Rio Tinto - The hole story

A few weeks ago I published one of my regular FTSE 100 value trawls on and within the lowest-forecast-P/E net, a number of big miners were caught, six out of the ten in fact, and thus this sector dominated the table. Quite a remarkable showing by one sector and telling us that, at least as far as P/E is concerned, the market most definitely does not like 'holers' right now.

Looking down that list in ascending order, the first mining share that superficially I like the look of is Rio Tinto. Its forecast earnings per share (eps) for the year to 31 December 2011 is 557p, so with the shares at 3,373p the forward P/E is 6.1. Now that's cheap. And looking ahead to 2012, the analyst consensus is presently 575p, making the share a bit cheaper still on a P/E of 5.9 -- though bear in mind that the further ahead the forecast, the less reliable it must be.

Why are the big miners so cheap right now? I'm not normally one for seeking the reasons behind everything that happens in the market, but the likely cause here is the fear of a slowdown in the world economy, resulting in reduced demand for raw materials such as metals. The question for value players is whether this fear has been overdone.

Sentiment over-riding the numbers is what causes value in the first place, but it is not always easy to figure out if poor sentiment is likely to be vindicated by poor numbers or will in time turn out to have been baseless. That is why not every value play works out. Sometimes, when value investors are betting against the sentiment, it transpires that the market's ill-feeling was right all along. You can't win 'em all, the hope is to win enough times so that on balance good profits are made.

What else does Rio have going for it? The last accounts were the interims to 30 June. Net debt then was $8.6bn, which seems a lot but compare it with net assets of $62.9bn and the gearing is only 13.7%. Okay, net tangible assets are much lower at $38.9bn, but even on that more conservative basis gearing is only 22.1%.

As those who follow my value approach will know, my ideal value figure for net debt is zero meaning net cash. I consider debt to be filthy stuff, but we're talking very big caps here where my PYAD criteria (low P/E, high Yield, good Assets and no Debt) will almost never apply in full. So in the absence of net cash, the lower the net debt the better and Rio is modest on this score.

Looking at assets, a Price/Tangible book of roughly 2 means Rio ain't no asset play. And looking at dividends, the forecast payout for 2011 is 76.1p per share for a yield of a miserly 2.3%, so it ain't no yield play either. Even the higher 2012 dividend forecast of 81.5p per share still delivers a forward yield of only 2.4%.

So the low P/E is really all that is going for it, from my four value criteria. But there's more.

Directorspeak within the interims referred to another set of record-breaking results and a positive outlook for the remainder of 2011 and into 2012. Rio's managers do though refer to the risks arising from the threat of financial crises, which could destabilise commodity markets. Looking further ahead, they see higher-than-average growth but characterised by "elevated volatility and scope for discontinuities". Lovely phrase those last three words, pure DS.

I mention the DS because I want to compare it with how the market sees Rio as measured by the very low P/E awarded to it currently. The two seem somewhat incompatible to me.

Now one could argue that DS will frequently tend to be over-positive when prognosticating. You won't often see the directors say something like: "we're heading down the toilet for 2012 and if you think that's bad you should see what we think of 2013" or the like. So what they say tends to be riddled with trite clichés and euphemisms copied from other companies, which is why they all use such a similar style. But the investor should try and read between the lines as far as possible. And doing this here, Rio just doesn't appear to me to believe the market's view of its own future.

Finally -- and most importantly -- I just love the nomenology of the name. When I first noticed this share, several decades ago, it was called Rio Tinto Zinc. Much later they initialled it to RTZ. The latter is meaningless. Then someone at the company, clearly in possession of a soul and not the usual corporate suit, realised the mistake and it was renamed the present Rio Tinto after a river in Spain. The company was formed originally in the nineteenth century to mine copper there.

I think this play has some mileage in it.

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