Should you buy into Rio Tinto now?

Rio Tinto is making an obscene amount of money, yet its stock is still cheap. Charlie Gibson looks into the story behind the share price and suggests what it means for investors.

Rio Tinto is making an obscene amount of money, yet its stock is cheap. Buy in, says Charlie Gibson, and take profits on BT while you're doing it

As regular readers of my column will know, I base my stock recommendations on a model I've developed to guide my own investment decisions. One of its features is that it is more sensitive to the numbers' surrounding a company than the story', and every once in a while it shows quite clearly something that isn't immediately obvious. A recent example of this was Rio Tinto (RIO).

I love natural resources companies. Not because I necessarily think they're always good investments, but because they have a mathematical purity about them. And that can tell you when they really are a good bet. Unlike most other firms, they are only price-takers. In other words, the market determines the price of their products and both buyer and seller have to accept it. No negotiations. Forecast the price of the natural resource and a company's expected output of it and you've forecast its future revenue stream. The problem, of course, is getting the first bit of that equation right. New mines take years to get off the ground and so an unexpected shortfall in the physical supply of a product cannot, for example, be quickly and easily compensated for. As a result, the market is prone to dramatic price swings.

So what has this got to do with Rio Tinto? Currently, the group is making an obscene amount of money $7.4bn in 2006, or $5.50 (about £3) per share. Historically, the stock has traded on a p/e of 14 to 22 times, implying that the share price should be between £42 and £66. But it isn't. Instead, it's skulking around the £24-£32 level, putting it on a p/e of just nine times, a 42% discount to the imputed value of the firm.

So what's going on? The chart shows seven years of data relating stock price returns for Rio Tinto (on the vertical axis) against its imputed valuation (on the horizontal axis). Tere is a gap' between the
two blocks of data points, roughly equating to 25% to 42% on the horizontal axis. While Rio Tinto frequently trades on either side of this valuation band, it rarely trades within it. The reason that it is now relates, I think, to the fact that the market cannot decide whether natural resources prices should come down, or Rio Tinto's share price should go up it's a time of extreme market uncertainty. That will resolve itself eventually, but for now we're in a sort of no-man's land.

What should investors in Rio Tinto do?

I think the shares are well worth holding. According to my model, analyst expectations for the next two years would need to halve before Rio Tinto becomes a sell. Copper prices have taken a knock this year. But iron ore and energy prices look firm and aluminium is unchanged. Feeding those numbers in, it looks like earnings will fall a bit this year, to around £2.80 a share. But that still makes Rio Tinto cheap on a p/e of less than ten times even if commodity prices stay exactly where they are. If you haven't already, I'd suggest having some of the stock in your portfolio.

At the other end of the spectrum from Rio Tinto is BT Group (BT-A, 319p). BT announced its third-quarter profit numbers last week and, on the whole, they were fine. As a result, there has been evidence of brokers upgrading their forecasts. But I'm nervous. BT has undergone a spectacular re-rating over the past 12 months, and my model suggests that process has now run its course.

In the past, BT has traded on a historic multiple of between 11 times and 24 times. But in recent years, the only time that it has approached 24 times is when earnings fell away sharply in the year ended March 2002. Otherwise, it's traded fairly consistently at a rating of around 12.7 times. Now, it is suddenly trading on over 16 times. That's punchy when you consider that Vodafone is on just 15 times.

It might be reasonable if one thought good earnings growth could be sustained. But can it? Traditional revenues are declining, albeit slowly, and the broadband market is intensely competitive. With more than 50% of all UK homes already subscribing to broadband, it's soon to become lower growth. Inputting a forecast of 23.5p for underlying earnings in the current year (ending March 2007), followed by 24.18p next year (the analysts' consensus) suggests to me that BT should be sold at 323p a share a whisker above where it is currently trading. I've noticed a couple of banks (notably Goldman Sachs and JP Morgan) recently downgrading their recommendation on BT, albeit with a few financial acrobatics, such as increasing their target prices as well. That suggests that while news surrounding BT is good now, the tide may be turning against its share price.

Anyone investing in BT at any time in the past five years should have made a decent return. There's an old City adage that it is never wrong to take profits' and now would seem a propitious moment to lock in those gains and look for your returns elsewhere.

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