One Thing To Consider Before Buying East Africa Metals Inc (CVE:EAM)

If you are looking to invest in East Africa Metals Inc’s (TSXV:EAM), or currently own the stock, then you need to understand its beta in order to understand how it can affect the risk of your portfolio. Broadly speaking, there are two types of risk you should consider when investing in stocks such as EAM. The first risk to think about is company-specific, which can be diversified away by investing in other companies in order to lower your exposure to one particular stock. The second type is market risk, one that you cannot diversify away, since it arises from macroeconomic factors which directly affects all the stocks in the market.

Not every stock is exposed to the same level of market risk. A popular measure of market risk for a stock is its beta, and the market as a whole represents a beta value of one. Any stock with a beta of greater than one is considered more volatile than the market, and those with a beta less than one is generally less volatile.

What is EAM’s market risk?

East Africa Metals’s five-year beta of 3.6 means that the company’s value will swing up by more than the market during prosperous times, but also drop down by more in times of downturns. This level of volatility indicates bigger risk for investors who passively invest in the stock market index. According to this value of beta, EAM will help diversify your portfolio, if it currently comprises of low-beta stocks. This will be beneficial for portfolio returns, in particular, when current market sentiment is positive.

Could EAM's size and industry cause it to be more volatile?

A market capitalisation of CA$44.72M puts EAM in the category of small-cap stocks, which tends to possess higher beta than larger companies. Moreover, EAM’s industry, metals and mining, is considered to be cyclical, which means it is more volatile than the market over the economic cycle. Therefore, investors may expect high beta associated with small companies, as well as those operating in the metals and mining industry, relative to those more well-established firms in a more defensive industry. This supports our interpretation of EAM’s beta value discussed above. Fundamental factors can also drive the cyclicality of the stock, which we will take a look at next.

How EAM's assets could affect its beta

During times of economic downturn, low demand may cause companies to readjust production of their goods and services. It is more difficult for companies to lower their cost, if the majority of these costs are generated by fixed assets. Therefore, this is a type of risk which is associated with higher beta. I examine EAM’s ratio of fixed assets to total assets to see whether the company is highly exposed to the risk of this type of constraint. EAM's fixed assets to total assets ratio of higher than 30% shows that the company uses up a big chunk of its capital on assets that are hard to scale up or down in short notice. As a result, this aspect of EAM indicates a higher beta than a similar size company with a lower portion of fixed assets on their balance sheet. This is consistent with is current beta value which also indicates high volatility.

What this means for you:

You could benefit from higher returns from EAM during times of economic growth. Its higher fixed cost isn’t a major concern given margins are covered with high consumer demand. Though, in times of a downturn, it may be safe to look at a more defensive stock which can cushion the impact of lower demand. What I have not mentioned in my article here are important company-specific fundamentals such as East Africa Metals’s financial health and performance track record. I highly recommend you to complete your research by taking a look at the following:

• 1. Financial Health: Is EAM’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
• 2. Past Track Record: Has EAM been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of EAM's historicals for more clarity.
• 3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.