Many fall into the trap of seeing the huge share price gains made by some mining explorers, tech start-ups and biotechnology companies and then buying shares in their peers hoping for the same results. But for every success story, there are dozens of failures, so this approach is likely to disappoint.
The vast majority of mining stocks listed on the ASX are exploration companies and if history is any guide then betting on them is a bad idea. I recently ran a stock filter for those mining companies that have delivered at least 10% per year in capital gains over the last ten years. Just 15 out of 634 or 2.4% of mining companies managed to achieve that. I did the same thing with a 20% per year hurdle rate over five years and this time 16 companies satisfied the requirement.
These results give a sense of the risks inherent in the sector but should not be solely depended upon. Here are some of the problems with drawing the conclusion from this information that mining explorers generally make bad investments.
- There are companies among the 634 that listed less than five years ago.
- Perhaps a number of stocks that were once listed and would have satisfied the conditions have since been delisted.
- I used a stock filter provided by my broker. I noticed that a couple of stocks that have undergone share consolidations were falsely returned – suggesting the data is not as accurate as it could be.
- The biggest problem is that the past five or ten years may not be representative of the future. For example, mining stocks have fallen out of favour with investors in recent times as commodity prices have been falling and there are worries surrounding demand from China.
On the other hand, there are some good reasons for avoiding mining explorers that may help to explain the low success rates.
- The majority of explorers hold prospective land that they need to spend money drilling to find out if what is hidden beneath the surface is actually worth anything. The success of any start-up company depends to a large extent on luck, but mining strikes me as a particularly unpredictable business.
- Once a promising site is identified, developing the mine requires lots of cash. Generally this money is borrowed, raised from investors or provided by partners in return for an ownership interest in the project. At this stage, there is limited certainty surrounding future returns which can make it difficult to raise the necessary funds.
- Mines have finite lives making mining companies less sustainable than other types of businesses. Miners need to continuously spend large sums developing a pipeline of projects reducing shareholder returns. This is like going through the high-risk start-up phase over and over again.
Two companies that were once junior explorers but struck it lucky are Syrah Resources Ltd (ASX: SYR) and Sandfire Resources NL (ASX: SFR). Earlier this year Syrah raised more than $200 million to develop its graphite project in Mozambique. Syrah acquired the rights to develop the world class Balama project in late 2011 and demand for graphite is expected to grow as it is used in lithium ion batteries.
Sandfire is an Australian based gold and copper producer. Its low-cost DeGrussa mine currently generates around 65,000 tonnes of copper and 35,000 ounces of gold per year and is expected to keep producing until 2021. It also has a host of other exploration assets including some promising ones in Western Australia that are close to DeGrussa.
In the case of these two miners, almost all share price gains so far occurred in the short period after the potential of their tenements first became clear. In the seven months after Syrah acquired the African exploration portfolio which included Balama, the share price rose from 11 cents to $2.36. In the 18 months after Sandfire made high-grade gold and copper discoveries at DeGrussa, its shares rose from 16 cents to over $8.00. Interestingly Sandfire's shares started rising a couple of weeks before the key announcement was released.
Perhaps the best way to play the sector then is to wait for significant news and jump on soon afterwards, before the majority of gains have been made. However, the problem then becomes interpreting the importance of announcements which is just as much a lottery for laymen like myself as picking the stocks beforehand. Perhaps it is not possible to know when a discovery is made whether there is a high chance of a mine being built but it just appears so from looking only at successful cases.
Some investors who have specialist knowledge of mining and geology may be able to tip the odds in their favour when choosing which explorers to buy. However, the starting odds seem to me to be so poor that I'm not convinced that even in this case it makes sense to invest in mining explorers. Certainly a high level of diversification is advisable to have any decent chance of good long-term returns.
