Investing in mining and resources stocks can be risky. Newcrest Mining Limited (ASX: NCM) and other gold stocks are the most recent example of how unpredictable commodity-dependent companies can be.
That's because running a business is tough at the best of times but when you factor in the seemingly wild gyrations of spot prices and a price taking industry, it only gets more difficult. Even the most experienced mining investors get it wrong.
Long-time Rio Tinto Limited (ASX: RIO) shareholders know it all too well. When their experienced board members signed-off on the disastrous $US38 billion Alcan investment back in 2008, they certainly got it wrong. So much so that the company is still feeling the effects of it today with some analysts declaring Rio Tinto missed the mining boom. But could the bad streak be coming to an end? Let's take a look at the three biggest risks affecting the company today.
1. Aluminium
Although it's already cost shareholders tens of billions of dollars in write-downs, it's quite possible the write-downs could continue into the next financial year with key metal prices tipped to remain at low levels. In its most recent full-year report, Rio wrote off $3.43 billion of investors' money, $1.29 billion of that came from the aluminium division.
However it could be reaching a turning point because despite posting a write-down in 2013, it also managed to grow its net earnings to $557 million.
2. China
Like Fortescue Metals Group Limited (ASX: FMG), BHP Billiton Limited (ASX: BHP) and many of the world's biggest miners, Rio is dependent on Chinese economic growth and, in particular, its government's spending on infrastructure projects such as housing, transportation and urban developments. Although Rio will be rapidly increasing production of key commodities in the next few years so too are its international rivals. As any business graduate will tell you, greater supply without an equivalent rise in demand will most likely result in falling prices.
3. Dependence on iron ore
If China's spending on infrastructure projects does slow, I'd rather be holding onto BHP shares than Rio because Rio is a near pure play on iron ore. Although it produces a mixture of different commodities, it doesn't produce them on the scale it does with iron ore. Over 90% of FY13 earnings were derived from iron ore so although it may be its greatest strength, it could also be its number-one weakness.
Foolish takeaway
Bullish resources investors would likely be seeing value in Rio shares at current prices, as the miner continues to ramp-up production and pay down debt, but for those unwilling to take on the risks inherent in the sector, you're probably asking yourself: "Why would I take on the added risk to invest in the company?"
If Rio can stem the bleeding and stop destroying shareholder value with constant write-downs and enjoy a couple of years with the iron ore price above $US110 per tonne, it's likely the miner's share price will jump in the next 24 months. If that happens, its current price will look like a bargain. But, if the stars don't align, remember it's the risk you took when you bought the shares.
