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In ore of the Big Australian

It began with Rio Tinto. Mergers and acquisitions in the 1990s made Rio the world's largest resources house and it was the first to develop a diversified portfolio of commodities.

It began with Rio Tinto. Mergers and acquisitions in the 1990s made Rio the world's largest resources house and it was the first to develop a diversified portfolio of commodities.

Gone was the volatility of a single product, replaced by a portfolio of assets to offset the fluctuating prices of individual commodities. As Rio established itself as resources royalty, others followed its lead, including BHP Billiton.

Australian investors have a choice of two diversified mining giants. But which business is the best?

Ten years ago, the answer was simple. Having made disastrous acquisitions in copper and suffering substantial losses in steel and elsewhere, BHP was a mess. Rio was larger and more accomplished.

Now, for the first time in years, a quality gap has emerged between the two local rivals. BHP Billiton is now a clearly superior business.

Rate of return

BHP's marvellous petroleum division is its second largest, generating about a quarter of BHP's profits from high-quality oil and gas assets, mostly in Australia and the Gulf of Mexico.

Conventional wisdom says the petroleum division offers something Rio, or any other mining company, lacks: exposure to energy. That, however, is not quite correct. Rio offers indirect exposure through its giant aluminium division, which, in essence, is manufactured energy.

So, both BHP and Rio are exposed to energy. The big difference is the amount of capital tied up in each business and the rate of return each company achieves on it. Whereas Rio Alcan earns a 3 per cent to 6 per cent return on $US35 billion of aluminium assets, BHP Petroleum earns 50 per cent to 70 per cent on a far smaller sum. Its profits tower over Rio Alcan's as a result.

The near $US40 billion that Rio paid for Alcan (not to mention the extensive dilution and interest payments that followed) has indeed transformed Rio - for the worse.

The second key concern relates to iron ore. Should iron ore prices fall substantially from present levels, profits from BHP and Rio's coveted iron ore divisions will be savaged. Vulnerability to iron ore prices is made worse by the abolition of the 40-year-old annual contract system and the move to spot pricing.

A fall in prices will be bad news for both stocks - but worse for Rio.

Vulnerable to lower prices

BHP retains a high level of diversification, with oil, iron ore, coal, base metals and other materials occupying greater prominence than at Rio, where just three commodities - iron ore, aluminium and copper - account for three-quarters of profits. And because Rio's capital expenditure program is focused on those metals, that concentration will grow.

Rio's iron ore division remains a world-class business, accounting for almost two-thirds of the group's value. High quality, however, will not be an adequate defence against a slump in prices. With so much of Rio's value tied up in iron ore, Rio remains vulnerable to lower iron ore prices.

On current forecasts, Rio Tinto trades on a price-earnings multiple of about 11, suggesting it is not obviously overpriced. But that does not diminish the risks.

As famed investor Peter Lynch notes, cyclical businesses are best bought on high P/E ratios low P/Es are often a sign of a cyclical peak. This commodities cycle might be more enduring than others but it is still a cycle.

Finally, Rio's strategy to get into the low-quality aluminium business, expand the iron ore business and develop a highly concentrated resources portfolio poses additional risks. Management is aggressively pursuing expansion from a weakened position.

Projects in Guinea and Mongolia, which would have struggled for approval under the old Rio, have taken centre stage, suggesting the company might be substituting size for quality, which is exactly what it did with the Alcan acquisition.

Something is rotten in the kingdom of Rio and, although it is a difficult decision to make, the risks of holding on outweigh the benefits. It's quite possible the iron ore boom will continue and Rio's share price will rise with it but, in the long term, this is no longer the sort of business one should aim to own, unless bought very cheaply.

Should you switch to BHP?

Not yet. Holding cash while cyclical stocks rise is frustrating but doing so allows that cash to be used more effectively when the inevitable correction comes.

BHP is a better business but it isn't yet better buying.

Nathan Bell is the research director at The Intelligent Investor. This article contains general investment advice only (under AFSL 282288).


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