The Pros and Cons of investing in mineral resources

Written by Steven Bacher
Thursday, 07 July 2011 16:42

Africa is known worldwide for its rich endowment with natural resources. The continent is a major producer of commodities and precious metals such as gold, platinum, palladium and copper. South Africa alone has seen resources accounting for close on 40 percent of exports by 2009, compared to 16 percent in 1990. The massive growth in the economies of China and other emerging markets over the past two decades had resulted in the demand for natural resources increasing substantially.


The question of the investment case for commodities and precious metals is one that has been revisited many times in the past few years. With the resources sector of capital markets delivering returns way ahead of the rest of the market, investors often find themselves questioning the merits of investing in resources.


Recent activities such as the buyout offer from Vale for Metorex, and the meteoric rise in the Sacoil share price from 20c to over 200c in less than a year certainly attract the interest of investors. However, policy debates such as the nationalisation of mines and a negative report on the sector by Goldman Sachs add to the confusion among investors.


What are resources?


“Resources” is a collective name for different types of metals and minerals that are found in the ground. They include base metals such as copper, manganese and iron ore; precious metals such as gold, silver and platinum; and natural resources such as oil and gas. It usually requires some kind of mining process to extract these resources from the ground.


How has the resources sector of the JSE performed?


The JSE resources sector has been a great place for investors over the past decade with annualised returns of more than 22 percent per annum versus 17 percent from the overall market. It certainly has been an attractive destination for investments. According to Craig Gradidge, co-founder of Gradidge-Mahura Investments, “While the difference of five percent does not seem like much, once you compound over 10 years the figures certainly look attractive. R100 000 invested in the market would have grown to around R480 000 and to R730 000 in the resources sector.”


What are the pros and cons of investing in the JSE?


Gradidge lists the following pros and cons when it comes to the resources sector.


Pros:

• The potential to earn higher rates of return are always present.
• The sector is best positioned to benefit from growing global economies such as India and China.
• The potential for corporate activity increases the expected return from shares in the sector.
• Precious metals such as gold and platinum are attractive options in the current environment where government debt and inflation are massive risks to capital markets globally.

Cons:

• The sector has two volatile price drivers: the currency and commodity prices.
• Gold shares in particular are generally very low dividend payers, meaning that the investor has to rely primarily on capital returns over time.
• Investors get running commentary on the top line of the income statement – because commodity prices and currency information are readily available. This can lead to sharp movements in the share price over the short term.
• In South Africa, costs are increasing at a very high rate as the industry is a heavy user of electricity and a large employer of unionised labour.
• The risk of nationalisation and further regulation remains a threat to long term returns.

How does one invest in resources?

• According to Gradidge there are a number of options available to investors wanting to get exposure to the sector. These include:
• Investing in a resource unit trust fund where the fund manager is mandated to invest only in commodity and resource stocks. The advantage of this route is that the fund manager makes share selection decisions.
• Investing in a commodity exchange traded fund (ETF) such as Newgold that provides the investor with exposure to gold as a commodity. The price of Newgold is simply the dollar price of gold multiplied by the rand/dollar exchange rate.
• Investing in an ETF that replicates the JSE Resi Index, such as the Satrix Resi.
• Investing in Exchange Traded Notes (ETN), which give the investor exposure to the performance of commodities such as silver and platinum. Standard Bank is the main market maker for ETNs in South Africa.
• Direct investments in resource shares on the JSE. This entails opening a trading account with a stock broker, depositing cash into the account and trading the shares.

The choice of which route to go would be determined by the level of sophistication of the investor, the amount of time that they have to devote to monitoring their investments on an ongoing basis, and the amount of money that they are looking to invest. According to Gradidge, “The majority of investors would be well served by a diversified unit trust fund that invests in locally and foreign listed resource shares. Investors can get exposure with as little as R500 per month or R10 000 once off. However, an investment in any specific sector should not constitute the largest portion of any investment portfolio, especially volatile sectors such as resources.”


Craig Gradidge is co-founder of Gradidge-Mahura Investments, a Sandton based financial planning and investment consulting business registered with the Financial Services Board. They offer financial planning services and investment consulting services to the public and can be contacted on info@gminvestments.co.za.