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Why I think Rio Tinto Limited shares could be a bargain

With the outlook for the ASX being highly uncertain, buying shares now goes against many investors’ gut feelings. That’s understandable, since the ASX has fallen by 7% already since the turn of the year and buying now could mean substantial losses in the short term.

Furthermore with commodity prices and the near-term outlook for China being somewhat challenging, avoiding the stock market altogether may seem like the right thing to do.

However, buying now could lead to significant gains further down the line. That’s because a number of stocks offer sound financial footings and yet trade at relatively low valuations. As such, the risk/reward ratio may have swung in the investors’ favour, producing a wider margin of safety through which to limit downside risk and maximise long term rewards.

For example, iron ore miner Rio Tinto Limited (ASX: RIO) has fallen by almost 10% since the turn of the year. This is unsurprising since even in the handful of trading sessions in 2016, the outlook for the mining sector has worsened due to commodity price falls. Clearly, further such falls could lie ahead, although Rio Tinto appears to be well-positioned to cope with them.

That’s because it continues to be one of the lowest cost producers around and, as the company’s half-year results highlighted, its financial strength is a major plus for the company’s investors. In fact, Rio Tinto reported in its interim results that its post-tax operating cash flows were US$4.4bn, and this comfortably covered sustaining capital expenditure as well as dividend payments.

Furthermore, the company’s gearing ratio remains relatively comfortable at 21% and indicates that Rio Tinto’s balance sheet remains conservatively managed during a difficult period for the industry. This, combined with cash flow per share having increased by 10.1% per annum during the last five years, indicates that Rio Tinto’s position relative to its peers could improve as a result of it being financially capable of riding out the present difficulties in the mining sector.

This will be aided by Rio Tinto’s cost savings measures which have been increased so as to provide a target of US$1bn in cost savings in the current financial year, with 64% of them having already been delivered in the first half of the year. This could enable Rio Tinto to further strengthen its long-term position compared to its sector peers.

On this front, Rio Tinto’s strategy to ramp-up production appears to be a major plus for its investors. Certainly, it has contributed to higher supply of iron ore which has negatively impacted on prices. But crucially, it has heaped greater pressure on Rio Tinto’s higher cost rivals and, in time, may enable Rio Tinto to become a more dominant and profitable player within the mining space.

With Rio Tinto currently yielding 7.2%, the market appears to be pricing in a dividend cut. However, the company is expected to maintain dividends at their present level in the current financial year. And with Rio Tinto’s cash flow holding up well and cost savings yet to come, any cut in shareholder payouts could prove to be a sensible reduction as opposed to a slashing of payouts.

While the past has been hugely challenging for investors in Rio Tinto, its sound financial standing, high yield and prudent strategy indicate that now could be a good opportunity to buy a slice of it for the long term.

Despite this, there are 3 other ASX stocks that I believe could outperform Rio Tinto.

In fact, they have recently been named as The Motley Fool's 3 Top Blue-Chips For 2016 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 them.

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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