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Rio Tinto and the art of the orderly retreat

Published: 01:18 13 Feb 2016 AEDT

Iron-ore

There was no panic on the market as Rio Tinto (LON:RIO) cut its dividend this week. Instead, initial heavy selling on the day was soon pared back to modest losses as investors faced up to the fact that they’d known that the cut was coming all along.

Still, the manner in which the announcement was made was almost as important as the substance itself, because as any military strategist knows, when a line of defence is breached, an orderly retreat is always preferable to a rout.

Rio’s attempt to structure its retreat looks well-judged and liable to limit any collateral damage along the way.

This year, the dividend will be held at a relatively robust US$2bn, even as the company cuts across the board costs and capital expenditures by comparable sums.

But so far as the years to come are concerned though, the language is much more vague.

Here Rio, and its advisors, know that markets have short memories. The company talks of returning between 40% and 60% of earnings over the course of “the cycle”.

What exactly constitutes a cycle wasn’t made clear, and a glance at Rio’s own share price graph sheds no light at all on what investors’ own views on that might be.

Rio’s shares are now at a six year low.

Indeed, if you exclude the precipitous plunge and subsequent rapid recovery that occurred when the financial crisis struck in 2008, then the shares are at a 10 year low.

Can cycles last longer than 10 years?

If Rio’s shares are anything to go by they can, because although the shares may currently be at a 10 year low, 15 years ago, the shares were much lower still.

That presents two options: either we still have a lot further down to go in the current down cycle, or share prices are not reflective of commodities cycles. And if the second case is true, is there therefore any rational basis for tying yield to cyclical factors at all?

Rio is not the only company whose shares follow this pattern. The share prices of all the major miners across all the major markets show a similar trend: broadly flat throughout the late 1980s and 1990s, mild gains from 2000 to 2005, a subsequent sharp upward spike that peaks in 2011 and then falls away rapidly.

There is a case to be made that the time that has elapsed over these years actually amounts only to a single “cycle”, but that’s a thirty year stretch, and if that argument was followed it would render Rio’s plans to balance its yield across the cycle meaningless on any normal investment horizon.

Another alternative is that there were several cycles during that period, but that investors bought heavily into only one of them – the so-called “Supercycle” that was much touted in 2006 and 2007 as a consequence of the ongoing seismic shift in global economic power from west to east.

But again, if that’s the case, then it would appear that investors’ idea of what constitutes a cycle may differ somewhat from Rio’s.

And in that context, this statement may turn out to only to have allowed Rio to execute a tactical rather than a strategic retreat.

On the other side of the coin though, legitimate questions remain about whether the Supercycle is actually over.

Expectations about the continuing salutary effects of Chinese growth on the global economy have been moderated by recent gyrations in Chinese stock markets and an overall slowing of the growth rate there.

But when all’s said and done, China’s 6.9% growth is still adding economic capacity the equivalent size of Switzerland or Saudi Arabia each year.

And such growth would, under normal circumstances, be able to account for all the iron ore that Rio Tinto and its significant peers BHP Billiton (LON:BLT) and VALE (NYSE:VALE) care to produce.

But Rio, VALE and BHP Billiton have been seized with something of the spirit of Saudi Arabia’s approach to the oil market: all are producing iron ore at maximum output levels in a bid to secure volume at the expense of margin and to drive weaker competitors out of business.

This is not a cartel in the strict sense of the word - it’s more perhaps an alignment of outlook amongst the world’s major iron ore producers. 

But it’s behaviour like this which tends to make investors ignore commodity pricing cycles when in turn setting share prices for Rio and its peers.

After all, iron ore accounted for more than 80% of Rio’s underlying earnings in 2015, and yet here is the company openly and actively chasing the price downwards whilst making feeble and transparent protestations about slowing demand.

It’s a long-term strategy, and not without risks. But the market’s moderation in the face of the dividend cut shows that perhaps there is some understanding out there about what’s being attempted.

Dividends would “constrain the business” and “act against shareholders’ long-term interest,” says Rio. But it also says that when the good times start rolling again it will likely up the dividend. Plus ca change – cutting the dividend in hard times and then saying you’re going to put it up again when things improve is not rocket science.

What we really have here is an object lesson in attempting to dignify a substantial retreat.

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