Aggressive Portfolio: Alternative investments

The slump in the gold sector provides an opportunity to add some alternative investments to our Aggressive Portfolio. Greg Hoffman outlines the strategy, benefits and risks.

Key Points

  • Goldminers currently in the dumps but this is unlikely to last forever
  • Portfolio of gold stocks gives us exposure to sector recovery
  • High risk, but potential for large rewards and diversification benefits  

Three years ago, gold mining stocks were among the hottest on the market. The gold price was riding high as investors sought refuge from imagined future inflation, as central banks around the world pumped unprecedented amounts of credit into the global banking system.

Yet even as Newcrest, Australia’s largest listed goldminer, reported a record $1.1 billion profit in 2012, closer analysis revealed there was little cause for celebration.

Newcrest’s shareholders had invested (or reinvested) some $15.1 billion in it over the years. So a $1.1 billion profit reflected a return on their equity of only 7.3%. That’s an unimpressive number. In fact it’s only a few percentage points more than might have been achieved by placing that money in a term deposit.

As investors began to realise that a high gold price didn’t automatically equate to higher profits for all miners, something else happened, something that hadn’t occurred for 12 consecutive years: the gold price fell sharply.

From a high of US$1,900 in September 2011, the price began a precipitous tumble that provided a swift kick in the shins to gold companies’ share prices. Shares in Newcrest have fallen more than 70% since then and it’s the sector’s ‘blue chip’. Many smaller stocks have fared even worse.

This begs the question: will the gold sector ever shine again?

We believe it will. Investments are cyclical and we believe goldminers will one day be back in vogue. But, perhaps more importantly, they offer the potential to reward us in scenarios where some of our other investments may struggle.

Significant potential

Perhaps inflation will break out and the gold price will shoot through US$2,000 at some stage. That would likely be bad news for our fixed interest investments. So gold stocks could offer interesting diversification in that situation.

If you added a weaker Aussie dollar to the equation, then conditions would be close to ideal for Australian goldminers. But buying gold (the commodity, or an exchange traded fund linked to it) would provide similar diversification benefits.

What the stocks offer that the plain commodity can’t is the old fashioned method of making money in gold: striking it lucky with a significant new discovery. At today’s levels, few goldminers have any ‘blue sky’ in their share prices.

So we’re interested in buying a basket of junior gold stocks, to get exposure to exciting exploration potential. We’re not interested in Newcrest, for instance, because it’s unlikely to make new discoveries that will significantly increase its value in the way smaller miners can.

Portfolio protection

Our eyes are open. We’re fully prepared for one or more of these stocks to go bust (if only we knew which ones in advance, we’d avoid them, of course!). We’ll also protect ourselves by allocating only a modest percentage of our model Aggressive Portfolio to these stocks as a whole.

There’s a case for more conservative investors (those following our model Conservative and Moderate portfolios) adding such exposure but we’ve opted to add them to the Aggressive Portfolio only at this stage.

And we’re not classifying them as an ‘Australian shares’ investment. We’re throwing this group into the ‘Other’ bucket in terms of our asset allocation. It’s a play designed to pay off in some unlikely scenarios, almost like insurance (or, to put it less kindly, a favourably-priced lotto ticket).

We’ve gone for a handful of junior miners. Not absolute tiddlers operating with little but a drill and a prayer but producers with a track record in addition to exploration potential.

Rather than try to pick the eyes out of such a beaten-down speculative sector, we believe it’s better to make a greater number of individual investments (or speculations, as such things might be more properly called) rather than concentrate our firepower.

This approach increases our chances of benefitting from a sector-wide upswing rather than risk being caught out in a stock that hits individual strife while the rest of the sector is going ahead.

By limiting our portfolio allocation to 2%, a total wipeout in every one of these speculative stocks would hurt but not be permanently crippling for the portfolio.

We’ve also picked stocks that range across the ‘cost curve’. Lower cost producers should keep churning out the profits if the gold price stays steady or retreats even further, a situation which might threaten the viability of higher-cost producers. But in the event of a gold price recovery, it’s the higher-cost producers that would give us the most spectacular returns.

Our individual stock selections have been influenced by the published research and opinions of Intelligent Investor Share Advisor’s resident resources expert, Gaurav Sodhi. Thanks Gaurav!

Six picks (and shovels)

Silver Lake Resources (ASX code: SLR) operates mines in Western Australia, from which it hopes to increase annual production over the coming 12 months towards 400,000 ounces. At that level, the company could be making $100 million or more in pre-tax profits, depending on costs and gold prices (it is unhedged). That would likely see the share price at two or three times today’s depressed level. Management expects the group to be debt free by the end of February.

Kingsrose Mining (ASX code: KRM) operates in the mountains of South Sumatra, Indonesia. And what it lacks in political stability compared to a company like Silver Lake, it makes up for in low costs and high grades of gold and silver.

Management is aiming for annual production of more than 50,000 ounces of gold within 12 months. And, given Kingsrose’s low costs, that could mean a pre-tax profit of $35 million or more depending on the gold price, plus the potential for further rich discoveries. In other words, this risky play has the potential to multiply investors’ money many times over.

Back in Australia, Northern Star Resources (ASX code: NST) has been firing on all cylinders. This Western Australian goldminer lifted production by 32% to 88,146 ounces in its most recent financial year and posted a record profit of $28m, up 29%.

The company also stumbled upon a potentially significant coal deposit a few months ago while looking for gold – an unexpected bonus. It also made an attractive-looking acquisition from a distressed seller in December which will double its production.

Note: Whilst writing this article NST has gone into a trading halt, pending an equity placement to help fund the acquisition of assets from Barrick Gold Corporation. So, whilst NST is one of our picks, we'll have to wait for it to recommence trading. We'll advise separately when we're adding it to the portfolio.

Ramelius Resources (ASX code: RMS) is another Western Australian goldminer. It’s tiny, though, and high cost. It may struggle without a higher gold price but if it gets one, today’s price will prove a steal.

Troy Resources (ASX code: TRY) is the fifth goldminer we’re adding. It’s currently on the cost-cutting bandwagon. Noting that it’s ‘important that management lead from the front’ CEO Paul Benson announced that directors’ fees and senior management’s base salaries will be cut by 10% this year and his own base salary will fall by an impressive 25%.

Troy’s main operations are in Brazil and Argentina and its production costs are low, meaning it should remain profitable even if the gold price falls further. Troy had more than $20m of net cash at 30 June, although that may change following the acquisition of Azimuth Resources, which has projects further north in the small nation of Guyana.

Beadell Resources (ASX code: BDR) is the last and largest gold stock in our basket. Share Advisor members can read about the company’s unique Tucano mine in Brazil in AU, check out this gold portfolio. Suffice it to say, we’re content to go with our colleagues’ positive recommendation on this low-cost miner.

In conclusion

There’s a case for each of these stocks individually and, together, they form an attractive balance of exposures to Australian and international projects. And, even after recent falls, all but Ramelius Resources boast a market value of more than $100 million, so there’s some substance to them.

Company ASX Code Estimated price Number Value % Allocation
Table 1: Gold portfolio purchases (for Aggressive Portfolio)
Silver Lake Resources  SLR   0.65    3,000   1,950 0.3%
Kingrose Mining  KRM   0.39    5,000   1,950 0.3%
Northern Star Resources  NST   0.95    2,000   1,900 0.3%
Ramelius Resources  RMS   0.13  15,000   1,950 0.3%
Troy Resources  TRY   1.05    1,750   1,838 0.3%
Beadell Resources  BDR   0.75    2,500   1,875 0.3%
       Total allocation to gold stocks   11,463 2.0%
Notes:           
1. Trades will be based on closing price 24 Jan (except NST due to trading halt).  
2. Allocation percentages based on a total portfolio valuation of $560,000.  

It’s easy to become excited about the prospects of speculative stocks but the risks must always be front of mind. Our aim is that together these stocks will play a useful diversifying role within our Aggressive Portfolio. And we might even have the pleasure of watching one or more of them multi-bag (ie rise to several times their purchase price) over the coming years.

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