Topic: Mining Stocks

Pros and cons of flow-through entity funds

Flow Through Entity

Most of the mining and energy stocks held in a flow through entity are highly speculative.

Flow-through entity funds are tax shelters that mainly invest in the flow-through entity shares issued by junior mining and oil companies. These companies spend the proceeds from the shares they sell on mineral exploration and development, an activity that qualifies for certain tax credits and tax deferrals. These tax benefits “flow through” to investors in the fund. In general, to take advantage of these benefits, investors need to hold the funds for a fixed period, usually 18 months to two years.

Investors buying into flow-through entity limited partnerships are able to deduct 100% or more of their investment against income by the end of the second year. This leaves the investor with an adjusted cost base on the units of zero. When you subsequently redeem or sell the limited partnership units, you pay capital gains on the entire balance of the sale.

However, the problem with these tax shelters is that they may persuade you to make a risky investment you wouldn’t otherwise make. Moreover, a portion of the benefits are set aside for brokers and the fund’s organizers. What’s left may not be enough to pay you for taking on the extra risk.

These tax shelters may post excellent results in booming commodity markets from time to time. However, as the current climate for resources and commodities shows, booms don’t last forever.

Keep in mind that most flow-through issuers are junior companies that are short on financing, or don’t have enough income to make full use of the tax benefits associated with their exploration. That’s why they sell these benefits to investors.

One big drawback in flow-through limited partnerships is that many of the flow-through mining and energy stocks they invest in are highly speculative. The partnerships are also usually in a hurry to invest their money to pass the tax deductions on to their investors as quickly as possible. That can lead to some hasty stock selections.

Another drawback with flow-through partnerships is their lack of liquidity. In most cases you can’t get your money out until the partnerships convert into mutual funds, or limited partnership trading on a stock exchange, after 18 months to 24 months.

Like all new issues, flow-through entities have upfront fees. These could include agent fees, offering fees and even annual management fees. Managers are often paid an incentive bonus which is a percentage of how much the asset has appreciated over the two years.

Despite their tax benefits, investments in illiquid flow-through partnerships are risky. That’s true even now, with prices of junior oil and gas stocks trading at multi-year lows on the basis of currently low oil and gas prices.

Rather than invest in flow through entities, we think you are much better off keeping things simple and investing in strong mining stocks. Below are 7 tips to help you pick the best mining stocks.

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7 tips for investing in mining stocks

  1. Seek stable political regions: We generally stay away from gold mining companies operating in insecure and politically unstable regions like the Congo and Venezuela, or in countries with little respect for property rights and the rule of law, like Russia or Mongolia. Mining is inherently a politically vulnerable business; you can’t move the mine to another country, and local citizens sometimes believe that a foreign mining company is robbing them of their birthright, even though they need the foreign company’s capital and expertise to get any value out of the ground.
  2. Invest in mining stocks that hedge against inflation: Many investors buy gold stocks as a hedge against inflation, and some gold stocks pay dividends. But there are other mining stocks that also offer an inflation hedge—and pay dividends.
  3. Dividend yields add appeal: Copper stocks generally have higher dividend yields than gold stocks because they have steadier demand and more stable prices. As well, they’re usually much cheaper than gold stocks in relation to their earnings and cash flow. That means they potentially have less room to fall if markets in general fall. That’s also another way of saying that they can be less risky than gold.
  4. Look into mining ETFs: Gold and silver could well regain their highs and move up even further over the longer term, although they will likely remain volatile. Higher prices would arise from investor fears that inflation or global political and economic instability will hurt key currencies, such as the euro or the U.S. dollar. If you want to hold a number of gold or silver stocks, many exchange traded funds offer top-quality global miners and low fees.
  5. Look for longevity in reserves: When you invest in any resource stock, gold included, you need to look at how long the company’s reserves are likely to last. Those with low reserves need to have consistent success in their exploration programs to maximize the production of the mine and the surrounding area. That success is far from guaranteed.
  6. Invest in diversified stocks: Even if the company has strong reserves, the best gold stocks with the least risk also have a diversified reserve base. That way they are not dependent on a single mine’s production or political stability in any one country. Gold companies can also increase their reserves by making acquisitions—with gold prices down from their record high you may see an increase in gold mining company acquisitions at distressed prices.
  7. Look for actual production: Some of the most highly promoted gold mining stocks are penny stocks that have yet to produce an ounce of gold. Many must still add to their reserves, invest in mine-feasibility studies, and raise a lot of money before they go into production. The prospects for most of these penny-mine properties, even though they may be in areas with production from existing mines nearby, are far from certain.

Have you ever invested in a flow through entity? Was it profitable for you? Share your thoughts and experiences with us.


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