Published Date: 2021-02-24 | Source: INCE|Connect | Author: Gary Booysen | Rand Swiss | Director and Portfolio Manager
It's an interesting question and it strikes at the heart of investment structuring. To answer this question, you first need to think about what investors desire when they buy the ordinary stock of a listed company or an ETF.
Why we invest in the first place
Ultimately, every investor seeks to capture the returns generated by an underlying asset. This is true no matter the vehicle. This is true of a Real Estate Investment Trust (REIT), a buy-to-let flat, shares in an early-stage tech start up or stock in Microsoft. It's true of the final underlying assets that form part of a mutual fund or unit trust's capital allocation. It's true of the savings stacking up in your back account. You could even make an argument that it's true of a commodity ETF which relies only on scarcity for value.
But, since we're talking specifically about mining companies and commodities this week, the mining sector investor would be looking to capture the economic returns generated by the underlying mining projects. The most direct form of investment in mining would likely be something akin to the early California gold rushes. You could head out to the local general dealer, buy a pan or shovel to dig up your gold, perhaps a few stakes and some rope to mark your claim, and you'd have the most direct form of investment in mining. You own the equipment, and you will be using your own labour to extract resources from the earth.
But of course, listed companies and sophisticated 21st century products offer you a much better way of investing in the mining sector.
"What you need to decide is how close you want to be to the underlying asset and what your selected structure offers in terms of benefits and drawbacks."
The major benefit of investing in the shares of a mining operation, would be you no longer need to supply the labour yourself. You also move from direct ownership of the mining assets to indirect. Instead of owning the digging machine, you own a share of a company that owns the digging machine. The benefit to you now is that you have, among other things, limited liability. If the company has borrowed money to fund its capital equipment (and the deposit you've decided to mine turns out to be poor) your company can go bankrupt. While it might ruin your business reputation, it won't ruin your personal fortune.
Let's take it one step further...
Instead of a small private mining operation, let's instead look at a larger listed company. The company has multiple shareholders and trades on an exchange. You're not the only person who will benefit from the underlying assets, but the scale of the operation is much larger. Since there are multiple people interested in the success of the venture, you can be less active. Professional management teams are in place to make sure your yellow machinery and labour force is digging in the right places. Your engineers are providing skilled assessments of the geotechnical information on your deposit and the most efficient way of mining it. There is an economy of scale to the operations which drives down cost. Suddenly, this business is more efficient than it could have ever possibly been before.
And since you are one of many investors (and this is a public company) the operations and finances of the business are available to public scrutiny. As many people interrogate the results of the mining operations, they hold your management team to account. You can be satisfied that a degree of safety is achieved for minimal effort. Not only is everyone watching your management team, but the exchange itself is requiring them to publish specific information ahead of results, have their financial reports audited correctly and provides you with some recourse should something happen to your stock holding.
But it's not perfectly safe. You're still investing in a single commodity stock. Our Californian prospector was digging for gold and the ultimate listed company we're talking about is also only mining gold.
You decide you need some diversification. So, since you have a position in listed stock, you benefit from the active nature of the exchange. Since shares are changing hands regularly you can easily exit your holding. You decide to sell your shares at the ruling market price (a feat made far more difficult when you own shares in a private company and incredibly disagreeable when you are the prospector with your pan and shovel forced to sell not only your equipment but your labour as well!).
So, you sell your gold mining stock and instead buy into Anglo American or BHP or Glencore. These are large multinational diversified miners. They have operations across multiple commodities in multiple geographies. You've successfully diversified away some risk.
"But wait, you're nervous that maybe this management team may underperform, even with their experience and the multitude or concurrent shareholders all scrutinising the financial information flowing from the company, you seek a lower risk investment."
So, you ponder on how to further diversify your risk?
Instead of just buying Anglo American, you buy a number of mining companies all sitting snugly in your online portfolio. Some go up and some go down, but overall your wealth continues to grow steadily. You notice one of your companies keeps going down. And after a little investigation, realise the mines are exhausted, the miners are striking, Eskom has rolling blackouts and you'd prefer not to hold that company. The market capitalisation is dipping with the share price, so you decide to exit the company and instead buy an up-and-coming miner with increasing revenue and profit, as well as share price and market capitalisation.
But as you furiously buy the good companies and sell the bad companies you realise two things: Firstly, you're too lazy to do this all the time. It takes work! The whole reason we started investing was to break free of the cycle of digging up gold with our shovels and panning the river for ounces. The second issue is, even though you're selling off the declining shares, every now and then you make a profit and the tax man comes knocking for his Capital Gains Tax.
Gary Booysen is a portfolio manager at multi-award-winning investment firm Rand Swiss. The firm has recently been rated the top overall stockbroker in South Africa, the top advice broker, the top online broker. They've also picked up awards for the best Tax-Free Savings Account as well as the coveted People's Choice award. If you're interested in building up your investment portfolio Ince has arranged a special package for you with the company. To find out more click here