VALUE INVESTING
Mining : All That Glisters

By Stephen Bland (TMFPyad)
November 5, 1999

A definition first of all. By commodity companies I mean those with a trade based on minerals or other natural resources such as plantations and so on. Generally speaking the price of such companies' shares will often be driven by the movements in the underlying commodity price. Gold and oil shares are perhaps the two most well known examples of this, although there are other well known mineral companies, some of which are very large, such as Rio Tinto (LSE: RIO) and Billiton (LSE: BLT) and which may mine a range of minerals. There will frequently be one predominant item though. For example Rio Tinto is often seen as a play on the price of copper, as is the famous Antofagasta (LSE: ANTO) or "Fags" as it is affectionately known in the market.

The question has arisen several times on the value board, on whether commodity based companies can be value shares in the sense that I have defined in my articles, or the variations of these ideas that the small group of some of the fanatics who follow the board understand the term "value." It has arisen because there have been several occasions when readers have put up small oil companies for consideration – gold and diamonds having been discussed as well.

Traditionally, mining companies have been divided into two distinct types. There are the pure exploration outfits and the integrated companies. The former find the stuff and sell it on to someone else to refine and process. The latter both mine and process.

This is perhaps best illustrated in the oil business. There are quite a number of small oil exploration companies around which are listed on the stock exchange. Typically they will receive licences from the ruling power of the area concerned to explore for oil. Not infrequently that power will not be, shall we say, in one of the more honest and democratic parts of the world. These companies are big risk takers. The geo survey will reveal the likelihood of oil. Dig a hundred holes and if you are very lucky you hit a gusher and happy birthday. The company can then be evaluated on its likely reserves of oil, given an idea of the oil price.

So naturally the value of its assets fluctuates with the oil price and the shares will tend to follow. Note that the correlation may not always be that close. Some oil may be cheaper to drill than others and thus the potential profits may not always be that comparable between two exploration companies. Political considerations regarding the areas concerned may knock the price of a particular explorer. And so on.

And one more thing, these small exploration companies, oil or whatever, are renowned for having people behind them who are not always candidates for sainthood. There is a temptation to "modify" the truth about the actual reserves of the mineral, discovered or potential. I think it was Mark Twain who remarked that a mine was a hole in the ground owned by a liar. Little changes.

What I am concerned with here is whether an exploration company can be a pyad share. Unlikely is my view. They rarely have any dividends, may well have debt and no cash. If they have any earnings per share (EPS) at all, the price to earnings ratio (P/E) can be low particularly where the price of the mineral has been falling. And they could also have a price to book value (P/BV) under 1 in similar circumstances as the shares get dumped. Often mining companies of all types, exploration and integrated, are not just a simple play on the underlying mineral price. They are a geared play. By that I mean that they may amplify the commodity price, going up or down by a greater percentage than their stock in trade. This is particularly the case with gold shares.

But let's assume that in a very rare case one finds an exploration company trading at pyad levels, plenty of cash and in addition market cap is right and rising eps is present. On paper a textbook case. But be careful because the share is at the mercy of its commodity price. You will probably be banking on a strong rise in the commodity to 'out' the value. But that is outside the control of the management. It may happen, but it is an added dimension of risk, contrary to the game my style. So how would it smell? Well it all depends on the individual case of course but a bit over ripe possibly for the reasons I suggested above. Just be more wary than usual if you ever find this. But as I said earlier it is very unlikely anyway with a pure exploration case.

Which brings me on to the integrated companies. Shell (LSE: SHEL), BP (LSE: BPA), Rio Tinto, Billiton, Anglo Gold and so on. Some of the biggest companies on the whole UK stock market and a completely different type of business from the pure hole diggers.

In fact Billiton was a pure pyad play, an absolute classic that I couldn't have designed better if I was trying to dream up a fictitious example, not so long ago after it was floated in its present form. It went on to do tremendously well.

By the way I love the name Rio Tinto, a wonderful evocation of times past. The Coloured River. The company, earlier known as Rio Tinto Zinc, changed its name a few years ago to the boring and soulless RTZ. More recently it reverted to the aforementioned Rio Tinto. If I invested on name alone, my personal farm would be on them amongst one or two others.

Names are interesting. In music, my all time favourite band name, one that makes me come over all funny, is the fantastic and never to be beaten "King Crimson." Poetic. A band from a long time ago. I am not referring to the quality of the music, just the name. I expect round at the Fool team, only I and maybe TMFKeith (eh Keith?) have heard the name, this knowledge having more to do with age I guess than some sort of rock expertise. And the worst, a modern band "Babybird" whom I saw a while back. But I plead not guilty, they're not my stuff, I really went to see a band that was backing them up, name of Idlewild. But that name, yuk.

Anyway, if ever any of these companies goes pyad again, I suspect I would have little hesitation in going in, assuming all the other features are present. Their dependence on the underlying commodity is far weaker than an exploration share because of their broad spread of interests. Yes they are linked to oil, copper or whatever but they are far more than that. Shell and BP for example have serious interests in the chemical by-products of oil in addition to the obvious motor fuel side. Stuff like plastics, fertilisers and so on. They are far closer to being trading concerns, where the deep value approach makes more sense, than the explorers. The big gold miners however will usually just mine and refine gold and do not have spread interests. Their share price will tend to follow the metal more closely than the relationship of the other large companies to their stuff.

But precisely because the big oil and general miners are far less dependent on the mineral price than explorers, the market sometimes gets them wrong, marking them down too much because the price of oil or whatever has fallen. Treating them like small high risk prospectors.

It will be very rare for any of the large integrated oil or mining companies to become pyad shares. But there are other opportunities, to buy them simply when they are depressed as recovery stocks or contrarian plays. Their financial strength can almost be taken for granted, similar to Land Securities (LSE: LAND) in the property sector.

An old favourite of mine is Shell. A company with a cast iron balance sheet. A world name. One of the very few British international brands. Maybe a year or so ago, the shares were knocked right back on the usual dismal overdone oil price stories that have this effect. You could have made 33-50% in a year. Probably the lower figure because nobody can time the bottom exactly. I can't. And no I am not speaking with hindsight, where everyone has perfect vision. I advocated the company as an attractive investment on some message board*, I forget now because the Fool has changed beyond recognition since then. I was told all the stories that had driven them down, poor management, it's only a commodity and so on. Wonderful stuff. This is what the contrarian wants to hear. Especially when he is convinced they're wrong. But he had better be right of course.

See you on the value board. Incidentally where I say "he", please read "she" as well. Why do women readers hardly ever come to the value board? We want some stock pickers there, lady ones.

*Editor's note - I found this message on the Qualiport message board.