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Why you should buy shares in Rio Tinto Limited and Woolworths Limited

Credit: Woolworths

Two stocks which have been major disappointments in 2015 are Rio Tinto Limited (ASX: RIO) and Woolworths Limited (ASX: WOW). Their share prices have fallen by 19% and 21% respectively and, in the short term at least, they could come under further pressure. Despite this, both stocks appear to be excellent long term buys. Here’s why.

For Rio Tinto the current weakness in commodity prices presents a tremendous opportunity for the iron ore-focused company to strengthen its position relative to rivals. That’s because, while Rio Tinto’s top and bottom lines have been hurt by iron ore trading at a ten-year low during the course of 2015, the company has the cost base and financial strength to outlast its sector peers and also to increase market share. This could place it in a favourable position to increase profitability in the long run.

In the meantime, Rio Tinto has adopted a sound strategy to combat lower commodity prices, with the company increasing production and also attempting to generate efficiencies so as to reduce costs. For example, it has delivered $4.8bn in sustainable cash cost improvements between 2012 and 2014 and recently increased its target for the current year to $1bn from $750m. This means that Rio Tinto’s capital expenditure requirements are adequately fulfilled, with a modestly geared balance sheet (Rio Tinto has a debt to equity ratio of 50%) indicating that it has the financial strength to overcome the present difficulties.

Even though Rio Tinto’s earnings are due to fall by 28.8% per annum during the next two years, the market appears to have factored this in. Evidence of this can be seen in the company’s forward price to earnings (P/E) ratio of 14.8, which is less than the ASX’s rating of 15.8.

Similarly, Woolworths has been hurt by the weakening Aussie economy, with the company losing out to cheaper, no-frills rivals such as Costco and Aldi in recent years. Their discount offerings have greatly appealed to an increasingly price conscious shopper, while Woolworths appears to have been drawn into a price war having invested $200m in pricing in the second half of financial year 2015.

The impact of discounting on margins is negative, with Woolworths stating in its first quarter results that it expects a decline in net profit of 28% — 35% in the first half of the year. While disappointing, the potential challenges which Woolworths faces appear to be priced in, with the company’s shares trading on a price to sales (P/S) ratio of 0.5. This is two-thirds of the wider retail sector P/S ratio of 0.75 as well as being significantly lower than the ASX’s P/S ratio of 1.4.

Clearly, the short term could be tough for Woolworths, but with a yield of 4.7% (fully franked) which is due to be covered 1.25 times by profit next year, it appears to be a sound income play – especially when its track record of annualised dividend growth of 10% in the last decade is taken into account. This, plus the potential for improved performance under a new CEO (who may not be appointed until the second half of 2016) as well as an appealing valuation, makes Woolworths appear to be a sound long term buy alongside Rio Tinto.

Despite this, there is another ASX stock that I believe could outperform both companies.

In fact, it's recently been named as The Motley Fool's Top Stock For 2015 and could make a real impact on your bottom line as we move through the year. As a result, it's well worth finding out more about it.

Click here to do so - it's completely free and comes without any obligation.

Motley Fool contributor Peter Stephens owns shares in Rio Tinto. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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