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Course 409
Hard-Asset Stocks

Introduction

Why invest in hard assets? Unlike most of the economy, which creates wealth from the relatively thin air of raw materials and brainpower, a hard-asset producer traffics in goods of supposedly intrinsic value. Windows 95 won't be worth much on doomsday, the thinking goes, but gold bullion can still be bartered for food. Even if the apocalypse fails to materialize, the diversification value of hard assets can still increase a portfolio's returns and reduce its volatility. Hard-asset stocks don't march in lockstep with the rest of the market. As their diversification powers suggest, hard-asset stocks feature unusual investment characteristics. Current profits are less important than large and easily extracted reserves of oil, gold, or other natural resources. The analyst's touchstones are reserves and production costs, which indicate the size of a company's natural-resource reserves and how profitably those resources can be exploited. To screen for companies with large reserves, use market capitalization as a proxy for mineral wealth (the two figures are closely correlated). To find the lowest-cost producers, screen for high net margins. The less cash a gold producer pours down its mine shaft, the better its profit margins. Let's use Barrick Gold ABX as an example. Barrick boasts the largest market capitalization in the gold-mining industry, more than $7 billion. That valuation is perched atop 50 million ounces of gold reserves, one of the largest deposits among North American producers. Furthermore, Barrick's high net margin indicates that it is a low-cost producer. The mining giant can bring an ounce of gold to market for about $160, excluding noncash charges such as depreciation. That's less than 60% of gold's price as of December 1999. Of course, a wealth of resources (even Barrick's riches) can always be frittered away. To pick the best hard-asset stocks, we need to examine how those assets have been managed and what the result has been for shareholders. To do that, we can look at profitability, growth of reserves, and production costs.

Has Barrick Capitalized on Its Natural Endowments?

Barrick has consistently been more profitable than the average gold-mining company, with returns on shareholders' investment (ROEs) generally in the industry's top half. And the composition of those returns is especially encouraging. Barrick has built its returns on profits--not financial leverage, which increases the risk of a balance-sheet blowup when times are tough.

What about Growth?

In the volatile hard-assets market, earnings growth is often nothing more than a spike in oil or metals prices. But Barrick has delivered the real thing. Although gold prices have been declining since the early 1980s, Barrick has made production increases a catalyst for earnings growth. From 1986 to 1998, according to Barrick's annual report, production increased at an annualized rate of 37% to 3.2 million ounces per year. Only the South African mining giants produce more. Over the same period, Barrick has made several large gold strikes, boosting its reserves and laying the foundation for continued production growth. South Africa's rock hounds, by contrast, have uncovered almost no new reserves. Barrick's cash-flow statements tell the same growth story. And in the hard-assets market, cash flow is a better measure of performance than earnings, which include noncash charges that can differ dramatically from company to company. Cash flow is roughly equal to earnings before depletion and depreciation charges, eliminating some of the distortions that lead two companies with comparable cash profits to report very different earnings. As long as cash flows are rising, as Barrick's have been, a hard-asset producer is delivering genuine growth.

What Has Company Performance Meant to Shareholders?

Despite Barrick's strong profits and steadily rising earnings and cash flows, its stock has performed erratically. From 1991 through 1996, these shares compounded at an annual rate of about 14%, beating most of the moribund gold-mining industry and almost keeping pace with the red-hot S&P 500 index. In 1997, though, a big charge in the third quarter caused Barrick to lose money for the year and sent its stock price tumbling, wiping out the gains from the previous few years. The shares were flat overall through 1998 and 1999. Even so, Barrick's long-term performance has been decent. In the 10-year period from 1989 to 1999, it returned an annualized 9% a year.

Has It Delivered the Diversification Benefits of a Hard-Asset Stock?

One of the supposed benefits of owning a hard-asset stock is diversification. These stocks will do well when the rest of the market is in trouble, the thinking goes, thus providing a hedge against losses. In 1993, when most of the market treaded water, Barrick's shares almost doubled in price. In the following year, it gave back some of those gains while the S&P 500 held steady. In 1997, Barrick lost 34% of its value while the S&P 500 gained the same amount. In the past, at least, Barrick has often zigged when the market has zagged.

What Does It Cost?

A strong performance in the mines has driven Barrick's impressive stock-market performance, but this package is attractive only at the right price. Because cash flow is a better measure of performance than earnings, a P/E multiple isn't the best way to value a hard-asset stock. A better gauge of value is the price/cash flow ratio. Barrick trades at 13 times cash flow, well below the broad market but expensive for the metal-mining industry. Although cash-flow multiples help us get a handle on the relative value of Barrick's current operations, these ratios are silent about the value of its untapped reserves, an important component of its long-term value. To put a price on Barrick's unmined reserves, divide its market capitalization by its unmined precious-metals deposits, which you can find in the company's annual report. This ratio tells you what you're paying for each ounce of gold buried in the company's mines. Expect to pay more for those reserves if the company boasts low production costs. Each ounce of Barrick's unmined gold is priced at about $200. At Glamis Gold GLG, a relatively marginal producer, the gold reserves are valued at just $50 or so per ounce. But Glamis spends about $230, nearly 50% more than Barrick, to bring an ounce of gold to market. Barrick isn't cheap, but its low production costs seem to justify the premium.

Conclusion: Appraising the Asset

Barrick meets the most important criteria for a hard-asset stock: plentiful reserves and low production costs. And the stock's historical performance, often zigging when the market has zagged, suggests that it is good for diversification. Its valuations at the close of 1999 were high relative to those of similar stocks, but Barrick's solid financials mean the premium is probably worth it. That said, hard-asset stocks, Barrick included, probably don't deserve star billing in most portfolios. These shares are extremely volatile, dancing to the syncopated rhythms of the global markets for gold, oil, and other natural resources.

Quiz 409
There is only one correct answer to each question.

1 Which of the following is <em>not</em> a supposed advantage of hard-asset stocks?
a. They seldom go down in value.
b. They deal in goods that have intrinsic value.
c. They are good for diversifying a portfolio.
2 For a hard-asset company, high net margins usually go hand in hand with:
a. Low reserves.
b. Low production costs.
c. High production costs.
3 A high level of reserves:
a. Is dangerous for a hard-asset company.
b. Indicates high financial leverage.
c. Is desirable for a hard-asset company.
4 If Company A's reserves are valued by the market at $100 an ounce and Company B's reserves are valued at $50 an ounce, this probably means that:
a. Company B is a lower-cost producer.
b. Company A is a lower-cost producer.
c. Company B has half as many reserves as Company A.
5 The best measure of a hard-asset company's performance is:
a. Cash flow.
b. Reported earnings.
c. Revenue growth.
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