It would all seem so easy.
An otherwise rational, long-term investor, you notice losses staring to creep into your carefully selected portfolio. Staring at the red numbers, twinges of fear start to set in.
Perhaps it's the recent bludgeoning of your stake of Myer Holdings (ASX:MYR), bought for its strong expansion plans over the next few years. Maybe you've taken a small hammering on your stake in Toll Holdings (ASX:TOL), attracted by its strong balance sheet. Or maybe you just had Billabong International (ASX:BBG) tipped as the next big thing and bought some to put away for your children at $8 (or $6 or $4) Regardless, you're looking at some ugly losses. The timeless Buffett teaching that 'the first rule of investing is; don't lose money' echoes through your mind. The fear takes hold.
But what's this? The same day your Myer shares dropped 7.8%, the media reports Syrah Resources (ASX: SYR) rocketed 95%. In one day! Then you spot it, a potential silver bullet; "Sirius Resources (ASX: SIR) shares have soared 1636 per cent in a fortnight following a WA nickel find".
As a rational investor you know risk abounds in the resources sector, but all you would need, you reason, is one home run. One good strike. One potential ten-bagger. After that, you'll take your gains, recoup your losses and get back to your goal of rationally seeking out long-term value. You just need to find the 'right company'…
Fear and greed
The size of the resources sector and the number of opportunities for investment have grown almost exponentially in recent years.
There are now 800 listed resources companies on the ASX (about one third of companies listed on the local bourse), and media coverage of their performance, both good and bad, has increased proportionately – or more.
For investors who rely on media outlets as their source of information on company performance, the message gets sent that if they're not part of the action, they are missing out on potentially huge returns. Like the formation of an investment bubble, the fear of missing the boat while suffering losses in their own portfolio can be a significant catalyst to jumping onto the resources band wagon to riches.
Risk factors
Moving into resources stocks with the expectations of big gains carries various risks. Firstly there's the issue of assessing value. Companies likely to see big share price rises include those where future earnings are uncertain and standard measures of assessing value have not been established.
Operating cash flows can be negative for years at a time while these businesses undertake exploration or initial set-up. With little or no earnings price earnings ratios are often negative and of no value for investors.
Dividends aren't paid and on-going financing costs may require additional capital in the form of debt or issuing more equity, requiring shareholders to stump up more cash or suffer a dilution of their holdings.
Picking a winner
Picking a winner amongst the huge number of mining and resource companies can be tantamount to picking red or black on a roulette wheel. And for companies heavily geared, with little or no proven earnings, it can quite literally be double or nothing.
Undoubtedly there are golden companies with strong, sustainable earnings, low debt and solid dividend yields. But investors propelled by fear and attracted by the allure of quick riches need to identify if a company is a serious bargain, or outright speculation. The answer to this question can be the difference between successful investment and outright loss.
While there are the winners, such as Syrah Resources, so too are there losers. Bathurst Resources (ASX:BTU) for example has seen its share price decimated from $0.85 in April to below $0.30 of late. The company, currently tied up in a legal stoush seeking resource consents to mine coking coal on the West Coast of New Zealand's South Island, has been hit by a double blow as global coal prices ease and cash flow eroded.
Foolish takeaway
As growth stalls and investor patience starts to run thin with what investors believed were 'blue-chip' companies, it's a level-headed investor who can resist the allure of quick riches in Australia's golden sector. Long term investors eyeing up a shift into the resources should be sure to put aside feelings of fear and greed and stick to the tried and true practice of searching for great companies at exceptional prices.
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Motley Fool contributor Regan Pearson doesn't own shares in any companies mentioned in this article. The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
