Political risk is back. First Tunisia, now Egypt. Suddenly, the established order of the whole Arab world is under threat.
Stock markets across the Middle East have been rocked. In London the share price of Egyptian gold miner Centamin Egypt (LON:CEY) hasdropped 22% in January.
In truth, political risk never went away. But in the scramble for commodity plays, investors have turned a blind eye to it.
Recently I have drawn attention to the perils of tangling with the Chinese, but it is hardly fair to single them out. Countries such as Zimbabwe, Iran and Colombia have long been beyond the pale for serious investors. But for the vast majority of developing countries, the question is not whether there is political risk, but how much.
Why investors need to get real about mining shares
Last year even the Australian government showed it was not above suggesting a windfall tax on mining profits. This is just the sort of unilateral appropriation of hard cash of which developing countries are routinely accused. Just last week, a major international mining company told a London audience that it would not invest further in South Africa. It’s an indicator of the concern global mining companies have about “perceived bias by the Department of Mineral Resources”. What might happen when Nelson Mandela departs?
The way I see it, investors need to get real. It’s the biggest consideration you need to make when you buy natural resources or emerging market stocks. When you buy these shares, you take on bigger risk in the hunt for big profits. Let’s consider how things work.
Mining projects start with the granting of an exploration licence. This costs the host nation nothing, while it allows private sector miners and foreign financiers to determine whether or not there are any assets worth exploiting. After that, the fun can start. And the greater the potential prize, the greater the incentive for the host nation to grab a share of the spoils.
Mining, and for that matter oil or agricultural projects, take years to come to fruition. Within that time a new government might come in and refuse to honour the contracts struck by its predecessor. The goalposts can be moved, with the host country demanding a larger share of royalties or a higher tax rate.
Then there is corruption. If you want to assess the risks here, I suggest you take a look at the website of Transparency International. This ranks countries in order of fair play (Denmark, New Zealand and Singapore are best, Afghanistan, Myanmar and Somalia are worst)
- Shares in Chinese security ‘ant’ jump 6.5% on bullish update
- A positive trading statement from Global Lock Safety (ticker: GLOK) sends its shares up a penny (6.5%) to 16p. This leading provider of alarm and security services has grown its customer base by 91% from 6,000 to 11,500 in under four months.
- A feature of today’s statement was a strategic collaboration with China Legal Daily. This is an official newspaper distributed to all Chinese governmental departments and law enforcement agencies.
- The paper has a readership of approximately 30 million. So this deal should help further boost the number of Global Lock’s customers. That’s certainly the ambition of the company’s CEO, Xuean Yan, who believes his small company has huge potential. “Today’s ant – tomorrow’s elephant”, he commented when the company came to AIM in October last year.
Last week, I met up with Paul Adams of Kroll Associates. His company specialises in the assessment of risk relating to politics and security, as well as to the credentials of prospective business partners.
Russia, he told me, is the worst. Here you can own a business one day and walk into the office the next to find it owned by somebody else. There is no right of reply. If the government does not like you, that is the end of the matter. White farmers in Zimbabwe would know the feeling.
Here’s what analysts should be doing
And yet investors plough on regardless. In theory, the risks of doing business in a foreign country are discounted in today’s share price. And it’s the same in resources companies. A typical natural resource project will require five years of spending before it will deliver its years of revenue and profit. Today’s share price should equate to a projection of these numbers, discounted back to today’s value. Key to this is the discount rate used.
Today’s value of 100 in twenty years’ time, discounted at a rate of 8% per year is about 21. Tweaking the discount rate to 12% halves the present value to ten. These calculations are the job of research analysts, but there is no consistency. I have seen projects in the same country discounted using quite different rates of interest. This raises the suspicion that the discount rate chosen is that best suited to support the analyst’s buy recommendation – a popular trick in the dotcom era.
The discount rate should take account of local interest rates, currency risk and political/security risk. To my mind, what is needed is an independent body, similar to a credit rating agency that can provide an independent view of the correct discount rate for each country. If analysts then decide to use a different rate they would need to explain why.
In the absence of such objective criteria, risk assessment remains a finger in the air job. And with the riots in Egypt, the wind is blowing a little harder.
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• This article was first published in Tom Bulford’s twice-weekly small-cap investment email
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