On 27 October 2020, we bought Rio Tinto (ASX:RIO) at $92.74. Our technical signals flagged a DeMark Sequential 13 Buy, suggesting a bottoming in the share price whilst fundamentals became increasingly attractive. We believed iron ore prices would continue trending higher on robust steel demand and an infrastructure-led economic recovery in China. RIO was our preferred exposure due to its history of production reliability and high fully franked dividend pay-out. We maintained a position after Brazil’s largest iron ore producer, Vale (NYSE:VALE), downgraded iron ore production guidance for 2021 which is expected to prolong the iron ore supply shortfall.
2. TECHNICAL INDICATORS
DeMark Sequential Indicators can be used to find turning points by identifying buying or selling exhaustion. We timed our entry into RIO by using a DeMark 13 Buy at the 200ma, signalling that the stock price had technically bottomed. The blue ribbon labelled “B” in the chart below marked our entry point. Similarly, a DeMark 13 Sell signal suggests a stock has been overbought and can be used to identify when to take profits.
3. ROBUST IRON ORE DEMAND
Iron ore demand is largely driven by China which imports over 80% of Australia’s iron ore exports. In response to the Global Financial Crisis, China allocated ¥4 trillion to infrastructure spending which drove global iron ore demand. We expected China to similarly ramp up infrastructure spending to stimulate economic activity in response to the COVID-19 downturn.
4. ATTRACTIVE DIVIDEND
RIO was our preferred lower risk iron ore producer at the time as it yielded 6.9% before franking and had reaffirmed their 2020 iron ore production guidance of 324Mt to 334Mt. It has a diversified production portfolio of base metals (iron ore, copper, aluminium etc.). We believed the market was too conservative in its forecasts and that the iron ore price could remain higher for longer. This would allow RIO to continue to enjoy elevated levels of free cash flows and payout large dividends for longer.
Source: Factset. As of 27 October 2020
5. LOW SENSITIVITY TO RATES
From a portfolio management perspective, RIO was an attractive opportunity to provide market exposure that was uncorrelated to interest rates. At the time of investment, treasury yields were trading near the bottom of their range and were at risk of rising with additional macroeconomic stimulus. Higher treasury yields increase the discount rate applied to equities, placing downward pressures on valuations. We found that the materials sector had little sensitivity to treasury yields.
6. VALE PRODUCTION DOWNGRADE
The production downgrade from Vale drove further upside in RIO. In 2019, a dam collapse in Brazil forced Vale to drastically scale back iron ore production to 312.5Mt in 2019, down from 385Mt in 2018, which created a material supply shortfall and caused the iron ore price to rally. In 2020, Vale production was again impacted by COVID-19 restrictions, driving a further rally in iron prices.
For 2021, the market had initially expected a material rebound in Vale production given that COVID-19 restrictions were being lifted and that Vale had repeatedly reaffirmed its 400Mt iron ore production target by 2022. On 2 December 2020, Vale downgraded 2020 production targets and issued a disappointing 325Mt target for 2021. The implication was that the supply shortfall would be extended for at least another year, driving another rally in the iron ore price.
RIO rallied 11.7% in the week after the production downgrade from Vale. Whilst the size of the move may appear excessive, it can be explained by two additional factors. Firstly, Australia is the largest exporter of iron ore and has geographical proximity to the largest importer, China. This positions Australian iron ore producers to best benefit from global supply disruptions.
Secondly, increased Chinese reliance on Australian iron ore exports reduces the risk of protectionism. In 2020, China imposed import restrictions or tariffs on wine, barley, beef, cotton, lobsters, and coal. The heightened risk of similar restrictions on iron ore prompted investors to apply a discount to RIO, which lifted as risks dissipated with the Vale production downgrade.
Source: Vale 2020
We bought RIO for its attractive dividend yield on iron ore upside and timed our entry using our technical indicators. A surprising but favourable production downgrade from Vale further reduced risk for RIO and allowed us to take profits at levels higher than initially anticipated.
Disclaimer: The content in this report has been prepared without taking into consideration any individual’s particular objectives, financial situation and needs, and is general in nature. Consider the appropriateness of the information in regards to your circumstances. All information used in the publication of this report has been compiled from sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report. Opinions contained in this report represent those of M3 Investment Group at the time of publication; this opinion may change over time and M3 Investment Group is not obliged to update the information in the report accordingly. This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. This document is provided for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations. Past performance is not a guarantee of future performance. To the maximum extent permitted by law, M3 Investment Group, its affiliates, the respective directors, officers and employees will not be liable for any loss or damage arising as a result of reliance being placed on any of the information contained in this report and do not guarantee the returns on investments in the products discussed in this publication. Copyright 2021 M3 Investment Group Pty Limited. No part of this report or its content may be reproduced, adapted, linked, distributed or transmitted in any form without the prior written consent of M3 Investment Group Pty Limited, other than to the extent necessary to view the material or as permitted by law. All rights reserved.