Rio Tinto Limited (ASX: RIO) and Commonwealth Bank of Australia (ASX: CBA) are two of Australia's most widely owned companies, but which one has the better prospects for providing investors with strong returns?
In my opinion, the more attractive investment opportunity right now is Rio Tinto. Here are four reasons why I'd favour buying shares in Rio Tinto.
1. Share price fall has opened up value
Rio Tinto's share price has fallen around 30% over the past five years compared with a 60% rally in CBA's share price.
Considering that the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has gained 30% in the past half-decade, CBA's performance is superb. However, arguably there is little room for upside from these levels.
Based on consensus estimates, this year's price to earnings (PE) multiple for Rio is about 19 times. In contrast, CBA's PE is around 13 times.
On first glance, an investor could reasonably assume that CBA looks more attractively priced, however when one considers the cyclical factors outlined below, I'd suggest Rio's pricing is currently more appealing.
2. Cyclical factors favour Rio
Most businesses are exposed to cyclical factors and none more so than the resource sector.
The commodity boom and subsequent bust, particularly in iron ore, has had a dramatic effect on Rio Tinto's profitability and that of its peers BHP Billiton Limited (ASX: BHP) and Fortescue Metals Group Limited (ASX: FMG).
While it would definitely be unwise to expect iron ore prices to revert to former boom time highs, there is also a reasonable precedent for prices to improve.
In contrast, the banking sector has been enjoying the equivalent of boom times.
Bad loans are at cyclical lows and the strong housing market has driven loan demand sky high. With bad loan rates expected to pick up and the housing market forecast to cool, clouds are beginning to appear for the profitability of the banking sector.
3. Earnings growth potential
According to data provided by Reuters, analyst consensus earnings forecasts show relatively flat earnings per share (EPS) for Rio over calendar years 2016 and 2017.
In contrast, CBA's EPS are forecast to grow moderately over the next two reporting periods.
While these forecasts would perhaps lead an investor to favour CBA for growth, in my opinion the earnings' growth potential over the medium term for Rio is much more exciting than for CBA, when the cyclical issues outlined above are factored in.
4. Expansion opportunities
While merger and acquisitions (M&A) might not be front and centre of Rio's agenda at present that could change.
Up until now, Rio has been busy realigning its own business operations to deal with the resource price crunch. Rio remains a diversified mining giant with global operations, which makes it well positioned to play a leading role in M&A activity both domestically and abroad.
In contrast, CBA already commands a significant domestic market share of the banking industry which constrains its growth options within Australia. Given the lack of success Australian banks have previously had in expanding offshore, enthusiasm for any expansion plans by CBA is likely to be minimal.
