As Gulf Keystone Petroleum (LSE: GKP), Rare Earth Minerals (LSE: REM) and Amur Minerals (LSE: AMC) are currently trading below their one-month highs, some investors could be tempted to buy more, bringing down their average entry price and securing higher returns if the price rebounds.
However, this strategy is inherently risky, and it’s not suitable for all investors. Indeed, there’s a chance that by using this strategy, you’re throwing good money after bad.
So, should you use recent declines to average down on Gulf Keystone, Rare Earth and Amur?
Two types of company
Some of the world’s most renowned investors have advocated averaging down if the market declines. Peter Lynch, for example — the author of the bestselling book One Up on Wall Street — argues that “price drop in a good stock is only a tragedy if you sell at that price and never buy more”.
But if you are going to average down, there are two types of companies that you should be looking for:
- An asset play;
- A good quality business with bright long-term prospects.
Do Gulf Keystone, Rare Earth or Amur fit into either of these categories?
Well, a good business, as defined by Peter Lynch, has a great product with a wide moat, a strong cash-rich balance sheet and a PEG ratio of less than one.
Unfortunately, as Gulf Keystone, Rare Earth and Amur are all resource companies, they don’t meet the ‘great product’ criteria. This means that the three companies aren’t (by Peter Lynch’s definition) great companies, but are they asset plays?
Potential asset plays?
Broadly speaking, Gulf Keystone, Rare Earth and Amur are all asset plays.
For example, earlier this year City analysts published figures that showed Gulf Keystone’s Shaikan field alone, in its current state after deducting debt, is worth in the region of 20p to 30p per share. The company’s other assets worth up to 79p per share.
These figures are slightly dated and don’t reflect Gulf Keystone’s recent level of cash burn. Still, even after factoring in Gulf Keystone’s cash burn, the company’s assets could be worth around 100p per share.
Rare Earth and Amur are not in the same position. The two companies do own some attractive assets, but as of yet, these assets aren’t producing any cash flow. Moreover, there’s a lot of work to be done before these assets start to create any real value for the two companies.
Further, Rare Earth and Amur are currently trading at a premium to book value per share. Rare Earth is currently trading at a book ratio of around 16 and Amur is trading at a P/B ratio of 1.9.
On that basis, neither company is an asset play.
The bottom line
Overall, averaging down can be a risky strategy that’s not suitable for all investors. But if you are going to average down, you need to know what you’re doing.
With that in mind, it doesn’t seem sensible to me to average down with Rare Earth and Amur.
On the other hand, Gulf Keystone is currently trading below the value of its assets and averaging down could be a valid strategy to boost returns when the company returns to growth.
