Since the turn of the year, shares in BHP (LSE: BLT) (NYSE: BBL.US) have easily outperformed those of Rio Tinto (LSE: RIO) (NYSE: RIO.US). In fact, while the former has risen by 11%, investor sentiment in the latter has caused its valuation to slide by 4%. Will this trend continue through the remainder of 2015 and beyond? Or, should you buy a slice of Rio Tinto rather than BHP?
Similar Strategies
On the face of it, the strategies of Rio Tinto and BHP are broadly similar. Both have seen their top and bottom lines hurt significantly by lower commodity prices (particularly iron ore, which is a major part of both businesses) and have responded in a similar way. That is, Rio Tinto and BHP have both increased production so as to try to increase their market share. This is a shrewd move, since at the same time both companies are doing all they can to reduce their cost bases and so they are essentially squeezing less competitive operators in the mining sector.
In the short run, this may contribute to even lower commodity prices, worsening investor sentiment and lower profitability. But, in the long run, it could allow Rio Tinto and BHP to exert even more dominance over the mining industry.
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Valuations
While there is considerable scope for asset write downs moving forward, as the earning potential of the two companies’ asset bases reduces due to lower commodity prices, their current valuations appear to more than take this possibility into account. For example, both companies trade on identical price to book (P/B) ratios of just 1.5. This shows that even if there are asset write downs moving forward, their share prices could be better supported than many investors realise and, if commodity prices do stabilise, then there is scope for a significant increase in their P/B ratios over the medium to long term.
Income Prospects
While there is little to choose between Rio Tinto and BHP when it comes to strategy and valuation, there is even less separating them when it comes to income prospects. For example, Rio Tinto currently yields 5.3%, while BHP has a yield of 5.2%. However, next year this situation is set to reverse, as BHP is forecast to increase dividends per share at a slightly faster rate than Rio Tinto, which puts it on a forward yield of 5.6% versus 5.5% for Rio Tinto.
Looking Ahead
However, where there is a major difference between the two companies is with regard to their earnings growth forecasts. For example, Rio Tinto is expected to see its bottom line fall by 45% this year, followed by growth of 20% next year. Meanwhile, BHP Billiton’s profitability is expected to decline by 42% this year, and by a further 11% next year. This could be crucial for income investors, since while Rio Tinto’s dividends are set to be covered a healthy 1.4 times by profit next year, BHP is due to pay out all of its profit as a dividend next year, which is clearly unsustainable in the long run.
So, while there will likely be improved sentiment for BHP resulting from the spin-off of its non-core assets to South32, Rio Tinto could turn the tables and outperform its sector peer over the medium term. Both stocks clearly have bright futures, with appealing valuations, sound strategies and great yields, but Rio Tinto’s stronger growth prospects give it the edge over its sector peer.
