Is Rio Tinto plc A Safe Dividend Investment?

Investing in big resources companies such as Rio Tinto (LSE: RIO) (NYSE: RIO. US) is like investing with a loaded Magnum pressed against our heads. We never know when the trigger will be squeezed, ending the game with blood on the street. “Do yer feel lucky, punk? Well, do yer?”

The problem is that investors once saw the commodity sector’s raw relationship with macro-economic cycles as the industry’s great attraction, when people were promoting the concept of super-cycles. However, that super-cycle stuff was always a transient thing and never a permanent justification for a commodity-based investment.

Maybe that Magnum simile is a tad dramatic but, in terms of potential investing outcomes, I think it makes the point — with the out-and-out cyclical firms such as Rio Tinto, we never know when the next profit collapse will come, which could mean a reversal of years’ worth of investor gains practically overnight, perhaps even a plunge into investing losses.

But look at that dividend record

Despite fluctuating output prices, Rio Tinto kept its dividend growing over recent years:

A rising dividend is tempting, but look at the profit and cash flow backing the dividend payout, which seem volatile. As the dividend rises, cover from earnings and cash flow becomes thinner, and a slump in profits in the future could easily sink both the dividend and the share price.

An ever-present threat

The risk of that happening seems enormous as output commodity prices fluctuate with the whims of demand. A commodity business such as Rio Tinto has very little pricing power and must sell its production into a market that dictates what it will pay. When the market says the price will be low, it’s out the window with Rio Tinto’s profits and down with its cash flow. The outcome for investors can be catastrophic, and not knowing when that might happen puts commodity firms such as Rio Tinto on my ‘avoid’ list.

It doesn’t matter how hard the firm is working to ramp-up production or to cut costs, or how big the dividend payment might be, the risk of share-price and dividend reversal being ever present is too big a worry, particularly with so many other investment opportunities on the stock market. There are many companies that produce products and services with added-value over and above raw materials, which generates pricing power and some insulation against macro-economic fluctuation.

What now?

Rio Tinto is not a safe dividend investment in my book, and dividend investing is not as straight forward as we might think.