LONDON -- Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you've covered all the bases.
In this series I'm subjecting companies to scrutiny under five headings: prospects, performance, management, safety and valuation. How does Rio Tinto (LSE: RIO) (NYSE: RIO) measure up?
1. Prospects
Rio is a diversified miner, but around 80-85% of earnings come from iron ore and 10% from copper.
The decade-long mining super-cycle is ending. Slowing growth in China and rebalancing of the economy away from infrastructure and toward consumption is tempering demand for both iron ore and copper.
Typical of a cyclical sector, supply has been increasing so iron ore will move into surplus production next year, putting further pressure on prices. Nevertheless, Rio is expanding its giant Australian Pilbara mine. It's a low-cost producer and will weather a downturn better than some rivals.
Like all the miners, Rio is cutting operating costs and capital expenditure, eschewing riskier development projects and the big acquisitions of past years.
2. Performance
Rio's return on capital employed has oscillated between 13% and 30% over the past eight years, somewhat below BHP Billiton's record of 25% to 40%, though somewhat better thanAnglo American's.
Results were hit in 2009 after Rio overpaid for aluminium miner Alcan, and writedowns on those assets sent the firm into the red last year.
3. Management
Long-time former CEO Tom Albanese departed as a result, replaced by Sam Walsh. Similar to other new CEOs in the sector, he's an operational manager rather than a deal-maker. He has a good reputation and has promised to prioritise shareholder returns, with a big cost-cutting programme and asset sales already in train.
The long-serving finance director plans to leave by the end of the year.
4. Safety
Rio's geographically diversified operations, largely in stable regions such as Australia and North America, provide a margin of safety. The lifetime of existing resources, some 20-years' worth, adds more.
Net gearing of 42% is reasonable, and interest cover is a healthy 13 times. Half of the share price is represented by tangible net assets.
Cash flow comfortably covers interest, tax and dividends but lumpy capex is financed by borrowings in some years, including 2012.
5. Valuation
A historic price-to-earnings (P/E) ratio of 7.9 is in line with peers BHP and Anglo American, and substantially lower than historic ratings, reflecting the industry downturn.
However analysts are anticipating earnings per share (EPS) growth at Rio against significant declines at the other two, putting Rio on a more favourable forward P/E. The dividend yield is 3.7%.
Conclusion
Miners are facing challenging times ahead, but Rio is well placed to weather the storm and is relatively cheap.
Cyclical stocks can be very rewarding for investors, but timing is important and they make sense as part of a balanced portfolio. You can pick up more ideas on how to pick stocks and build your wealth in "Ten Steps To Make A Million In The Market", an exclusive report prepared by the Motley Fool. You can download it by clicking here -- it's free.
