As my wife and I are reviewing our accounts to prepare for an early retirement, an idea like Rio Tinto (RIO) really sparked our interest. It is also a good example to illustrate the philosophy of our newly launched marketplace service. So we thought it was a good idea to provide a bit of background before we dive into the detailed discussions specific to Rio.
First, a bit of background of our general strategy. Contrary to the popular advice of building “a” retirement portfolio or “the” perfect retirement portfolio, we suggest you ALWAYS build TWO portfolios at any stage of life in a so-called barbell model. One for the short-term (eg, in case of a visit to the ER next month) and one for the long-term (eg, take care of things we are 90 years old and estate planning for kids and grandkids). Delineating survival and growth is the first step toward financial security.
Under this general background, RIO really sparked our interest as a candidate for the short-term portfolio for several good reasons as you will see:
- It generates an attractive and reliable current dividend income (the dividend yield is almost 9.7% as of this writing).
- The currently reasonable valuation and dividend provide good downside protection in the near term.
- Commodity stocks go through cycles and have been disfavored by the market in the past decade. Now seems the beginning of a new cycle. And RIO is well poised to deliver an outsized return in the new cycle. Its large cash position and manageable debt level support ongoing exploration and development efforts.
The last cycle has ended
As seen from the next three charts, RIO investors have been decent in the past decade but lagged the overall market by a large margin. The stock delivered about 150% of total return (assuming dividend reinvestment) over the past decade, translated into a CAGR of 9.6%.
The above return was driven by three factors as illustrated in the next chart. EPS growth is the first driver. Over the past decade, RIO was able to grow the EPS at 6.4% CAGR. Second, PE contraction is the second driver as seen in the second chart, contributing a NEGATIVE 0.94% CAGR to the total return. Lastly, dividend reinvestment contributed the remaining 4.1% (again illustrating its appealing dividends for current income).
Now looking forward, the natural questions are: is the last cycle over or not? And what will the return be different in the next decade?
And my answers to both questions are a definitive YES. And we will see why by closely examining the return drivers immediately below.
How would the PE change?
In short, the current PE is at a cyclical low and I expect it changes to go up from here. The following chart shows the annual average PE of the stock in the past decade. You can see the contraction of RIO’s valuation since its peak in 2015 and at the same time also the cyclical nature. The valuation bottomed in 2021 at a mere 5.2x and marked the beginning of the new cycle.
As seen, the average is 9.9x and the standard deviation is ~ 2.4. The current FW PE is only about 7.1x, not only significantly below the historical average but also below the 1-sigma level. Obviously, there is no reason why the PE has to be around mean. But for a stable and well-established stock like RIO, there is no reason to expect a sudden quantum leap in its valuation either. And a large part of being a conservative investor means to be aware of the rule of reverse selectivity – I am more inclined to expect something old to repeat itself again than to expect something completely new to show up.
And as to be seen next, RIO is well poised to deliver healthy growth too with its ongoing exploration and development efforts.
Would the EPS growth continue?
My take on this question is YES. I expect the EPS to grow AT LEAST at the same pace as it did in the past one. When I think of long term growth (like in 10 years or more), the framework I use is the following – in the long term the growth rate is “simply” the product of ROCE and reinvestment rate, ie,
Long-Term Growth Rate = ROCE * Reinvestment Rate
ROCE stands for the return on capital employed. Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how much additional capital a business needs to invest in order to earn a given extra amount of income – a key to estimating the PGR. The reinvestment rate is the portion of the income the business plows back to fuel further growth.
So to estimate the long-term growth rate, we need to estimate two things: ROCE and reinvestment rate.
A detailed description of the method I use for ROCE analysis has been published in my earlier article here. And I here will just directly show the results below. In these results, I considered the following items capital actually employed A) Working capital, including payables, receivables, inventory, B) Gross Property, Plant, and Equipment, and C) Research and development expenses are also capitalized. The ROCE of RIO over the past decade is shown below. As seen, RIO was able to maintain a respectably high and quite consistent ROCE over the past decade: on average 20% for the past decade.
Capital allocation effectiveness
Now let’s see the reinvestment part. The following chart shows how RIO has been allocating its income in the past decade. As can be seen, it has been managing its capital allocation in a quite consistent and balanced way. Dividend and maintenance CAPEx have been the major items, very typical for a mature business like RIO. These two items cost on average 57% of the operating cash (“OPC”). Neither cost is optional. For a dividend stock like RIO, the dividend is not really optional – it probably will be the last cost that management is willing to cut.
For the remaining 43% of the OPC, the company does have a choice. It can use it for a variety of things: reinvest to fuel further growth, pay an extra special dividend, pay down debt, buy back shares, et al. The business generates enough cash so it has been a consistent buyer of its own stocks. lastly, given the capital-intensive nature of the business, RIO has been allocating a good portion of the remaining earnings in CAPEx expenditures. The business has been reinvesting about ~ 15% of the OPC on average in recent years, and retaining the remaining to maintain its balance sheet strength.
Now with both ROCE and reinvestment rate estimated, we can estimate the long-term growth rate by simply multiplying the ROCE (~ 20%) and the reinvestment rates (15%). And the result is an organic and real annual growth rate of about 3.0%.
The nominal growth rate would be the above real growth rate plus inflation. It is only reasonable to add the inflation escalator for a commodity stock like RIO which has demonstrated long-term pricing power. As a case in point, in the first two quarters of the year, Bloomberg’s general commodity price index rallied more than 20%, largely driven by the rise in energy prices (44.5%), followed by agricultural goods (20.5%) and industrial metals (17.6%).
Here to be on the conservative side, I will add 3% of the inflation escalator, resulting in a nominal growth rate of 6% (3% real organic growth + 3% inflation).
Putting it all together
Now we can put all the pieces together and make some observations for the outlook in the next decade.
What I always like to do is a reality check as shown in the chart below. It is essentially a back of envelope calculation to estimate what is the growth rate and valuation required to deliver a target ROI in the next 10 years. And see if such growth rate and valuation can pass a common-sense test. To make it really simple, let’s assume dividends and earnings grow at the same rate, and dividends are not reinvested.
As an example, if we require a 10% annual ROI, represented by the black line (10% annual return translates to 160% total return in 10 years because 1.1 ^ 10 = 260%), the growth rate will only need to be about 3.8% due to the high dividend yields – way below even our conservative estimate of growth rate. And if the PE further contracts to 5.2x (the historical record low in the past decade) as shown by the green line, the growth rate would have to be about 5.7% to deliver the required 10% ROI – still in the range of our growth rate analysis.
With the above background, the purple box symbolizes what I think would be the expected region for the next 10 years. Based on the discussions we had in the earlier sections, the reasons are:
1. For the valuation – I do expect the PE to expand in the next decade for the fundamental reasons analyzed above. A PE reversion to the historical average of 9.9x would be reasonable.
2. For the growth rate – as aforementioned, I consider it to be somewhere near the upper single-digit range (say around 6%) given the average ROCE and the reinvestment rate that makes sense to me for a business at RIO’s scale.
Under the above arguments, the expected return would be 9.5% to about 15% in the next 10 years as highlighted by the purple box. And it is likely that the stock can deliver the high end of the return. All we need is a moderate growth rate and some luck – but not too much – for the valuation to revert to the historical average. A 15% annualized return would translate into almost 310% total return – quite sizable considering the quality of the business.
These are some short-term risks due to the pandemic. During the third quarter, Rio Tinto’s commodity output moderated, due to pandemic-related labor shortages, equipment outages, and project delays.
There are always large volatility risks associated with commodity prices, especially iron ore prices for RIO. The recent large drop of more than 50% serves as a case in point. Although such volatility risks are only short-term in nature. Good businesses like RIO certainly understand the cyclical nature of commodity prices and are well-prepared. For example, RIO has a quite low debt level (about $ 13B in recent years) and maintains a quite large cash position (about $ 10B in recent years).
Conclusion and final thoughts
This is a good time to buy RIO in a decade. After lagging the market in the past decade (though still delivering close to double-digit total return), its valuation has passed a cyclical low of only 5.2x PE in 2021. In the near term, the investment enjoys good downside protection given the compressed valuation (below the average by more than 1 sigma) and generous dividend. In the long term, its large cash position and manageable debt level support ongoing exploration and development efforts.
The stock is well poised to capitalize on the next commodity cycle thanks to its scale, high ROCE, and effective capital allocation. These drivers are expected to deliver an outsized return in the decade ahead. And the total return is estimated to reach 310%, or more than 15% when annualized.