No doubt about it, the current mining boom is the biggest in our lifetime and many investors have been richly rewarded. Australia was the second-most active nation for mining mergers and acquisitions last year – 16 per cent of the total, or $US16 billion.
Phenomenal gains have been made on companies that specialise in the hottest commodities, such as coal explorer Bathurst Resources (BTU), whose shares have risen from just 14 cents to 1.20 – a gain of 750 per cent over the past year, or rare earths explorer Lynas Corporation (LYC), which has more than quadrupled shareholders’ money in just 12 months.
Almost 90 per cent of last year’s 96 initial public offerings (IPOs) were resource-related companies and the top performers gave shareholders well over 500 per cent returns.
Up until March this year the entire materials sector had been a standout performer, with an annualised return of 10.99 per cent to 31 March 2011. For the same period, the S&P/ASX 200 booked a negative annualised return of 0.77 per cent, according to Standard & Poor’s.
However volatility over the last two months have seen these gains erased, with the materials sector now showing a negative return to May 27th 2011 of 3.71% versus a negative return of 1.29% for the ASX200.
This highlights how mining companies, especially smaller ones, have higher risk than established, profitable industrial or finance companies. Mining companies that produce a single commodity can be especially vulnerable if the price of that commodity falls, and mining explorers yet to make profit can go bust if they cannot raise new funds. Also, note that most mining companies pay low or no dividends, as they reinvest profits to grow.
So where to from here?
The Federal Treasury says that the mining boom could have another 15 years to go; despite recent volatility in commodities prices it believes demand from China and India is showing no sign of slowing.
Australia is China’s largest investment destination, and second-largest source of foreign direct investment. Exports to China were worth a staggering $58 billion in 2010. Add to that global food shortages, rising inflation in the developed and developing world, and China and India growing rapidly but still in the early stages of economic development, and you have a perfect mix for upward-trending commodity prices.
Investing in resources is a minefield, but there are plenty of options for more conservative investors as well as speculative risk takers.
Below is a list of the top 10 ways to take part in the unprecedented boom in metals, minerals and energy companies in Australia. As always, ensure that you do further research of your own before relying on the ideas below. Investing in the mining sector may not suit your investment goals or risk tolerance as mining stocks can be incredibly volatile.
1. For broad exposure, buy diversified resource companies
Two companies dwarf the rest of the resources sector: the world’s largest miner, BHP Billiton (BHP), followed by Rio Tinto (RIO). Together they make up more than half of the S&P/ASX Resources Index by market capitalisation, and dominate mergers and acquisitions activity.
Fund managers, who do not like to stray too far from the index, have little option but to include these goliaths in their portfolios. And investors who also want a broad exposure to the metals and materials sectors – across iron ore, aluminium, nickel, coal, petroleum, manganese, copper, silver, lead, uranium, and zinc – can achieve that by buying into one company.
2. To lower risk, buy producers over explorers
You can roughly divide resource companies into those that currently make money by digging material out of the ground and those that hope to do so in the future. The first are called producers and they can earn billions of dollars by selling coal, iron ore, gold, and so on, to resource-hungry importing nations. The second group are explorers, which often boast little more than a piece of land and a belief that there is something valuable underneath it.
Producers, with runs on the board, are clearly the safer investment because their financials can be properly valued by the market and compared to their peers. Explorers, on the other hand, will not generate earnings until sometime in the future. Therefore, downgrades to global growth or commodity price forecasts can make a sizeable dent in their share price.
Although explorers can offer explosive gains, they should be considered speculative and not suitable for conservative investors.
3. To reduce the universe, stick with major commodities
Investors might be wise to stick to the main commodities, including gold, iron ore, coal and oil. Australia is the world’s largest coal exporter, the world’s largest iron ore exporter, and the second-largest gold producer.
Speculation that crude oil could hit $US120 a barrel and beyond this year could be a reason to look further into smart oil plays. In other commodities, gold prices are forecast to hold up, and increasing demand for iron ore is pushing up prices from an average $US112 a tonne in 2010 to $US149 this year.
4. If handing selection to a manager, choose LICs
Rather than testing your stock-picking skills by buying shares in individual miners, you can buy a listed investment company (LIC) on ASX that invests in a range of resource companies. Three such LICs are traded on ASX – Global Mining Investments (GMI), LinQ Resources Fund (LRF) and Global Resource Masters Fund (GRF).
GMI invests in resource companies globally, diversifying across commodities, geographic regions, and listed and pre-IPO companies. The fund currently owns shares in miners based in Latin America, South Africa, Russia and Australia. It offers exposure to major global diversified miners that do not trade on ASX, such as Xstrata and Vale.
LRF targets small to medium resource companies in Australia and abroad, generally with a market capitalisation under $3 billion. Currently the fund holds iron ore companies in Brazil and Australia, and coal companies in South Africa and Mozambique, among others.
GRF gives Australian investors the opportunity to invest in physical commodities and global natural resource companies through a ‘fund of funds’ approach, where it invests in other resource funds.
5. To match the resources index, buy an ETF
If you are confident of the resources sector generally, you might choose an exchange traded fund (ETF) that mirrors its underlying index, the S&P/ASX 200 Resources Index. This covers metals, mining and energy, and all companies involved in the exploration and production of base metals, gold, precious metals, mineral sands, diamonds, iron ore, oil and natural gas, coal, coal seam gas and uranium.
BetaShares recently launched its Resources Sector ETF (QRE). Over the past month, for example, the Resources Index returned 2.01 per cent and the ETF matched it, offering 2 per cent to investors.
Australian Index Investments (AII) also seeks to closely track the S&P/ASX 200 Resources Index. With one fund, investors are exposed to BHP Billiton, Rio Tinto, Newcrest Mining, Woodside Petroleum, Origin Energy, and the list goes on. The ASX code is RSR. AII has another other ETF over oil and gas companies and an ETF over miners in the ASX 300 index.
For those accustomed to the SPDR range of ASX-listed ETFs, there is the SPDR S&P/ASX 200 Resources Fund (OZR) from State Street Global Advisors.
6. For physical commodity exposure, buy an ETC
If you think commodity prices are set to go higher but are uncertain about the outlook for particular commodities, you might prefer an exchange traded commodity (ETC), which tracks the performance of a physical commodity or commodity index.
An example is the Perth Mint. Called PMGOLD, this instrument is based on physical gold holdings and is backed by the Western Australian Government. PMGOLD sets out to track the international over-the-counter market spot price of gold. It can only be bought on ASX and can be redeemed for physical gold.
Five ASX-listed ETCs are offered by ETF Securities. They aim to deliver similar returns to movements in the underlying spot price, less fees.
The ETFS Physical PM Basket (ETPMPM) aims to deliver a return equivalent to the spot price of precious metals (gold, silver, platinum and palladium). The ETFS Physical Platinum (ETPMPT) is based on the platinum spot price. There are also the ETFS Physical Silver (ETPMAG), ETFS Physical Palladium (ETPMPD) and ETFS Physical Gold (GOLD). Type the code in the ASX browser for further details on these instruments.
7. For leverage, buy an instalment warrant
Confident about the outlook for mining companies and wish you had more money to boost your exposure? Look at buying an instalment warrant. You only pay 20 to 50 per cent of the market value of the shares upfront. Once this down-payment is made, you take full ownership of the shares, benefiting from any share price growth, dividends and franking credits.
If the shares continue to rise, you do not have to make the final instalment or take delivery of the shares. Instead, you can receive a cash payment for the gains made, minus the instalment amounts owing. Note that as with all leveraged instruments, instalment warrants can magnify gains as well as losses.
Instalment warrants trade on ASX and are recognised by a six-character ASX code; the first three characters relate to the underlying share and the fourth identifies the type of warrant. Look for “I” for instalment warrant.
8. For higher risk, buy a mid-cap producer
If you are prepared to take on more risk, look at mid-cap producers, which tend to steal the show when it comes to mergers and acquisitions activity. Total deal activity in the mid-tier 50 companies boomed from $8.9 billion in 2009 to $31 billion in 2010, according to PriceWaterhouseCoopers.
It reported: “The market capitalisation of the mid-tier 50 increased by over 35 per cent to $63.9 billion in June 2010 compared to June 2009 levels, delivering strong capital gains to any investors shrewd enough to have bought at the bottom of the market.”
Mid-tier coal companies such as Macarthur Coal, Whitehaven Coal and Riversdale Mining each increased their market capitalisation by more than $1 billion during 2010. PriceWaterhouseCoopers does not foresee a decrease in the near term. “China’s influence on the Australian mining industry and demand for our commodities is not done yet,” it said.
9. For speculators, buy junior explorers
During the global financial crisis it was the junior miners that bore the brunt of market panic, and it will the junior miners that lead the charge sharply lower if the resources boom hits a roadblock.
But it is also the junior miners that can offer explosive gains when optimism reigns. The trick is to get the timing right and know when to buy and when to run for the exit. One caveat – most investors should only ever allocate a small fraction of their portfolio to speculative companies because they don’t have a risk profile that suits conservative portfolio investors.
Because exploration companies are based mainly on projections, to value them you must estimate the earnings they could produce at some time in the future should all things go to plan.
However, this end of the market is less researched by analysts and largely avoided by fund managers because of liquidity issues. Therefore, getting onto an exploration share early and riding any big wave, is a possibility for the average punter.
Many explorers trading on ASX have operations in emerging markets, such as South America or Mongolia, which can give investors exposure to other fast-moving markets, albeit with higher risk.
10. Buy a mining IPO for an even higher risk/return profile
Probably the most risky avenue for resources is to buy into an IPO. With little more than a prospectus in hand, investors in IPOs do not have a history of publicly available financials to assess. Clearly, in a booming market, IPOs generally perform better than in flat conditions. But not all IPOs will travel higher than their listing price.
That said, there can be sweet gains for those who get the selection right. The top three performing IPOs last year – Doray Minerals, Hunnu Coal and Forge Resources – returned 595, 570 and 340 per cent respectively. Thirteen other IPOs more than doubled their issue price by the end of last year, and only one wasn’t a resource company.
In summary, the winners will be…
Investing in resources is risky business and there is no way of knowing for sure how long this current boom will last. The investors who win in this probably once-in-a-lifetime commodities boom will be those with access to the best information, are well diversified and have a sound strategy. Consider using a listed managed fund or an ETF if you want diversification in the resources sector, and don’t be afraid of selling if investing in the resources sector is causing you sleepness nights. When mining booms end, they end quickly and you don’t want your life savings tied up in a downward-spiralling investment.