Attention Rio Tinto Limited (ASX: RIO) shareholders, it's time to take a cold shower…
Data sourced from indexmundi.com; prices in USD.
…because commodity prices are plunging.
And while they may rebound in the near term, the consensus is for further falls in major commodity prices over the medium term.
But if falling commodity prices weren't enough to send shivers down your spine, consider the next chart.
Figure 2. Rio's Dividend Policy may come under Pressure
Data sourced from Annual Reports; '2015F' was created using my own, and the company's, guidance; all figures are in USD.
According to my forecasts, over the next full financial year, Rio Tinto – like BHP Billiton Limited (ASX: BHP) – may pay out more cash in dividends than it generates in free cash flow. My forecasts assume the miner's 'progressive dividend policy' is maintained over the full 2015 financial year.
Now, functionally, a falling Australian dollar has been a blessing in disguise for Rio Tinto because it lowers operational costs at local sites and boosts the dividends paid from US revenues when converted into pounds and Australian dollars.
So Rio which also has scope to lower its capital expenditure on new projects if it needs to (which would boost free cash flow) won't go bust anytime soon.
But even during times when commodity prices were riding exceptionally high on the unprecedented growth of the Chinese economy (between 2006 and 2014), Rio Tinto struggled to make satisfactory levels of free cash flow and its share price lagged the market.
Of course, notable management blunders such as the Alcan and Mozambique coal acquisitions weighed on investor sentiment. However, that just proves just how difficult it can be – even for the 'experts' running a multi-national resources powerhouse – to forecast commodity prices and then profit from the higher prices.
Buy, Hold or sell?
Throughout 2014, I held Rio Tinto warrants, and they were – by far – my worst investment. I thought resilient copper and aluminium prices would offset weakness in the iron ore market, but prices didn't stay at acceptable levels, and I lost 54% of my investment.
In hindsight, it was easy to see I was simply 'hoping' for a catalyst in commodity markets to vindicate my investment thesis. And for the record, hope should take no part in any investment – ever.
I've already sold my Rio Tinto warrants because I realised there were many flaws in my strategy. Moreover, there was little sense in holding an investment that was more than likely to underperform the market.
So if you too are holding onto Rio Tinto shares (or BHP for that matter) hoping for a turnaround in the broader market's fortunes over time, I urge you to consider this quote from Warren Buffett:
"Turnarounds seldom turn".
I should have listened to Buffett sooner, and avoided mining stocks altogether!
