Where should resources investors look to find a quality company which might provide a decent return?
The highly speculative nature of exploration companies is not a safe bet as we mentioned in our previous article in the series. Unfortunately for shareholders, over the past 5 years the big miners including BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) have hurt shareholder returns with continual asset impairments – the result of poorly timed and expensive acquisitions.
It seems that the best place to look, therefore, is everywhere in between these two extremes: the small to mid-sized producers.
Investors have a diverse range of companies to select from within this group which includes small, single mine operators such as iron ore producer Grange Resources Limited (ASX: GRR) through to larger diversified miners like Independence Group NL (ASX: IGO), the operator of 3 mines which produce gold, nickel, copper, zinc and silver.
Their operations are smaller and easier for investors to analyse and understand. For example, Western Areas Ltd (ASX: WSA) operates two high-grade, low-cost nickel mines in Western Australia. The company has been producing nickel from its Flying Fox and Spotted Quoll mines for more than 5 years and a quick health check of the company can be performed by a simple glance at the following table provided in each annual report:
Smaller companies can often run a leaner, more efficient mining operation due to lower overheads and less bureaucracy. However, the smaller companies need to have high-grade, low-cost assets, like Western Areas, to be able to compete with the big global mining companies who usually own and operate "tier 1" assets. Rio Tinto describes its tier 1 assets as large, long-term, expandable, cost-competitive mines such as its huge Pilbara iron ore mines.
This is where most small to mid-sized miners fail to compete against the big miners – some parts of their mining and corporate operations may be more efficient, but the smaller scale and lower quality mineral deposits they usually operate result in higher overall costs to extract the same quantity of minerals.
Small and mid-sized mining companies generally operate a small number of assets. Mining operations are exposed to countless risks and a major incident could shut down production at a key asset which would severely impact these companies. Iron ore miner Mount Gibson Iron Limited (ASX: MGX) recently abandoned its Koolan Island mine site after a seawall collapsed and flooded the pit. This was one of three main assets the company operated and led to a $844 million impairment charge.
Summary
The savage downturn in commodity prices over the past few years highlights the most important fact for resources investors: higher-cost companies will struggle to survive when the commodity price cycle turns against them. The best investment returns are likely to be the profitable small to mid-sized producers operating low-cost assets. Unfortunately, there's not many of them around. They are usually either taken over by major miners, or don't fit the criteria.
Later in the series we will take a closer look at some of the lowest cost small to mid-sized Australian mining companies and determine whether or not they could provide good returns for investors.
