m to $664m.
The FTSE 100 business has been trading well. And the directors increased the ordinary shareholder dividend by 21% with a special dividend on top of that. Chief executive Jakob Stausholm said in the report the year had been “extraordinary”. He reckons “strong commodity prices” helped drive the good performance of the business.
But if commodity prices fall in the future, so might the company’s profits and cash flows. And if that happens, the share price and shareholder dividend payments will likely decline as well. Meanwhile, the stock is currently trading above the top of its previous multi-year range.
Of course, share price levels mean little in themselves and good investing is all about analysing the fundamentals and valuations of underlying businesses. But the highs on the Rio Tinto chart have almost always been fleeting and followed by precipitous plunges.
Valuation compression is a ‘thing’
After all, this business is cyclical. And its nature means revenues, cashflows, earnings, shareholder dividends and the share price will likely fluctuate. Meanwhile, City analysts predict an advance in earnings in 2021 of around 30%. If this was a growing business in a less cyclical sector I’d expect a lofty valuation with those growth prospects.
But with the share price near 6,477p, the forward-looking earnings multiple for 2021 is just above nine. And the anticipated dividend yield is a little under 7%. That valuation looks undemanding.
But when cyclical businesses are posting big profits, the stock market tends to compress their valuations. That happened with the London-listed banks over the past decade before the Covid crash, for example. And I think it could be happening with Rio Tinto.
So, as profits perhaps continue to rise in the years ahead, the valuation could contract to account for those increases rather than the share price going up. And I reckon that could happen because the next cyclical down-leg is coming. We just don’t know exactly when!
Rio Tinto may prove to be a decent investment from where it is now. But I’ll watch from the sidelines for the time being.
