Resources companies are sometimes deemed a riskier investment than industrial stocks for the mere fact their share prices are directly linked to the price movements of commodities. Commodity prices can be extremely volatile and unpredictable.
Just ask everyone who expected the price of iron ore to fall to below $US90 per tonne this year – it didn't. The price of the steel making ingredient is comfortably sitting above $US 130 per tonne, the best Christmas present any iron ore miner could ask for. Not many analysts expected the resilience in the iron ore price, but those who did were rewarded with very good share price gains.
When resources companies get it right, they're extremely profitable. Rio Tinto (ASX: RIO), BHP (ASX: BHP) and Woodside Petroleum (ASX: WPL) are three companies which have rewarded shareholders time and again, thanks to their high margins and ability to scale production.
Although when they're wrong it makes for tough investing. In the last few months Rio Tinto's share price has performed exceptionally well because the price of iron ore has stayed strong, the AUD has fallen, management have ramped up production and slashed costs. However past years have not been so enjoyable and shareholders have witnessed the company writedown billions of dollars with debt blowing out to significant levels.
A step in the right direction
Since Sam Walsh was appointed CEO earlier this year, Rio has been moving to a different beat. Instead of side-stepping issues like debt and writedowns, he is meeting them head on and cutting costs and divesting unprofitable assets everywhere he can. I think for the large part this is great and shows the commitment of the CEO to long-term growth.
The board's decision last month to increase production of iron ore to 360 million tonnes per year was a no brainer. Rio is already dependent upon iron ore as it accounts for over 80% of earnings and offers spectacular margins.
However it's important that Rio has adequate balance sheet flexibility to make sensible acquisitions and expansions even if iron ore prices do fall (which many people are predicting) in the long term. Rio's purchase of Alcan in 2007 was perhaps the worst takeover in mining history and shareholders would be right to question any acquisition in the near future. However its Oyu Tolgoi copper and gold mine in Mongolia is a great example of the company investing in projects outside of iron ore which are very profitable.
Foolish takeaway
In 2014, Rio shareholders can expect cost reductions of more than $US3 billion, capital expenditure to be on its way down to $US8 billion by 2015 (it currently spends $US14 billion), debt will be lower at around $US19 billion and production of iron ore will grow to 290 million tonnes per year. If investors are bullish on the price of iron ore, it seems there's value to be had in Rio Tinto shares at current prices.
However, as I prefer to steer clear of commodities and invest in more sustainable business models, I believe Rio is too high risk for an average reward and it pays a sub-par dividend. BHP has less debt, more diversified earnings and just as much room for growth. Therefore it may appeal to a more risk-averse investor.
