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Here’s why BHP Billiton Limited shares look cheap

Credit: Lucas Walters

BHP Billiton Limited (ASX: BHP) shareholders have had a year to forget, with shares diving a massive 50% since posting a 52 week high in March this year. Meanwhile, rival Rio Tinto Limited’s (ASX: RIO) shares have fallen (only) 36% in that time, implying under performance by BHP.

According to Fairfax press, leading investment manager and research house, AllianceBernstein, now rates Rio as a buy and recommends caution on BHP (though still rates it a market perform). With BHP shares trading at 10-year lows and providing a fully-franked trailing yield of 10%, I beg to differ.

AllianceBernstein report

It is undoubted that Rio Tinto’s iron ore operations are the best in the world. The economies of scale Rio generates through unhindered rail and ports access, as well as geographical proximity to growth markets in Asia allow it to produce top-quality iron ore at market-beating prices. AllianceBernstein views these traits, amongst others, as the reason why Rio is a buy at today’s prices.

On the other hand, AllianceBernstein regards BHP’s exposure to oil as a risk, and key reason to avoid the stock at current prices. Although AllianceBernstein admits BHP is well positioned if commodity prices recover, it takes the view that at current commodity prices, BHP’s operations face downside risks which mean the stock is best avoided.

The investor mindset

Whilst I can appreciate AllianceBernstein’s views on why Rio is a better buy than BHP, long-term investing is not about picking stocks which will outperform over a finite time-frame. As Buffett famously preaches, his favourite holding period is forever, implying that investors need to buy companies on the assumption that they will never sell them.

On this metric, arguably both BHP and Rio are buys given their world-class operations and market-leading positions as commodity producers. However, when you factor in their respective dividend yields and growth potential, I believe BHP is a better buy.

Investing 101

The dividend yield of a company relies on two things; the price at which it is bought and the dividend the company pays. Assuming the dividend a company pays remains stable forever, an investor’s dividend yield is determined by the price paid for that stock. This means that if a company is guaranteed to pay a certain amount of dividend every year, forever, an investor’s yield will be locked in on the day they make the purchase.

In BHP’s case, this guarantee is known as its (controversial) progressive dividend policy. As management has recently reiterated, BHP endeavours to maintain or increase its annual dividend every single year. In the 2015 financial year, BHP paid US$1.24 in dividends. Through translation gains, Australians received approximately AU$$1.69 implying a yield of 9.9% at yesterday’s closing price.

The progressive dividend policy has been under fire lately, with analysts fearing BHP will require debt to fund constant dividends given the downturn in commodity prices. Although management would be loathed to resile from its promise to pay the same amount (in US dollars), even if BHP’s cut its dividend by 50%, investors would be able to lock in a solid c. 5% fully-franked yield at current prices (assuming the Australian dollar stayed the same). This would increase if the Australian dollar falls further.

Industry dynamics

The kicker for BHP lies in its growth prospects. It commands a market-leading position as either the cheapest or second cheapest commodity producer in its core markets, meaning it can sustain further prices falls before it starts losing money. Based on the economics of supply and demand, BHP’s position allows it out last higher and marginal cost producers as prices fall. Therefore, when demand increases, or supply decreases (because the high-cost producers have left the market), BHP should stand to benefit and rebound higher.

Foolish takeaway

Whilst it is unknown if we are at the bottom of the commodity downturn, buying BHP provides a solid income stream over the long-term. As the dividend is effectively underwritten by management’s staunch resolve to maintain its progressive dividend policy, an investment in BHP today is likely to provide a steady 9.9% dividend yield over your investment time frame (which should be forever).

Adding in the potential for significant capital gains when commodity prices eventually recover, BHP appears to be one investment proposition that should be on everyone’s radar as a buy.

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Motley Fool contributor Rachit Dudhwala has no position in any stocks mentioned. 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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