The Guide to Investing in Stocks and Shares

Pan African Resources

Dan Tebbutt - A Shareworld Contributor

Published - 14th November 2010

As an investor I think it's generally wise to stick to companies that you can understand reasonably well. That either means those with a very simple business model, or those within your own "circle of competence". It's not a policy that I've always followed - I hold shares in BP, National Grid and GlaxoSmithKline, for instance - but for most of the shares I own, I feel I understand the business pretty well.

One sector that I've never touched before is mining. It seems particularly full of risk factors that I don't feel able to properly assess:

• Price risk. A miner operating on a margin of 10% is in trouble if the price of their product falls by 15%. I've never pretended to be able to predict commodity prices, but by investing in a miner you inevitably have to make some sort of judgement.
• Hedging. Some miners avoid price exposure by hedging - securing a guaranteed price for years into the future. But if prices then rise, then they can find themselves dramatically outperformed by their unhedged peers. Anglo Gold seem to have made a particularly impressive mess on this front - first of all hedging more than 10 million ounces of production at $450 per ounce, then watching the gold price soar, and finally unwinding their hedge at a cost of billions of dollars.
• Political risk. Many of the world's resources are in countries with fairly erratic governments - but miners can face risks even from the most unlikely sources, such as Australia's recent mining super-tax.
• Operational risk. Digging out resources from miles under the surface of the earth obviously has risks of its own - as "Los 33", the recently liberated Chilean miners, would attest.
• Exploration. Many miners spend vast sums on looking for new areas in which to establish mines. There is clearly a risk that they won't find anything - thereby hurling shareholders' cash down a series of holes in the ground.

Now, having explained all the reasons why it would be silly for me to buy shares in a mining company, I'll talk about a miner that I'm thinking of investing in: Pan African Resources (PAF). PAF is primarily a gold miner operating in South Africa and Mozambique. Last year they produced 100,000 ounces of gold, earning revenues of £68m. They are working on a project to extract platinum from chrome tailings (the ore discarded from a chrome mine after extracting the chrome) which should eventually result in 11,000 ounces of platinum, rhodium and palladium per year.

So, how does PAF stack up against my risk factors above?

• They have an extremely healthy margin. Last year they made £22m pre-tax on revenues of £68m. So they should remain profitable even if the price of gold were to fall by ~30%.
• The have no hedging. So apart from that healthy margin, there is nothing else standing between them and failure if the gold price should fall.
• Their gold mine is in South Africa, which in terms of political stability is about as good as you get in Africa (at least South of the Sahara).
• Their mine is relatively shallow, so at least they're not pushing the envelope of what is technically feasible. Their platinum project will be surface-based (since the chrome tailings are just dumped on the surface) and should therefore be even less risky - and will give them some diversity as well. They have had some problems with illegal mining, where criminals just walk into the mine and start pulling out lumps of gold. They've had to increase security expenditure to almost £3m per year in order to get this under control.
• In the past they have focused on exploration, but they are now a production company. They may expand, but will look to do so by acquiring projects that are ready for production, not be engaging in speculative exploration.

Finally there's the question of price. Pan African Resources's market capitalization (at a share price of 9.7p) is £138m. Last year's post-tax profit was £17m, putting them on a P/E ratio of 8. Analysts expect post-tax profits in 2011 and 2012 to be about £20m (although they will be heavily influenced by the price of gold, so that should be taken with a large pinch of salt).

On the whole I like the look of PAF, and I'm considering having a small punt on them. My only quibble is that 3 months ago their market cap was only £85m - so I'm coming a bit late to this party. That's annoying, but really the only thing that should matter is whether they are cheap on their current price - it would be silly not to invest just because it has been cheaper in the past.