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Should investors be buying Rio Tinto?

The past two years have been rocky ones for Rio Tinto’s (ASX: RIO) shareholders. In the last six months Rio’s share price has rallied 16% while iron ore, Rio’s number one commodity, has averaged above $125 per tonne despite many predicting China’s demand for the steelmaking ingredient would fall away. The reason so many analysts have been bearish on Rio is the looming oversupply that awaits its number one commodity.

According to Goldman Sachs and Macquarie Equities Research, iron ore is expected to drop to below $100 per tonne in coming years, severely impacting Rio’s top and bottom line. However, Rio has chosen to counteract the lower prices by boosting production and stripping away costs, which seems to be a win-win for shareholders regardless of the iron ore spot price.

The truth is, it is. Rio Tinto produces strong ore grades cheaply, giving it an advantage over both Australian and international competitors.

If Rio’s former management didn’t make such poor investments decisions such as the purchase of Alcan for $37 billion in 2007 and Mozambique-focused coal miner Riversdale Mining  for $3.7 billion in 2011, its share price would be well above $140. Instead, after the GFC, it was left with $40 billion in debt.

A turning point?

The good news for shareholders is that many of Rio’s businesses may have already hit rock bottom. Uranium, aluminium, copper, coal and iron ore commodity prices have all been higher in the past 10 years.

CEO Sam Walsh’s determination to cut away more than $5 billion of costs in the next year will be important for shareholders. They should also watch the company’s mounting pile of debt and if the board approves an iron ore production target of 360 million tonnes per year, it’ll be noteworthy to see how the $5 billion expansion will be funded and what impact it will have on the possibility of increasing dividend payouts.

Foolish takeaway

Compared to other iron ore producers like BHP (ASX: RIO) and Fortescue (ASX: FMG), Rio has the largest upside if iron ore spot prices stay high. However to mitigate the risk of a fall in the spot price of iron ore, investors may wish to wait for a lower entry point. BHP remains a more diversified miner, has huge exposure to iron ore and pays a better dividend.

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Motley Fool contributor Owen Raskiewicz does not have a financial interest in any of the mentioned companies.    

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