Should I Invest In Mega-Cap Miners Rio Tinto plc And BHP Billiton plc?

In its simplest form, investing for the long term is a bet that people will produce and consume more tomorrow than today. It is a bet on human ingenuity. It is a bet that we will advance and overcome hurdles such as global warming and political tensions and disease.

Progress isn’t always a linear journey, however, and plummeting iron ore and oil prices, combined with slowing growth in China and a stalling Eurozone, has really hit mega-miners Rio Tinto (LSE: RIO) (NYSE: RIO.US) and BHP  Billiton (LSE: BLT) (NYSE: BBL.US) hard, knocking 20% and 32% off their share prices respectively.

Eventually, populations will rise, we will construct more cities and we will harvest more raw materials than yesterday. Therefore miners will always have a spot in my portfolio.

The recent price fall in these two blue-chip behemoths might be the perfect chance to buy. But which of the two, if any, is worth buying now?

Strategy: Just Keep Digging

For years, the mega-cap miners had a very simple strategy: growth at all cost. Increasing demand from China pushed raw material prices higher, and mining companies responded by expanding as fast as humanly possible to meet demand.

BHP has recognised that the good old days of easy money might be over, and has overhauled its plan of attack. Rather than focusing on expansion, it is now only investing into the 12 commodities in its existing “core” portfolio, where it believes it can achieve an impressive 20% return on investment.

Furthermore, this core portfolio, which generated 96% of the Group’s EBIT last year, has a projected two-year growth rate of 23%, pretty impressive for such a behemoth.

The 18 operations that do not qualify as “core” are being sold off. Over the last two years, $6.5bn worth of non-core assets have been sold, while 11 of the remaining unwanted projects will be combined into “South32 Limited,” a new company headed for IPO early next year. It will contain all of BHP’s aluminium and manganese assets, and analysts have valued the portfolio between $8bn and $17bn, a nice cash boost that could take a chunk off of the company’s $30bn long-term debt pile.

A simplification of the portfolio from the current 30 operations to 12 will not only raise money through the sale, but should also help BHP save on costs and capEX. Management have recently revised efficiency saving predictions up by $1bn to $2.9bn.

Record Iron Production, Lower Costs.

Rio is the world’s most efficient producer of iron ore. It accounted for nearly 90% of the company’s profits last year and so when its price halved recently I presumed Rio’s operations would be in danger of becoming unprofitable. However, I was very wrong. Rio can produce a tonne of iron ore for only $27.50. With the price currently sitting at around $70, Rio is still comfortably making money.

In fact, Rio reported a 21% rise in underlying earnings in spite of pricing issues as they successfully reduced operating costs by $3bn, six months ahead of schedule, while also producing record volumes of iron ore.

Rio intends to keep on driving efficiency to reduce the average cost per tonne of iron ore produced to only $20.00.

Net debt also fell by $1.9bn, to $16.1bn, leaving the balance sheet looking strong.

Value or Momentum?

Trading at under 8 times last year’s earnings, I feel the bad news surrounding the oil and iron ore price is baked in to BHP’s valuation. A 5.6% yield is more than enough to keep me content while I wait for prices to stabilise at higher levels.

BHP’s dividend payment is nearly twice covered by earnings, quite a comfortable position to be in. Earnings look likely to fall next year though, the consensus being by about 30%, but the dividend would still be covered.

Rio trades on a loftier price to earnings ratio of 12, and yields a slightly lower 4.67% more than twice covered by earnings. Like BHP, earnings are set to fall next year, although analysts predict a lower 7% fall.

It is hard to separate the two, but it depends what you are looking for in an investment. BHP Billiton seems to represent greater upside and pays more, but Rio Tinto has momentum on its side and due to its world-beating iron ore costs looks a safer bet than BHP.

BHP suits my risk profile better at current, and I believe it’s more diversified portfolio will serve shareholders well in the future, even if it has not fared well of late.

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Zach Coffell 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.