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Shares in FTSE 100 commodities giant Rio Tinto (LSE: RIO) have dropped 15% from their 28 December 12-month traded high of £59.08.
This was in line with bearishness in the sector primarily caused by weak ongoing demand from China. The country has been the world’s biggest buyer of the commodities required to power its economic growth. But the scale of its ongoing expansion has appeared less certain since its Covid years.
A big deal?
One lesson I learned as an investment bank trader was to buy long-term bullish assets during bearish market pricing periods. And this also appears to be what Rio Tinto has done with its 9 October $6.7bn purchase of Arcadium Lithium.
Arcadium’s current annual lithium production capacity is 75,000 tonnes, with plans to more than double that by end-2028. Together with Rio Tinto’s previous lithium assets, these now represent the world’s largest lithium resource base.
Lithium is a key component in batteries used in electric vehicles, phones, and computers, among other items. It also plays a vital role in the storage of wind and solar power.
So the deal establishes Rio Tinto as a global leader in energy transition commodities – from aluminium and copper to high-grade iron ore and lithium.
Currently, lithium’s price is down about 80% from its record $70+ per kilogram level at the end of 2022.
However, analysts forecast a 10%+ compound annual growth rate in demand for it to 2040, culminating in a supply deficit. As this happens, the projections are that prices will more than double.
Are the shares undervalued?
A risk to the firm is that this price change does not happen. Another is that China’s economic recovery remains slow.
However, as it stands, Rio Tinto shares trades on the key price-to-earnings ratio (P/E) measure of stock valuation at just 9.9.
This is the bottom of its competitor group, which has an average P/E of 26. It comprises Griffin Mining at 18, BHP at 19, Antofagasta at 30.3, and Vedanta at 36.7.
So, Rio Tinto shares look very cheap to me.
The bonus of a high dividend
Last year, the firm paid a total dividend of $4.35 (fixed at £3.41), giving a current yield of 6.8%.
It means £10,000 invested in the shares would generate £680 of dividends in the first year. Over 10 years on the same basis, this would be £6,800 and over 30 years £20,400.
Using the dividends to buy more Rio Tinto shares (‘dividend compounding’ in market lingo) would produce even greater returns.
Specifically, on the same average yield, £9,701 would be made after 10 years (not £6,800) and after 30 years £66,465 (not £20,400)!
Therefore, the total investment by then would be worth £76,465, which would pay me £5,200 a year in dividend income. But of course, that is not guaranteed and I could lose money as well as make it.
My investment view
I already have shares in Rio Tinto, but I would buy them today if I did not for three main reasons.
First, they look very undervalued to me.
Second, they pay a high yield.
And third, the new lithium deal should turbocharge its earnings in the coming years, in my view. Ultimately, earnings drive both a company’s share price and dividend higher over time.
