Investing in Mining Stocks 101
A Few Helpful Tips for Investors Interested in Resource Stocks
Speculators have often used resource stocks as a hedge against credit, liquidity and business risks. With a few of our concrete investment tips, you could do the same.
The list of things that are wrong with the U.S. economy keeps getting longer and longer. The housing market has nearly imploded. The credit crunch has squeezed almost all juice out of lenders and borrowers. Corporate earnings are sending mixed signals at best. The U.S. dollar is dying a slow and very quiet death. And, instead of taming the inflation and moderating the economic growth with higher interest rates, the Federal Reserve is forced to cut rates dramatically to bail out, albeit only temporarily, reckless investors and wobbly stock markets. Yep, you could say that the U.S. economy is not exactly hot right now.
What About Resource Stocks?
Recent turmoil in the financial markets, spawned by the credit crisis, has had adverse impact on the rest of the economy, commodities included. However, when observed within a longer investment horizon, resource stocks have, for the most part, held their ground. Why? Simply, the laws of supply and demand are powerful and finite. And while the U.S. economy could be heading for a recession, in the emerging markets that have been generating excess demand in recent years, it is still business as usual.
To illustrate, countries such as China and India have to “contend” with GDP growth rates of nine, ten or more percent. We are talking about powerful engines that need exorbitant amounts of “fuel” to keep them going. As a result, the demand for base and precious metals, as well as energy from these markets appears insatiable.
As far as mining companies are concerned, a slowdown in China would actually be more worrisome than what goes on in the housing market in the U.S. And, as long as that demand exists, and in all likelihood, it could keep its torrid pace for years to come, mining companies will remain both a solid bet for long-term investors and an excellent hedge for speculators.
1. Check out the Properties
Our first tip is to identify a junior mining company that has one, or preferably more, properties in advanced stages of development. It only makes sense to look for growth companies that have already discovered significant mineral deposits and completed economic and feasibility studies, based on which final decisions had already been made either to commence drilling or to start production.
One more factor concerning mineral deposits is something called the “diversification grid.” Mining companies often have properties all over the globe. However, properties that are located in politically and economically stable regions are that much more valued in the eyes of traders and investors.
Once you identify such a junior miner, buy shares in it, having in mind, of course, your risk tolerance level, investment objectives and investment horizon. When a growth stage mining company has advanced properties, it is awarded a label the industry refers to as “blue sky potential,” (think of it as the often used and abused cliché “sky’s the limit”), assuming there is relatively controlled risk versus reward ratio.
2. Analyze the Fundamentals
There are hundreds of mining companies and picking the right one may seem rather intimidating. Thankfully, there are also quantifiable factors that can separate “losers” from “winners.” Our next tip is to check out a company’s balance sheet, and particularly cash in the company’s coffers, as well as cash flow from operations, working capital and free cash flows. Mining is very much a capital-intensive industry, and having strong cash positions can save many headaches to both the company’s management and its shareholders.
3. Examine the Ownership Structure
Next on the list is a company’s ownership structure. More specifically, investors should check whether the company’s insiders are compensated with stock options or warrants. If so, there is potential of both common share dilution and cash drain to pay them out. Also, check how many shares are owned by insiders. If insiders do not hold many shares, it is indicative of the management’s lack of confidence in the company’s future prospects. If a company's management is reluctant to invest in the company, why should you?
4. What About the Mining Company's Hedging Activities?
A knowledgeable investor in mining stocks would also be wise to read in a company’s Annual Report about its hedging activities. When metal prices are declining, it makes sense for mining companies to lock their revenues in futures contracts. However, when commodity prices are appreciating, hedging activities not only decrease revenues, but are also regarded as the company having bearish sentiment towards its own product.
5. Who Is Behind Its Success?
Our last tip is to read up on the management’s biographies. You can find information in the company’s Annual Report or on the Internet. The issue of management experience and education in the sector is of paramount importance. After all, would you like a plumber to examine your intestinal tract? Or, would you like a baker to cook up your medicine? Along this line of reasoning, who better to manage a mining company’s operations than a geologist or a mining engineer?
To help you along the way, we recommend “arming” yourselves with a few tools of the trade, such as how to utilize the capital asset pricing model (CAPM) when evaluating expected returns of securities, or how to evaluate a stock’s risk with its beta, or what can be learned from the Price-to-Earnings (P/E) Ratio and PEG Ratio.
