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Do the rewards compensate for the risks taken?
Shareholders in miner Rio Tinto (RIO) have enjoyed a 12.3% total return so far this year. While more than twice the total return from the FTSE 100 index (5.6%), is such a reward adequate to compensate for the risks involved with investing in such a volatile sector?
Investors should always think about the ‘equity risk premium’ when establishing the desired return from putting money in a certain sector. That is the extra return you hope to generate on top of the ‘risk-free’ rate, which in the UK is benchmarked against the UK 10-year government bond (aka gilt).
At the time of writing, the 10-year gilt yield is 1.31%. The equity risk premium is the excess return required by shareholders to justify investing in stocks rather than risk-free government bonds.
The FTSE All-Share index has achieved 6.35% total return so far this year. Deducting the 1.31% risk-free rate means the equity risk premium, or the reward for investing in equities, is approximately 5%.
That figure represents a basket of sectors. The expected returns vary considerably at an individual sector level.
For example, you might expect a fairly low return with utilities as they have fairly stable and regulated earnings. You might want 8% to 9% from retail, for example, as that sector is at the mercy of consumer spending habits and economic health.
When it comes to mining and biotechnology, you may want to have significant returns – such as 15% to 20% a year (at a minimum) – to compensate with the risks of those industries. Mining is exposed to unpredictable commodity prices; biotechnology can often be a binary outcome – a new drug either works or it doesn’t.
Looking at Rio Tinto
With Rio, if it has made circa 12% for shareholders for half of the year; sustaining that trend for the rest of 2017 would imply a 24% return on an annualised basis. Therefore you are being adequately compensated in this situation for the risk of investing in mining, in my opinion.
Just remember that past performance doesn’t always equate to future performance – you aren’t guaranteed to make that extra 12% in the second half of the year.
Why invest in Rio?
It is one of the lowest cost mining producers on the market and has one of the strongest balance sheets in the sector.
BlackRock fund manager Tom Holl predicts a market re-rating of miners with strong cash flow. He says Rio, in particular, has a double-digit free cash flow yield if you run the calculations using spot iron ore prices. Iron ore accounts for a large amount of its earnings.
Investment bank Jefferies says it expects a significant increase in capital returns to shareholders from many miners this earnings season as ‘balance sheets are strong and cash is abundant’.
It believes Rio’s surplus cash in its 2018 financial year will represent c8.5% of its market cap. That money is the cash available to return to investors or investing in projects without increasing net debt/EBITDA (earnings before interest, tax, depreciation and amortisation) to more than a one times ratio.
Jefferies doesn’t believe all the cash will be used for dividends or share buybacks. ‘However, we do consider surplus cash to be a direct measure of financial strength’.
Rio looks as rock solid as you can get in the mining sector, assuming there isn’t a major downwards correction in the price of commodities.
Important information:
These articles are provided by Shares magazine which is published by AJ Bell Media, a part of AJ Bell. Shares is not written by AJ Bell.
Shares is provided for your general information and use and is not a personal recommendation to invest. It is not intended to be relied upon by you in making or not making any investment decisions. The investments referred to in these articles will not be suitable for all investors. If in doubt please seek appropriate independent financial advice.
Investors acting on the information in these articles do so at their own risk and AJ Bell Media and its staff do not accept liability for losses suffered by investors as a result of their investment decisions.
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