The financial fortunes of resources firms like Rio Tinto (LSE: RIO) (NYSE: RIO. US) move up and down with macro-economic conditions. The share prices of resources companies move up and down, too, but not always in the way we might think.
The cyclicality of the resources sector can make a long-term investment unattractive, so if you’re investing for retirement, beware.
Supply and demand
I expect most investors, whether new to the game or with shoe leather worn from walking the walk, will have some grasp of how supply and demand affects resources firms in a very direct way, such as with global mining company Rio Tinto.
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Economic cyclicality drives the resources sector and causes output commodity prices to rise and fall. That makes forward investment planning difficult for the directors of firms like Rio Tinto, and when commodity prices slide, so does profitability, which can lead to some projects becoming financially unviable. When that happens, firms might shelve planned project development and even stop some existing operations in an effort to balance the books. Falling output prices tend to reflect falling demand and what we see with the commodity companies is forced reduction of supply.
We’ve seen it happen recently at Rio; when commodity selling prices fell from recent high levels, it left the company with costs that had risen too high in the boom years as markets like China sucked up resources like a turbo vacuum cleaner to fuel industrialisation and infrastructure build. Rio’s recent strategy involves tackling costs and reforming its internal culture. The firm is pushing up production levels from still-profitable existing operations to try to overcome profit attrition from reduced margins, and has also appointed new top management to drive the company’s ‘turnaround’.
However, in my view Rio isn’t really involved in a once-and-for-all turnaround of its fortunes at all, it’s just engaged in the ‘normal’ management of its affairs through the undulation of the normal macro-economic cycle.
Forward-looking stock markets
If you’re thinking about buying and holding shares in Rio Tinto for the long term, forget it.
Perhaps you find Rio’s forward dividend yield attractive, which, at a share price of 3,087p, comes in at around 4.3% for 2015, with city analysts predicting forward earnings to cover the payout about 2.6 times.
Or, maybe it’s the forward P/E valuation of around nine times’ forward earnings looking tasty, set against predictions of an 11% earnings uplift next year.
Stop! We shouldn’t measure pure cyclical companies like Rio Tinto using a traditional value-investor’s toolkit. The ratio’s tend to work upside down, so don’t get caught out.
The stock market as a whole might be fickle, irrational, and over- or under-exuberant and act like a voting machine and all that stuff but, taken as a whole, investors aren’t stupid all the time and the market, a term that neatly describes investors collectively, got the measure of cyclicality long ago and adjusts for it.
After all, stock markets look ahead, and that means the share prices of commodity companies such as Rio Tinto tend to look ahead, too. As macro-economic cycles mature and unfold into a period of growth, such as now, commodity company share prices look towards the next peak-earnings event, which will precede the next cyclical decline into the next period of economic contraction. Typically, economic contraction means profit contraction for miners like Rio. So resource-company share prices tend to discount rising profits ahead of that fall. Right now then, we are likely to see a falling forward P/E rating and a rising forward dividend yield.
When to invest
Such a drag on the share price performance can really eat into any investor gains from a chunky dividend yield. Then there’s the ever-present threat of a dividend-payout and share-price collapse just over the next peak, which could reverse years’ worth of long-term investor gains — that’s a roller-coaster not worth riding.
It will take a mighty growth spurt for Rio to overcome its cyclical handicap to deliver worthwhile long-term investor total returns, and holding now seems fraught with risk. The only time it’s really worth holding a big miner like Rio is when profits are low, the P/E is consequently high, the dividend and share price have both collapsed and we are looking to trade the share for the next cyclical up leg.
