Author: Ticker Magazine 
Ticker.com 
Last Update: May 04, 10:07 AM ET

If technology and geology play a pivotal role in the precious metals industry, a thorough understanding of the geopolitical environment on the ground proves equally important for the savvy investor in this marketplace. Shanquan Li, portfolio manager of the Oppenheimer Gold and Special Minerals Fund, makes his selections in the sector by segregating companies based on a well-structured three-tier model.

Q:  What is the fund’s main investment objective? 

A : As the name suggests, this is a fund investing in securities of companies that deal in gold and other special minerals. The fund mainly invests in common stocks of companies that are involved in mining, processing or dealing in gold or other metals or minerals and may invest all of its assets in those securities. As a fundamental principle, the fund invests at least 25% of its net assets plus any borrowings for investment purposes in mining securities and metal investments.

The fund may invest in U.S. or foreign companies including companies in developing or emerging markets without any limits on its foreign investments. We may buy securities issued by companies of any size or market cap and at times we might increase our emphasis on securities of issuers in a particular capitalization range.

Q:  What kind of investors should consider adding this fund to their portfolios? 

A : First of all, the fund is designed primarily for those investors who seek capital appreciation over the long-term in a fund that emphasizes investing in gold and precious metal industries. Additionally, this is a suitable offering for investors who would be willing to assume the risks of short-term price fluctuations that are typical for an aggressive fund concentrating its investments in these industries with the additional risk of investing in both developing and emerging economies. 

This fund is certainly not tailored for investors seeking current income, but it is quite appropriate for some portion of a long-term investment plan for investors with a high risk tolerance, or as a hedge against inflation and volatility in other equity sectors.

Since 2002, the fund has been converted to a non-diversified fund to be closely aligned with peers.

Q:  What kind of precious metals does the fund invest in and what do you mean by the term special minerals? 

A : The other precious metals covered are silver, platinum and palladium. Special minerals would encompass minerals such as uranium and lithium, and these industries are selected only when they are experiencing supply and demand mismatch.

Q:  How do you define your investment philosophy? 

A : We believe that if you are invested in the best companies in this sector, you are bound to enjoy capital gains in the long run. When I say the best companies, I mean the following three things.

First, I look at those companies that have the best reserve of resources of the metal ores that they deal in. We also examine the quality of those reserved resources and the ease of extraction of the ore as well as the metal from the ore.

Second, even if the reserve of resources is of the best quality, it has to be located in a country with very stable and friendly governments and a good environment to operate in and extract precious metals. That will ultimately help reduce the production cost.

The third factor would be the management team of the company, their past history and capacity and their trustworthiness, especially with respect to shareholders.

Once we have identified these companies, we will take the market cap and liquidity into consideration. In general, we avoid very small companies as their shares would be harder to trade. We would consider the correlation of a company with the sell side analysis since this would prompt to what extent the firm is tracked and recorded. This formulates the first step in our research. In this space we have different approaches to analyzing companies dealing in gold and silver and a very different evaluation method when dealing with platinum.

At this point, we take up the fundamental research by talking to the sell side analysts, internal analysts and management team. We also look at the balance sheet and various other filings available for a three-to-five year period to evaluate the growth potential of the company. This is much more true in this sector, where from the time you start to mine a product but it is not easy to start production immediately, so a five-year term would do well in most cases.

Q:  Do you evaluate all manufacturing and mining companies in the same way? 

A : The evaluations are pretty much the same but we form the company positions in the portfolio in three tiers in order of importance. The first tier would be a list of some ten companies with relatively lesser risk, which form the core holdings in the portfolio. These holdings would represent about 50% of the assets in the portfolio.

The intermediate tier would consist of emerging producers or miners that have put in resources and money and are on the verge of production after a hiatus of say five years or so. Those firms typically draw a lot of investor attention in terms of liquidity, trading, coverage and almost pretty much everything else.

The third tier has the list of companies that are in the riskier stage of early stage exploration type of companies. Most of them are relatively smaller cap firms that have good assets and resources but do not produce anything now. They may become potential large scale producers at a later stage but right now they are in a nascent stage of development. Since these firms have no production, it is very difficult to evaluate them and so it becomes a necessity for us to hold as many names as we can find to have diversity and thus reduce the risk.

Q:  What is the size of your universe and how many names do you tend to select? 

A : The size of our universe is about 500 names and we choose somewhere around 95 names to make up the portfolio while covering all three tiers. 

Q:  Do you consider only pure plays or resource companies with a portfolio of multiple assets? 

A : We focus mainly on high quality precious metal producers but have owned the stocks of these companies for short periods of time in the past. We have held them exclusively as a diversification tool and to mitigate volatility, bearing in mind that the prices of these stocks do not fluctuate as much when the price of gold falls all of a sudden.

Q:  Do you also consider investing directly in Exchange Traded Funds? 

A : We feel that investing in ETFs involves some legal issues, which becomes, in our view, somewhat controversial. Once the legal issue is clarified, we can buy ETFs in full, which is a brilliant play in our opinion. If we run into the equity fund and if someone wants a bullion exposure, we can buy certain kinds of futures but you may need to roll over this from time to time. I would rather have the portfolio be simple since we feel that’s the best way forward.

Q:  Could you give us some examples that illustrate your selection process? 

A : Currently, the largest holding in our portfolio is a company called Red Back Mining, which falls in the second tier based on our methodology. In fact, at the time of the purchase it was not that large. The company listed in Canada. They have very good reserves located (in the US and) in West Africa, a region which is quite stable compared to other parts of the continent. The company had very good deposits and they had an acquisition policy of some of the other available deposits in this area, a strategy that gave them a good pipeline of resources. With their low cost of production the company grew rapidly and it is now the largest holding in our portfolio.

Q:  What kind of metrics do you rely on in your research process? 

A : In the mining area one rarely uses the price-to-earnings ratio for evaluation, especially if the company is at its nascent stage. In this sector it takes at least five (odd) years to develop the mines, therefore there would be no earnings worth comparing, but the stock could still be selling cheap. We prefer taking into account price-to-net asset value instead.

On average, the life of a mine in this sector is around 15 years. Thus, if a company is in its 14th year, it will not be worth considering the P/E ratio, but if they have acquired good reserves to make some good asset value, it would still be worthwhile to consider such a company for evaluation. We always look at the price-to-net asset value as a crucial metric to asses a company’s worth.

Q:  Do you set a target price as part of your sell discipline process? 

A : We use a target price at the evaluation stage. We will not necessarily sell the stocks of high quality companies when they reach the first target price. What we will do is trim the position instead, which makes a lot of sense with gold companies. As far as they are concerned we always keep an eye on the price of bullion since this could be fluctuating very much, so trimming might be a relevant way of controlling the risk of overweight (and inflation).

Q:  How significant is macro economic analysis for you? 

A : It is very important to keep an eye on macroeconomic developments because there are so many factors that could affect the price of gold and other precious metals and, consequently, the value of the dollar. The price of platinum is also affected by the health of the automobile sector because of the demand for catalytic converters.

Q:  What are some of the risks that you focus on and how do you mitigate them? 

A : By far, the greatest risk in this fund is the uncertainty associated with the price of precious metals. Even though we cannot mitigate it, we can act fast enough if the situation warrants to control this risk by selling or trimming positions, as already explained. The second level of risk is real-time political risk, especially when we are entering a new country. The only way we can react in such a situation is by being very analytical in our research as we assess the political and social environment in each country where we invest. Yet, the fact remains that this is a riskier industry than others and we have to accept that. As a further step to reduce risk in the portfolio, we try to stay fully diversified at any given time.

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