The Best Commodity Stock to Own

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In many races, the fabled tortoise always beats the hare. That's the lesson learned by diversified miner Rio Tinto ( RIO ) , which tried to race ahead, stumbled badly, and is now running the race at a more moderate and safer pace.

At the height of the commodities boom in 2007 and 2008, Rio's executives were enraptured by a stock price that had tripled and abandoned their historical moderate growth plans by making a $40 billion bet on Alcan to become a massive player in the aluminum market. The deal made strategic sense. The price did not. And when credit markets eventually swooned, Rio Tinto nearly choked on its massive debt load , sending shares down more than -85% from $140 in early 2008 to just $16 in early 2009. Shares have since rebounded to $66.

That stumble provided a valuable lesson. Rio has since pared debt and is more content to simply grow in line with the broader commodities market. The company now has a much better reputation on Wall Street, thanks to the relative youth of its mines and its low-cost operations. The company's main focus is iron ore mining (54% of revenue), aluminum (21%), copper (10%) and coal (10%). That kind of diversity means Rio is not as beholden to pure play miners such as copper producer Freeport McMoran ( FCX ) .

Right now, Rio appears to be firing on all cylinders, as commodity prices have rebounded from the 2009 lows. Just-released quarterly results came in slightly ahead of forecasts, pushing the stock to a fresh 52-week high. Yet shares remain at less than half of their early 2008 peak, and though it may be several years before Rio gets there, the rebounding global economy could propel results back to previous peaks.

That's not to suggest that commodity prices will again be in a bubble. They'll likely fall short of those 2008 peaks, but Rio's rising production is making up for lower prices. Rio's net income should rise from $6.3 billion in 2009 to more than $13 billion this year. And analysts think profits could top $16 billion next year, assuming commodity prices don't fall.

Judicious use of debtleverage
As noted above, Rio has been working off debt after getting carried away in 2008. Yet the company still employs enough debt to generate impressive returns on its equity base. The company is on track to generate a return on equity of more than +25% this year, thanks to EBITDA margins approaching 45%.
Yet management is more careful these days not to employ too much debt leverage , just in case the global economy slumps and commodity prices fall. Nevertheless, investors should know that shares would take a pretty serious hit if China's voracious appetite for commodities comes to a halt. That's not an expected scenario, but some investors such as well-known short-seller James Chanos think China is in a bubble and headed for a crash. He's in the minority with that view, but it's worth noting.

Action to Take --> Many investors try to focus on the best commodity play. Gold and copper have been the strong plays in recent quarters. [Read our recent takes on gold here and copper here ]

But a broad-based approach to commodities is the best bet, and Rio Tinto offers almost all of the diversification you need in one place. Despite the recent run, shares look very reasonable at around eight times projected profits. That multiple is unlikely to expand too much further, perhaps to 10 or 11, representing +25% to +35% upside. To re-visit the stock's 2008 peak of around $140, we'd need to see a clear resumption of global economic growth, which would push commodity prices up. That's a possibility, but not something you should bet on. Instead, look at Rio as a great long-term holding to make sure your portfolio has exposure to commodities.


-- David Sterman

David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and a Managing Editor at TheStreet.com. Read More...

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Commodities , International

Referenced Stocks: FCX , RIO

David Sterman

David Sterman

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