How to invest in resources beyond BHP and RIO

One commentator recently observed that Australian SMSF investors’ exposure to the resources sector can be summed up in six letters: BHP and RIO. That’s probably a fair call, although there are plenty of other unexplored good options in the sector.  

ATO statistics show that approximately 31 per cent of SMSF assets are in ASX-listed stocks and research, while anecdote and intuition points to seven big stocks dominating not only the major indices but also DIY investor holdings. The other five stocks, of course, are the four big banks and Telstra.

While there has traditionally been a certain comfort level in owning two of the world’s three biggest resource companies, both of which have strong Aussie connections, the dramatic fall in their share price over the past 18 months has tarnished their image somewhat and knocked a hole in many SMSF portfolios.

Three years ago, if a financial adviser had said, “You should consider getting out of BHP because we believe the company could lose half its value in the next two or three years,” it’s likely the most common response would have been, “Thanks for the advice but we have faith in ‘The Big Australian’.”

Yet that’s exactly what happened, although a recovery has stemmed that loss to around 40 per cent at present.

Rio’s fate has not been as dramatic but it too has suffered a somewhat ignominious fall, even if it’s only been 17 per cent in value in the same three-year period

The point is, big and familiar is not always best when it comes to resources stocks or any other stocks for that matter.

There are many interesting and profitable players in the resource market but because of their relatively small size, some capitalised as low as $50 million to $250 million, and the dominance of a few big players, sorting the wheat from the chaff, is a time-consuming and skilled process.

The FTSE Global Mining Index is currently trading around 30-40 per cent off its December 2010 highs. The recent bear market represents the longest period of decline since the FTSE global mining index began in 1985. Many analysts, including ourselves, believe that this extended period of bear market supply cuts, coupled with a strengthening of demand, particularly from emerging south-east Asian countries, makes an attractive backdrop for equity investing in the sector.

However, we do not advocate a top down approach when it comes to stock picking. Rather, we believe successful resource stock investing demands value or bottom up methodology.

Research is crucial. As a rule of thumb, we typically investigate 50 companies for every one we eventually invest in. Our filter for resource investing includes the following:

  • From an asset perspective, look for either projects that have world class potential i.e. high grade and scale or projects with the ability to generate near-term cash flow. We also prefer the projects to be located in stable, first world jurisdictions.
  • From a company perspective, look for first-class founders and management teams with a track record of success. The capital structures of the companies should be clean and simple.
  • Lastly, from a market perspective, look for positive share price catalysts (drilling reports, resource upgrades, positive commodity dynamics etc) associated within the enterprise.

These are valuable aspects to look at in a crowded and sometimes limited or restricted entry resource market.

I say restricted because sometimes companies seeking capital go to industry specialists rather than the IPO or rights placement market route. Sometimes even ASX-listings still need specialist knowledge and detailed research for sound investment opportunities to become apparent. Specialist investment managers can help with this.

There are excellent opportunities in the resource sector outside the few household name heavyweights. However, it takes in depth knowledge of the sector to find many of these opportunities and avoid the many pitfalls.

Jeremy Bond, founder and chief investment officer, Terra Capital

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