How about those falling iron ore prices – Adding Rio Tinto to my High Dividend Yield Portfolio

While those around me at work are talking about the holidays, fashion and gadgets they have bought with their bonuses I've kept fairly quiet as I have chosen to save 100% (after HMRC has of course taken 40% Higher Rate Tax and 2% National Insurance) of mine.  So having saved all of it where have I invested it wisely?  I've gone for 4 main areas and I’ll cover 3 of them today, saving the fourth for a separate post.

The first deployment was sending 35% of the bonus to my better half to keep both of our financial independence end dates synchronised.

With only 18 months or so to go until Financial Independence I also want to make sure that I have positioned my financial life to also give myself the option of Early Retirement.  From where I am today this means I need to do two things:

• I am currently renting in London but want to give myself the option of buying a home in whichever country my family chooses.  I therefore need cash for this and lots of it.  My second deployment was therefore sending 33% of the bonus to my savings account and RateSetter P2P account (plus a little to my Stocks and Shares ISA which is yet to be invested so is currently cash but ensures I've at least used all of my 2014/15 £15,000 Allowance).
• I don’t like the idea of having to sell down assets to eat in Early Retirement and would much prefer to be simply spending dividends/interest with a little left over to invest.  After I net off the cash I've saved for a home my investments are currently yielding 2.1% and I’m planning on drawing down at 2.5% after investment expenses.  I therefore need to find ways to improve my dividend yield and fast.  My High Yield Portfolio (HYP) is one way I have been trying to do this.  My third deployment was therefore 15% of the bonus into Rio Tinto (Ticker: RIO).  So why Rio Tinto?

The price of the FTSE100 is today near record nominal highs (the real high is something different altogether but that’s for another day). In comparison the price of Rio Tinto is almost half of previous highs:

Click to enlarge, Price History of Rio Tinto (Source: Yahoo Finance)

So Mr Market doesn’t really like Rio Tinto all that much at the moment which has allowed Rio’s historic dividend yield to rise to 5.3% forcing me take a look.  Why?  Well I don’t profess to being any sort of trading expert and so really have no idea.  In fact I tried trading and was an abject failure.  I do however know that compared to recent times Iron Ore real (after inflation adjustment) prices are looking pretty ugly and in 2014 49% of all Rio Tinto’s revenues came from Iron Ore so that could be one reason.

Click to enlarge, Real Iron Ore Price History

So why did I buy Rio Tinto?  Within my HYP I’m looking to buy solid companies that currently have high yields but which I hope to be able to hold for the very long term, ideally the rest of my life.  I pulled the trigger and bought RIO at £28.17275 per share having read the annual report and recent news feeds.  Some of the key criteria for me were:

• The Rio Tinto business model is very easy to understand and I'm sure nearly everyone knows what they do without research.  They rip commodities like aluminium, copper, diamonds, minerals, coal, uranium and iron ore out of the ground, process them to various degrees and then sell them on.  It’s big heavy capital intensive engineering with in my opinion a pretty wide competitive moat.
• I prefer large and non-cyclical industries.  It’s large with around 60,000 employees and $47.7 billion in revenues.  I do however acknowledge that profitability is very exposed to commodity price changes.
• I already own BHP Billiton, another Mining company, so I am again breaking a rule here as I should have been adding a new industrial sector to my HYP.  I've broken this rule previously when I added GSK when I already owned Astra Zeneca and also when I bought BP when I already owned Royal Dutch Shell so I have previous form.  Today against my buy price RIO is already underwater by 3.1% after considering buy/sell spreads and the 0.5% Stamp Duty Reserve Tax (SDRT).  I'm still sleeping well as this is a long game.
• I'm looking for shares with dividend yields somewhere between the current FTSE 100 yield of 3.5% and 1.5 times the FTSE 100 yield or 5.3%.  On a trailing yield of 5.3% RIO is therefore right at the top end of that range.  Forecast dividend yield is currently a little higher at 5.6%.
• The company should have an unbroken history of continually increasing dividends plus dividends that increase at a rate equal to or greater than inflation.  In the 5 years to 2014 RIO have raised their dividends from $1.08 to $2.15 or 99% which is a country mile above inflation.
• A dividend cover of greater than 1.5 for all HYP type shares except utilities where I think that greater than 1.25 is ok.  Here RIO passes with flying colours sitting on 2.3.
• ‘Creative accounting’ can make earnings and hence dividend cover look good.  I therefore also set a greater than or equal to 2 criteria on Operating Cash Flows compared to Dividends.  At 3.6 this also looks ok.
• In addition to increasing dividends nicely RIO has in parallel also been paying down some debt to increase balance sheet strength.  Net debt has reduced from $22.1 billion in June 2013 to $12.5 billion at the end of 2014 for a gearing ratio of 18.6%.
• Valuations don’t look excessive with a P/E ratio of 8.1 and a Price/Book ratio of 1.1.

The addition of Rio Tinto now brings my HYP stamp collection to 12 (lucky 13 if you count the government Royal Mail Group gift).  So I’ve again doubled up on sectors and I’m sure commodity prices are going to hit profits in the short term however I’m not buying for the short term.  My only thought is that RIO is not a contrarian play with 15 of the Brokers surveyed by Digital Look suggesting RIO is a Buy or Strong Buy.

As always DYOR.