Why African gold is cheap

“Penny share status is unattractive for many investors.” So says Caledonia Mining (AIM: CMCL), which is going to consolidate its shares so that the current price of 8.5p becomes 85p (but holders will only have one share instead of ten).

You would think that the type of investor that Caledonia is attempting to attract with this manoeuvre would have the brains to understand the irrelevance of the nominal share price, which tells you nothing about a company’s stock-market valuation. That aside, there is something much more unattractive about Caledonia than its share price, which I will come to in a moment.

First though, let me set out a few facts.

Costly ventures into unstable territories

Caledonia has a mine that produced 45,000oz of gold last year. The cost, $500 per oz, compares very favourably with a local average of around $800/oz. Production is rising towards a target of 76,000oz by 2016, the $37m investment cost can be paid for out of cash flow, still leaving sufficient funds for Caledonia to pay a dividend and have a look at a copper project in Zambia.

Despite these rosy prospects, broker Edison Investment reckons that the shares trade at a discount of around 50% to comparable gold miners. So what’s the problem?

I have no doubt that if this mine was in Australia or Canada, this 50% discount would not apply. But this mine, called the Blanket Gold Mine, is in Zimbabwe. Dare we venture into this troubled country?

Political risk is a major factor in the mining sector and has become more so in recent years. Governments have responded to the mining boom by selectively changing the rules or by simply helping themselves to mining assets that foreigners thought they owned.

A comprehensive study of country risk has been produced by the UK-based consultancy Maplecroft, and it gives plenty of reasons to venture carefully.

Its Political Risk Atlas 2013 “includes dynamic short-term risks, such as rule of law, political violence including terrorism, the macroeconomic environment, expropriation, resource nationalism and regime stability, as well as structural long-term risks, such as economic diversification, resource security, infrastructure readiness, and human rights” – the latter “considered a leading indicators of political risk.”

 

Prompting a mining revival in Zimbabwe

For companies that venture into these hot spots, the threat is not simply a knock on the door from a friendly government officer who’s come to seize your business assets. Maplecroft explains that “the steps required to mitigate threats to employees, assets and supply chains increases the costs for business, including for insurance.”

Zimbabwe is not rated “extreme risk” by Maplecroft across all categories. The list of countries where investors should most fear to tread is headed by Somalia, the Sudan, the Democratic Republic of the Congo, Central African Republic and Afghanistan.

Beware, though, that in the sub-group “terrorism risk”, Maplecroft identifies 18 countries including Nigeria, the Philippines, Colombia, Thailand, India, Russia and, for the first time in five years, Turkey, which has seen increased terrorist attacks by the separatist Kurdistan Workers’ Party.

In Zimbabwe though, the worst could be over. In 2010, President Robert Mugabe created his ‘indigenisation’ law that required international mining companies to transfer 51% stakes to local investors.

This replaced the hopeless arrangement that required all miners to sell their produce to the Central Bank, which then failed to pay for it. Unsurprisingly, the mining industry was brought to a standstill, but the new rules have prompted some revival of mining in a country that is rich in resources, especially gold and diamonds.

Investors will remain wary of Caledonia

Caledonia has complied with the indigenisation law. It was obliged to give 10% of the business away for free, but agreed a price of $30.1m for the remaining 41%. It has not actually received this money though.

In the convoluted way in which these things happen in developing economies, Caledonia has made a paper loan to the buyers. The loan is then repaid as Caledonia withholds dividends that would otherwise be due to the indigenous bodies. At least in this arrangement, the money need never leave Caledonia’s bank account.

So, the situation is stable at present. Caledonia is getting on with the development of the Blanket mine and is encouraged by a return to the country of some South African platinum miners. But what is in store for the future? Will the indigenisation law continue after Mugabe’s reign?

Maplecroft names Zimbabwe as one of the countries “most at risk of societally induced regime change”. That could be messy. So, penny-share price or not, investors are likely to remain wary of this gold play.

• This article is taken from Tom Bulford’s free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

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