Few industries dangle the prospect of huge speculative gains in front of an investor more tantalisingly than the resources business. If you can find a mining company that "strikes it rich",it can be like winning the lottery.
The downside is that many miners either fail, or produce little or no returns for their investors. Even worse, the sector is notorious for scams. The most prominent example was Canadian miner Bre-X (the subject of a recent film, Gold, pictured), which achieved a market capitalisation of $6bn on the back of a reported gold discovery in Indonesia, only to be exposed as a fraud. Here are some red flags to watch out for.
Location: much of the world's accessible natural resources are found in emerging markets, so avoiding all political risk is difficult. However, conflict, sanctions, or government expropriation are all risks to be aware of in many countries. A lack of transparency also makes it easier for unscrupulous operators to conceal fraud. So do your research: do other, established miners operate in the area?Is there a history of sudden tax changes or expropriation? What about war? Also ensure that the infrastructure (in terms of labour and transport links) is adequate.
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Management: you cannot monitor the day-to-day activities of a mining company in the same way that you can walk into a branch of Marks & Spencer to test the customer experience. So you have to be confident that the management team is honest, and knows what it is doing. Look into the history of the top executives. If their track record is patchy, the chief executive is stuffing the board with friends, or the company has a lot of vacant positions, give it a miss. Also check whether board members are holding onto shares or quietly selling out.
Spending: a miner that thinks it has a good chance of striking it rich will be investing in production or exploration, and keeping unnecessary costs such as administration and staff salaries to a minimum. If you dig into the accounts and find large payouts for executives, then it is pretty clear that the interests of shareholders aren't its top priority. Be particularly wary if the group is spending large sums on promoting the firm to investors, while doing little actual work.
Debt: the converse of spending too little is taking on too much debt. Commodity prices are highly volatile, whereas it takes several years for a mine to go from exploration to production. So it makes little sense to borrow heavily when prices down the line may not be high enough to make that mine viable. So avoid miners that have taken on too much debt and make sure any group you plan to invest in has enough cash on hand to sustain itself until it becomes self-sufficient.
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