Nobody doubts the potential of African-focused exploration stocks. The question is valuation. After staggering share price gains in 2010, some are seemingly “priced for perfection” and vulnerable to the slightest exploration disappointment. But recent sharemarket weakness could create opportunities to buy higher-quality African explorers, such as Perseus Mining, at lower valuations.
I count more than 100 Australian mining companies with the bulk of their operations in Africa. Put another way, one in almost every 20 stocks listed on the Australian Securities Exchange have pinned their fortunes to Africa – a remarkable trend. The continent is seen as one of the last great exploration frontiers and the destination of choice for ambitious miners seeking “elephant size” discoveries.
Recent exploration success by West African gold explorers, including Perseus, Ampella Mining, Gryphon Minerals, Adamus Resources and Azumah Resources, has made the market take notice. Interest has spread beyond gold to copper, iron ore, coal and even phosphate. More media reports and broking research about the “African mining boom” are emerging. More initial public offerings (IPOs) for African-focused explorers are launching – often a sign of an overheated market.
The danger with any boom is buying at the top and owning what I call “tombstone stocks” where the share-price chart resembles the shape of a cemetery gravestone and kills portfolios. Never forget exploration stocks, by their nature, are speculative and that mining in developing nations in Africa or South America, or in Mongolia, Indonesia or Eastern Europe, has high sovereign risk.
When hype builds, it is easy to overlook the threat of civil unrest, safety challenges (such as the board of Sundance Resources being tragically killed in a plane crash last year) and the chance that new governments change mining rules as projects move into production and earn bigger royalties. Protests in Egypt this week have shown just how much damage can be done when governments lose favour.
But there is also a risk of giving up on boom markets after they take off, believing gains are over. My approach in hot markets is twofold. First, do not chase unknown speculative exploration stocks ever higher, for the time to buy most was in 2009 and 2010. Second, focus on the best-quality exploration companies and buy them on corrections.
Perseus Mining could be a candidate. The mid-cap gold explorer is the largest, most advanced of a clutch of West African explorers. Its shares soared from 30 cents in 2008 to more than $3 as excitement built about the size of its resource and potential upgrades. The stock has more than doubled from its 52-week low of $1.47.
After peaking at $3.55 in late 2010, Perseus shares have eased to $2.85, capitalising the company at $1.2 billion. A lower gold price, market weakness in late January, and perhaps a share price that had simply run too far, too fast, were behind the sell-off. Eagle-eyed investors will watch whether Perseus shares hold support around $2.75 or drift to between $2.25 and $2.50.
Macquarie Group initiated coverage of Perseus in mid-January with an “outperform” rating and a $12-month price target of $4.40 – a 55 per cent gain from current prices. “If we assume exploration success to extend mine life at both mines to 2030 (possible 12-18 month scenario) our valuation would theoretically increase to (more than) $5 a share,” said Macquarie, which this week published a $4.30 12-month target for Perseus. Most other brokers that research Perseus have “outperform” recommendations.
It worries me when the consensus for any stock is so bullish, thus my preference to wait for price corrections before cautiously accumulating such companies.
Nevertheless, Perseus appeals in several ways. The first is the potential of its two key assets in West Africa – the Central Ashanti Gold Project in Ghana and the Tengrela Gold Project in Cote d’Ivoire. Perseus’s resource upgrade in December put its reserves for all projects at 3.9 million ounces of gold, and continues a strong record of resource upgrades. The company wants to develop into a 400,000-ounce-per-year gold producer by 2013, and that could increase if the resource is expanded.
Should that happen, Perseus would fill an important void in the Australian mid-tier gold space following the Lihir Gold/Newcrest Mining merger, and explains why big investment banks are researching the stock and fund managers are joining Perseus’s share register.
I like that Perseus’s key asset is in in Ghana, a well-established mining province thought to have lower political risk than most African countries. Political uncertainty in Cote d’Ivoire has delayed work at Tenregla, although Perseus should be able to make up some lost time. Perseus’s management is clearly doing a good job, judging by the company’s consistent exploration record.
Also, I favour a higher gold price in 2011 as developed nations struggle to maintain economic recovery and as expectations firm for higher inflation. I believe the recent correction in the US-dollar gold price is just that – a correction within a longer-term uptrend.
As to valuation, I like to compare explorers on the simple basis of enterprise value per ounce of gold in resources and reserves. To deduce enterprise value, add the company’s market capitalisation and debt, and subtract cash. Then divide by the company’s last stated reserves and resources. If you want to get trickier, use the fully diluted market capitalisation (to account for options conversion) and subtract government royalties from the resource equation. The calculation is only a rough guide; much depends on the quality and status of exploration projects.
Macquarie’s research shows Perseus compares favourably on an enterprise value/reserves basis to most ASX-listed gold producers and explorers, at $292 an ounce. My calculations suggest Perseus is cheaper on an enterprise value/resources basis than fast-growing West African explorers, such as Ampella and Gryphon, although Perseus is probably at a stage where it should be compared with a broader set of gold companies rather than only African-focused explorers.
Prospective investors should consider whether any future share price gains might be slower as Perseus moves into production. Much can go wrong for any miner moving into production, so Perseus is not without considerable risk. Long-term investors should only allocate a fraction of their portfolio to higher-risk exploration stocks, especially those in Africa.
Perseus is clearly not for conservative investors or the risk averse. But experienced investors who expect a higher gold price and believe in the potential of African exploration could do worse than investigate companies with large and growing resources, and nearing production in more stable countries.
The trick is to take advantage of short-term share price weakness that is more about macro events than company-specific factors.
– Tony Featherstone is a former managing editor of BRW and Shares magazines, and a business journalist for almost 20 years. He is not a licensed financial adviser This column provides general information and ideas on market, sector and company trends, rather than specific financial advice. Readers should not imply stock recommendations from this column. Do further research or consult a licensed financial adviser before acting on information in this column. The author does not own shares in any company mentioned in this article.