VALUE INVESTING
Mining for Value

By Stephen Bland (TMFPyad)
April 25, 2003

A few weeks ago, I'd been looking at how my deep value concept may be applied to certain market sectors, where the four basic pyad criteria perhaps do not apply in full or may need modification to determine what constitutes deep value in those sectors. Readers may recall that I reviewed bank, insurance and property shares.

This week, I'm looking at mining and oil shares - holes in the ground. Broadly, these can be split into two groups: companies which are primarily just explorers and miners of the stuff concerned, and integrated businesses, which seek it out, dig it out and process it. The latter includes very large, frequently well-known multinationals, including Rio Tinto (LSE: RIO)(NYSE: RTP) and Shell (LSE: SHEL)(NYSE: SC). These have to be big, simply because of the enormous capital investment, human and other resources required to mine, process and distribute the final product(s).

In contrast, there are several, often very small, quoted companies engaged in the exploration and mining of a range of minerals; oil and gold being two of the most common. Some of these are amongst the riskiest businesses in the market, being little more than gamblers' plays - the possibility of striking paydirt may owe more to the imagination of the directors than anything actually buried in the ground! There have been a number of bubbles in these shares over the history of investing - both here and in the US and Australia. The usual outcome involves a load of naive small investors being sucked in and losing their shirts.

Even my mum -  whose interest in the stock market is so limited that she thinks "share" is an American actress and singer - has told me repeatedly about how her father lost his fortune in gold shares. This had such an impact on her, it inspired a lifelong distaste of stock markets as places to invest, even though this loss must have happened in the early part of the twentieth century.

One thing sticks out with value and mining. The overwhelming influence on these shares is the fluctuating market price of minerals. What's more, this effect will usually be geared, so that a rise (or fall) in the price of the mineral magnifies the rise (or fall) in the share price. For value players, it follows that the time to buy mining shares is when commodity prices appear low.

Usually, there is a direct correlation between the company's fundamentals and the mineral price, such that the share will appear very cheap when the mineral price is low. Thus, when hunting value using the usual filters of low P/E and high yield, these shares often stand out. Nevertheless, the shares will likely to mark time in the absence of that kicker (a rise in the commodity price.)

So, when you buy your value mining share, you are - like it or not - hoping for a rise in the price of the underlying commodity, because you are unlikely to see any substantial share price gain in its absence. Consequently, you need to give some serious consideration to the probability of this happening, as well as being happy with the fundies. Not an easy task!

Please bear in mind that mining is a particularly high-risk area, especially those small "one product" businesses with just a few ongoing explorations or actual working mines. Mineral price fluctuations are just one element of investing in these firms, there are political risks too, with many of the world's largest mineral reserves bring found in areas of geopolitical instability. This - when added to the infamous economies of truth to which small exploration companies are prone - gives you a potent mixture of unusually high share-price risk. This isn't a major problem for the Shells of this world, but for Minuscule Oil (with only one or two wells in Darkest Peru), it could well prove to be a disaster. However, this high volatility can occasionally be attractive .

I've always liked mining shares (to the extent that I have any emotions for shares at all) but, these days, I would invest solely in the majors - and only when I smell rising commodity prices. Of course, it's easy to get it wrong; I've done that enough times in my distant past when starting out as a classic mug punter. Recently, I had a small play in a large gold share for a short time. As it happened, it worked out quite nicely, but you never know whether you were simply lucky to hit on a rising price.

With gold, it takes only a small rise in the metal price to produce serious gains in the shares; this extreme gearing effect is very attractive to me. However, the gold price had been stagnating for many years before its recent rise. Doubtless, many investors bought into gold shares at low prices, banking on a metal price rise, only to become disillusioned when the expected uplift did not emerge.

One little tip for value in gold shares, in addition to the usual fundies, is to watch the relationship between a gold shares index and the gold price itself. For example, the South Africa FTSE/JSE index recently stood at around 2051, while the spot gold price was about US$326 per ounce. Dividing the index by the metal price gives a ratio of 6.3. This is historically quite high, though it was as high as 10 a year ago. Go back to the years of when the gold price drifted along below $300 and it was around 3 or lower.

Clearly, this acts as a guide to value investors seeking a period when the shares are cheap, relative to the metal price. Unfortunately, although it gives you some idea about when gold shares appear cheap on historical comparisons, it cannot predict when any geared rise might be about to take place. That bit is down to the investor's forecasting skills.