Why Investors Should Steer Clear Of South Africa

The commodities boom of the past decade has helped the economies of many emerging nations to power ahead. But not every country has benefited from the boom. Here is the story of one commodity-rich country that investors should avoid.

South Africa and Commodities

For much of the last decade, rising commodities prices have boosted the economies of the emerging markets, attracting investment and jobs and allowing those countries begin growing their own middle-class consumers.

Countries such as China, Russia and Brazil have used raw materials prices to power their efforts to strengthen their societies by lifting people out of poverty. The one notable exception to the last decade's mining-as-income-generator story is a place where riches of the earth first attracted Europeans more than a century ago, South Africa.

South Africa is a nation of more than 50 million people and was welcomed into the BRIC (Brazil, Russia, India, China) countries this year. It has the African continent's most developed corporate and industrial base. Since the discovery of diamonds in 1866, it has been one of the world's most significant mining centers. Even today, South Africa remains the largest global source of many metals, such as platinum and chromium.

South Africa boasts the world's fifth-largest mining industry by market capitalization. The sector includes well-known gold stocks such as Goldfields (NYSE: GFI) and AngloGold Ashanti (NYSE: AU). Mining accounts for about 8% of GDP directly (an estimated 20% indirectly) and employs some 500,000 people in Africa's biggest economy. It also provides about 50% of South Africa's foreign exchange earnings.

What Commodities Boom?

Yet nearly everyone in the country, including those in the industry, believe the country has missed out on the latest commodities boom and may do so in the future. During the 2001-2008 period of the commodities upswing, the world's top 20 mining countries showed an average growth rate in their domestic industry of 5%.

Yet according to data from South Africa's Chamber of Mines, the mining sector shrank by 1% a year during the period. Globally, only Venezuela came close to this figure.

Part of the reason is geology and age. After more than a century of work, many of its gold miners are being forced to dig deeper and deeper underground, in very difficult conditions, to mine the gold. In addition, there are infrastructure problems with rails and ports, and rising production costs from higher prices for electricity, problems with electricity supply, and increased labor costs.

It should come as no surprise then to find out currently there's no single major mining company that is making significant greenfield capital investment in South Africa due to the uncertainty over the conditions for mining.

Political Turmoil

There is another material uncertainty about South Africa which is growing rapidly.

Mining companies also face a large amount of political risk, with the leader of the youth wing of the ruling African National Congress, Julius Malema, party calling for the mining industry to be nationalized and for property owned by whites to be expropriated.

Julius Malema, variously described as "outspoken" and "radical," recently was named as one of the "The 10 Youngest Power Men In Africa," by Forbes. Malema, 30, remains one of the country’s most divisive and polarizing figures. His power grows as discontent over economic conditions increases.

South African youth are not happy with current economic conditions. Unemployment for those between the ages of 18 and 25 is running at 50%. The lives of the average black South Africa has not improved much since the end of apartheid. In 1995, median per capital expenditure among black South Africans stood at 333 South African rand ($43) a month. By 2008, the figure had only risen to 454 rand ($58).

The ruling party is in fact listening to Malema and his followers to a certain extent. It has commissioned a team to research nationalization of the mines and report its findings by June 2012. Until that report is issued, it is extremely doubtful whether any large mining company will put a penny into any new or existing South African mines. This will only add to the decline in foreign investment in the country. According to a UN report in 2011, South Africa's share of foreign direct investment fell 70% last year from 2009.

There are worries in the country too that this rise of populism will expand beyond the mining sector. It may eventually lead to the government intervening in all forms of corporate decision making.

Investors interested in South Africa broadly can use the iShares MSCI South Africa Index Fund (NYSE: EZA) as a good proxy. The ETF currently has about 25% of its portfolio in mining stocks.

For long-only investors, avoid South Africa entirely. For investors willing to take on a bit more risk, they should consider shorting EZA during any period of strength such as when commodity prices are strongly on the rise.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.