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Riding the markets – BHP RIO FMG

The truth is you don’t know what is going to happen tomorrow. You can guess. Markets are a crazy ride and nothing is guaranteed.

But you can back favourite odds, generally which pay off well.

Having hollered from the rooftops, a changed view of RIO, which at $103 was a sell, the stock has been banging around in the mid $80’s finding a base. The Mongolian mine news and iron ore production problems are now better understood by the market.

Although the risks to global growth seem to be increasing, the market is likely to continue to flip flop from risk on risk off, and this presents good trading opportunities in RIO. A short term target for RIO is now $103. Which was the exact same point I called the recent sell.

Increased concentration risk in the resource sector perhaps is not desirable at this point. It then becomes a view what must be lightened so a position can be added.

BHP, which has a very similar investment case to RIO. Both are lowly geared and with modest capital expenditures. Excess cash continues to be distributed to shareholders. But on a valuation basis RIO outshines BHP.

On long term valuation multiples, like price to net present value (P/NPV), RIO is trading at 0.91 times, below its long-term average, and much cheaper than BHP at 1.01 times.

RIO offers a higher forecast dividend of about 7% versus BHP 6%. We think the resources earnings upgrade cycle will continue for some time as higher iron prices hold their ground for longer. In this situation BHP’s share price is expected to rise to around $38. But in percentage terms by not as much as RIO.

Other valuation metrics favour RIO over BHP. RIO’s one year forward enterprise value to operating earnings multiple is 4.8 times versus BHP’s 5.3X.

And any uptick in spot iron ore prices will deliver RIO a bigger bottom line impact than BHP.

BHP has typically traded at a premium, particularly on price earnings, to BHP. This has been ascribed to BHP’s additional asset diversification, oil. And we saw the impact of that this week when the share price jumped over a $1.00 on Tuesday. However, BHP’s China steel exposure is similar to RIO’s and the petroleum business which contributed about 9% to BHP’s EBIT doesn’t provide that much significant earnings leverage. A $10 a barrel oil increase adds 3% to BHP’s net profit.

So, it begs the question of why pay more for the same thing.

There is no doubt markets are going to be future bumpy ride. There is at least 12 months of volatility ahead, as global growth concerns are worked out and the US-China trade war is finally, hopefully resolved. Not to mention rogue Middle East states like Iran impacting on geo politics.

If, however, you want to back something on longer China odds, FMG is your stock. The share price has rallied from a recent low of just above $7 to $9.10. And FMG looks like spinning off supercharged dividends in the coming 12 months – possibly with a dividend yield as high as 14%, including specials.

FMG could rocket through $10, as the retail market awakens to the consistency of its earnings cashflow and dividend payout ratio.

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