In this blog post I review my decision to buy Rio Tinto shares in 2012, and my decision to sell them last week.
Here’s the executive summary:
Rio Tinto was a volatile investment with some extreme ups and downs, but when I eventually sold its shares the returns were okay.
The investment also rammed home the importance of buying highly cyclical companies at extremely low valuations, which is something I recently learned from my investment in Braemar Shipping.
Overview: One of the world’s leading mining companies
Back in 2012, Rio Tinto had all the qualities I like to see.
It had high and consistent growth, a long and unbroken track record of dividend payments and little in the way of debt. The share price was also reasonable, as was the dividend yield.
It was (and is) one of the world’s leading mining companies, with a history stretching back almost 150 years and mining operations that span the globe. There were some problems though, two of which stood out:
- First, the company had made a massive acquisition in 2007. The acquisition was paid for with huge amounts of debt which subsequently had to be paid off by raising cash from shareholders through a rights issue.
- Second, Rio Tinto was a miner, and miners are highly cyclical. I, on the other hand, am a defensive value investor.
At the time, I thought these problems were not particularly serious. I also though an investment in Rio Tinto could teach me more about miners whilst potentially making a reasonable return.
In the end it did more of the former than the latter, but I still think it was a worthwhile investment.
Here’s a quick summary of the results:
- Purchase price: 2988p on 07/09/2012
- Sale price: 3782p on 06/11/2017
- Holding period: 5 years 2 months
- Capital gain: 24.7%
- Dividend income: 22.4%
- Total return: 47%
- Annualised return: 8.4% per year
An 8.4% annualised return isn’t particularly brilliant, but it isn’t a disaster either. And as I’ve mentioned, there were important lessons learned, which I’ll get to in a minute.
Here’s what the investment looked like from the share price’s point of view:
Buying a cyclical company at the top of its cycle (again)
The late 2000’s were a time when Rio Tinto was riding high on the back of the commodity super-cycle, much like Braemar Shipping which left my portfolio a couple of months ago.
In fact, when Rio Tinto joined the portfolio is was pretty much at the absolute peak, although of course I didn’t know that at the time.
As the chart above shows, Rio’s growth over the previous decade was astonishing.
Its annual growth rate over that period was 21%, averaged across revenues, earnings and dividends, but even that fails to capture the true pace of its expansion. Annual revenue growth was close to 30% and annual earnings growth wasn’t far behind at 25% per year. Those are seriously jaw-dropping figures.
However, when I reviewed the company in 2012 I was well-aware that such rapid growth was not sustainable. Instead, it represented only the boom phase of Rio Tinto’s business cycle, in this case perhaps the biggest commodities boom in history.
Despite this rapid growth, the company’s valuation ratios were relatively low, partly because investors were worried about a slowdown in China and its impact on commodity prices.
As you can see from the table below, in 2012 Rio Tinto’s combination of growth and value metrics were, for the most part, much more attractive than the market index.
From a purely quantitative point of view, the numbers stacked up. But as I’ve already mentioned, there were some problems.
The first was the 2007 acquisition of Alcan, a large Canadian supplier of Aluminium. This was a very large acquisition, paid for with enough debt to take Rio’s debt ratio to 9, more than double my preferred maximum for cyclical companies of 4.
To me this shows a willingness by management to take on an unacceptable level of risk in the pursuit of rapid growth. Today, this would place a serious question mark over whether I would buy such a company, but in 2012 I was much less experienced and much more forgiving.
The second problem was that Rio Tinto is highly cyclical while my approach is to look for relatively defensive companies. In a nutshell, my investment strategy is not well-suited to analysing highly cyclical stocks.
Still, I chose to invest in Rio because I wanted to learn from the experience, to improve my strategy and yes, to hopefully make some money as well.
Holding on as the commodity super-cycle came to an end
After I bought the shares in September 2012, it didn’t take long for things to start going wrong.
By January 2013, Rio Tinto was announcing asset write-downs of 14 billion dollars and the replacement of the CEO, mostly in relation to the previously mentioned acquisition (summary: the company massively overpaid at the peak of the cycle, which is precisely why I don’t like large acquisitions).
Oddly enough, I think this disaster was good for the company, at least in the long-term.
The new CEO appeared to be much more focused on squeezing maximum cash out of the company’s existing mining assets, rather than simply looking to expand its assets by acquisition or capital expenditure.
The company’s 2013 annual results were a mixed bag, with revenues and dividends going up as profits went down. It was, in effect, the calm before the storm.
And let’s be clear – This was not a storm of Rio Tinto’s making. As a miner of commodities, Rio is like a supertanker crossing the Atlantic ocean. Massive storms are simply an unavoidable part of its business.
In this case, the storm was the ending of the commodity super-cycle.
In terms of prices, the commodity super-cycle started to decline in 2008, during the financial crisis. But even after the crisis, China continued to build what seemed like a new city every other day, so demand for all sorts of commodities like coal and aluminium was outstripping supply.
But by 2013 that supply/demand imbalance was turning around. China’s breakneck pace of development slowed, and following years of strenuous effort and heavy investment from miners and other commodity extractors, supply eventually exceeded demand.
And that, of course, had a negative impact on commodity prices which was very bad news for miners like Rio Tinto.
Although the company’s efforts to reduce costs, reduce capex and increase cash flows managed to offset falling prices in 2013, further commodity price declines in 2014 were just too much to absorb.
The result was falling revenues and a steep decline in earnings.
Ever the optimists, Rio Tinto’s board decided not only to raise the dividend but to also begin a 20 billion dollar share buyback program.
This may seem foolish, but the company’s debts were not excessive and returning cash to shareholders may well have been the sensible thing to do.
By the end of 2015, commodity prices had more or less hit rock bottom and, as you might expect, so had Rio Tinto’s revenues and earnings.
In just a few short years the company’s ten-year track record had changed completely.
In 2011, Rio Tinto’s track record showed nothing but incredibly rapid growth. By 2017, it showed almost nothing except rapid decline.
This sort of boom to bust story is, of course, what you should expect from highly cyclical companies and I don’t think these results reflect badly on Rio Tinto at all.
More recently, commodity prices have stabilised. The problem is they’ve mostly stabilised at very low levels.
Despite this headwind, Rio Tinto managed to increase revenues and earnings in 2016. Perhaps more importantly, the dividend was only cut very slightly which has helped the share price to recover dramatically.
Selling near the bottom of the cycle, but aiming to do better next time
Commodity prices are still generally very low and it seems as if we’re still close to the bottom of Rio Tinto’s cycle.
Surely this is a bad time to sell a mining company, when commodity prices and mining company valuations are depressed?
It could well be. However, I have a well-developed investment strategy and I intend to stick to it. I don’t want to start making ad-hoc investment decisions, such as hanging onto Rio Tinto, when my stock screen and portfolio management rules are telling me to get rid of it.
So as with every stock I sell, Rio is being sold primarily because it has one of the lowest stock screen ranks of any holding in the portfolio.
It has a low rank because its:
- ten-year growth rate is 1%
- ten-year growth quality is a mere 54%
- ten-year profitability is an unexceptional 11.5%
- PD10 ratio (price to ten-year average dividend) is not attractively low
As far as the stock screen is concerned, Rio Tinto is a slow growth company at a middling valuation, which is not a particularly attractive combination.
Of course, we humans are much smarter than a stock screen and we know that Rio’s current growth rate of 1% is probably temporary.
When the commodity cycle turns upwards, Rio Tinto’s growth rate will probably turn upwards as well.
But I have no idea whether the commodity cycle will turn a year from now or ten years from now. For me, having an opinion about where commodity prices will go is pure speculation, and speculation is something I try hard to avoid.
I would rather stick to Plan A, which is to trust the stock screen and not my opinions about commodity prices.
Lessons learned from a highly cyclical company
However, the stock screen is not perfect and one of the reasons I invested in Rio Tinto was to learn about highly cyclical companies, and learn I have.
I have learned that Rio Tinto is a good but highly cyclical company and that my stock screen is not very good at valuing highly cyclical companies.
The stock screen overestimated how attractive Rio was in 2012 and it is probably underestimating how attractive Rio is today.
This is not a satisfactory state of affairs, so something needs to change.
I could simply refuse to invest in commodity-related companies. This is something that Warren Buffett has often spoken about. He calls it the circle of competence. Here’s a quote from the man himself:
“You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
My circle of competence is defensive value investing; finding relatively defensive companies and buying them at attractive valuations. Highly cyclical companies like Rio Tinto do not fit that description and so they sit outside my circle of competence.
Avoiding all commodity-related sectors is therefore a reasonable choice. But there is an intermediate step, which is to only buy them when their valuations are at absolute rock-bottom levels.
Only buying mining companies (and other commodity-related companies) at extremely low valuations should improve the odds that I’ll buy them towards the bottom of the cycle rather than near the top.
My current rule on maximum valuations is this:
- INVESTMENT RULE: Only buy a company if its PE10 and PD10 ratios are below 30 and 60 respectively
PE10 and PD10 are basically price relative to ten-year average earnings or dividends. Anything above 30 and 60 respectively is unlikely to be attractively valued in my experience, no matter how wonderful the company.
However, a PE10 ratio of 30 and a PD10 ratio of 60 are not rock-bottom valuations.
They are in fact quite generous limits because many of the companies I invest in are high quality steady growth companies. These are companies like Reckitt Benckiser, which command reasonably high valuation ratios even when they’re attractively valued.
But mining companies are not steady growth companies. Instead, boom is typically followed by bust, and I want to buy them during the bust, not the boom.
So from now on I will follow this additional rule for commodity-related stocks:
- INVESTMENT RULE: Only invest in a commodity sector company (Mining, Oil & Gas Producers, Oil Equipment, Services & Distribution) if its PE10 and PD10 ratios are below 10 and 20 respectively
Those valuation limits are just one third of my standard maximums and I think they could reasonably be described as “rock bottom”.
Having such strict rules on valuation will be limiting of course, and I expect my future investments in commodity stocks to be few and far between.
But when I do invest in them, I’m hoping for much better results, and in the case of Rio Tinto, its share price has more than doubled since falling below those rock-bottom valuations in early 2016.
So buying Rio Tinto at rock-bottom prices in 2016 would have been a very profitable move, and hopefully that’s something I can pull off next time around.