With the outlook for commodity prices being rather downbeat, now may not seem to be the perfect time to contemplate adding resources companies to a portfolio. After all, there is a very real chance that the likes of oil, gas and iron ore could see their prices fall further. That's especially the case since the Chinese economy continues to experience a soft landing which, even with a devaluing of its currency, is showing little sign of improving over the short term.
However, looking back at history tells us that buying when the outlook is blackest can prove to be the ideal moment to take the plunge with financially sound, high-quality stocks. Clearly, buying such companies at difficult moments requires an acceptance that things can get worse before they get better and, crucially, the position may be a loss-making one for a period of time. But, in the long run, such moves can be highly profitable.
As a result, the likes of Rio Tinto Limited (ASX: RIO) and Origin Energy Ltd (ASX: ORG) appear to be worth buying at the present time. A key reason for this is their financial standing, with both companies delivering significant improvements to their cash flow in recent years. For example, Rio Tinto has increased cash flow per share at an annualised rate of 10.1% during the last five years, while Origin Energy's equivalent figure over the same timeframe is 16.5% per annum. This shows that, while their outlooks and profitability have worsened, cash flow remains relatively strong.
This affords them the opportunity to maintain generous dividend payments. For example, Rio Tinto currently yields a fully franked 5.4%, with dividends per share increasing by 39.2% per annum during the last five years. And, with shareholder payouts representing 42% of earnings last year, there appears to be sufficient headroom for them to be sustainable over the medium term.
Similarly, Origin Energy has a higher yield than the ASX's 4.6%, with it currently standing at 5.2%. As with Rio Tinto, there appears to be sufficient headroom for current dividend levels to be sustainable, with Origin Energy due to have a dividend coverage ratio of 1.5 in the next financial year. This should allow it to increase dividends even if profit growth is somewhat modest over the medium term.
While commodity price falls could be bad news for the short term profitability of Rio Tinto and Origin Energy, their share prices appear to include a sufficient margin of safety so as to limit their potential downside. For example, Rio Tinto trades on a price to book (P/B) ratio of just 1.68, while Origin Energy's P/B ratio is even lower at 0.79. Both of these figures indicate that there is significant potential upside on offer at the current price level and, while short-term challenges remain, the two companies appear to be excellent long-term buys.
