During Rio Tinto Limited's (ASX: RIO) 2014 financial year, iron ore, copper and coal, accounted for two-thirds of total revenue.
In all, 66.3% of revenue comes from these three commodities alone with the low margin Aluminium business making a further 24.2%.
By remaining diversified across markets and commodities Rio Tinto appeals to risk averse investors who seek exposure to the resources sector. However, now more than in recent times, the returns on offer from the sector are expected to dwindle as China's thirst for raw materials begins to subside.
Indeed, China is now transitioning away from its infrastructure-led economy towards one of consumerism. At the very most, this will likely result in a plateauing of demand for raw commodities like iron ore, a steel-making ingredient.
Three reasons to avoid Rio Tinto shares
As it stands, I suggest investors avoid buying Rio Tinto shares for the foreseeable future. Here's why…
- Plunging iron ore prices. The fallout of iron ore prices has been well documented in financial media as it remains Australia's most lucrative export. While some forecasters suggest medium-term prices will be buoyed by high cost producers exiting the market, smaller miners have proven more resilient than many expected. As a result of an imbalance brought on by increased production and waning supply, the short-term outlook for Rio Tinto's number one commodity continues to appear bleak.
- Falling copper prices. Over the past five years, copper prices have fallen 38% to around $US6,000 per tonne. According to one official Australian government forecaster, the Department of Industry and Science, although consumption from China is expected to grow strongly until 2020 market prices for copper are expected to soften as the market enters surplus.
- Coal prices. Coal accounts for 7.2% of Rio Tinto's segment revenues but over the past three years has produced just $463 million in net earnings (before interest) despite the business unit consuming over $2.3 billion in capital expenditure. Unfortunately, there appears no end in sight for lower coal prices despite them having fallen over 42% during the past five years.
Should you hold Rio Tinto?
First year economics students will know that when waning demand is coupled with rising supply, prices in a free market will not hold up.
Although Rio Tinto is a low-cost producer across many commodities – and will therefore likely survive under even the toughest market conditions – it does not guarantee shareholders market-beating investment returns.
Therefore, until its valuation becomes more compelling, or the market for key commodities clearly shows signs of recovering, Rio Tinto shares are likely best left on your watchlist.
