The last year was a brutal time to be an investor in the junior mining sector – the worst that I’ve seen in more than 30 years in the industry. After that painful experience, now is a good time to be investing in this sector: BUT, invery selective companies.
We are all familiar with many of the reasons for that broad sell-off: Investors shunned risk in the face of extraordinary global financial uncertainty. The gold companies delivered disappointing operating performances, driving many investors away from the gold sector. The lack of upward movement in the commodity prices and the perception of further downside risk in metal prices have all added to the unfavorable investment climate. The net result has been that shares of nearly all junior mining companies have been clobbered, the good along with the bad.
Another Factor That Is Depressing Junior Resource Stocks
There is another factor that many are probably familiar with, but you may not appreciate its magnitude. During 2010 and 2011, there was an extraordinary amount of new capital coming into the junior mining sector. Just looking at the Toronto Stock Exchange Venture board, there was $20 billion of new primary investment in TSXV-listed companies.
Roughly three quarters of the companies on the venture board are mining related, implying about $15 billion worth of new share certificates were created over a two year period, more than at any other time. That was a period of irrational exuberance, with the Venture index coming off the low point in early 2009 to triple by early 2011.
During that time of exuberance, Fund managers seemingly suspended their judgment and due diligence, making private placement investments into an astounding array of companies, many with questionable geological merit.
Unfortunately, much of that new money failed to generate any real value for shareholders. A lot of it was eaten up by management salaries, head office rent and investor relations activities. A portion of it funded drilling programs aimed at making new discoveries. Very few new discoveries resulted from all that geophysics, trenching and drilling.
There was $15 billion of new money added in those two years. Today, the total value of the TSXV-listed mining companies is $11 billion and still falling.
In my opinion, many exploration and development companies are still trading at share prices well above their fundamental value. The ongoing sinking feeling of so many companies declining in price is creating the impression that the whole market is still declining. Indeed, many share prices still have a long way to fall, even if they are now at a level of a few pennies. Over the past few weeks, tax-loss selling has added to the downward pressure on prices.
Share Prices Are Reacting to Various Forces
There are a number of factors that influence the different trajectories of the various companies.
Some people like to speculate on a new discovery. Finding a big new metal deposit can be enormously rewarding for shareholders: We recently saw GoldQuest go from a nickel to $2 in a matter of weeks. Unfortunately, new discoveries are few and far between.
Many people invest in resource companies on the basis of the expectation of rising metal prices. That works as long as the company actually holds some of the metal in question. You won’t get much leverage to a metal price off a company’s best intentions to make a discovery next week.
Another big pit-fall is to get caught up in the various fads that go through the sector. For example, there is enormous merit in the fundamentals of the critical elements story, or graphite, or lithium or whatever the story. It’s just that most of the companies that get caught up in the flavor-of-the-month fads have little to contribute to the fundamental story.
Looking For Companies Which Are Adding Value
Another approach, and the main driving force in all of the companies listed above, is to seek out companies that have a high-quality metal deposit in hand. In this way, you avoid the discovery risk, yet there is still potential for enormous gains. For example, a gold deposit with widely spaced drilling and which is classed as an inferred resource will be valued by investors at just $10 per ounce of gold in the ground. By the time those same ounces advance to production, the value per ounce has increased by 30 or 40 times.
Finding companies with high quality metal deposits which have the potential to advance toward production requires a great deal of hard work. One must sort through a pool of companies that numbers a couple of thousand to identify those few that have quality assets; and then, it is necessary to do extensive due diligence. Many metal deposits that look attractive on the surface may have metallurgical problems or permitting issues or some other fatal flaw.
This approach continues to have validity because the exploration and development companies are vital to the future of the mining industry. Most of the discoveries and re-discoveries are made by the juniors. The juniors supply deposits on which the mining industry builds new mines to replace depleted mines and enables the industry to keep up with the growing demand for metals.
As important as these companies are, they are presently shunned by investors. There are a number of notions, which are not accurate, that are impacting on investor sentiment.
For example, there is a perception that metal prices aren’t moving. But, that perception is because people are so focused on the near term. If we take a longer term perspective, we see the gold price is up 6-fold in the past decade. The silver price is also up six times in that period.
Some people are surprised that the copper price is up by nearly the same 6-fold ratio as gold and silver. There is a perception that the world economy is in a state of suspended animation and therefore base metals are no longer needed.
The reality is that Europe is using slightly less metal this year than last. America is using slightly more. China, by far the largest consumer of metals, is using more than 7% more metal this year than last. Even at a time of slow growth, demand for metals continues to grow.
Another of the important misperceptions comes from basic economic theory, which tells us that when the price of a commodity increases, the supply of that commodity will expand to bring down the price. The expectation that there will be a jump in production has meant that forecasts of metal prices have consistently understated the actual metal prices.
In the case of gold, the price is up 6-fold in a decade while the production level has barely increased. New mine development over the past decade has barely offset depletion of older mines.
Whether for gold, or nearly any the other metals, actual metal supply growth has consistently fallen short of analyst projections. New projects are nearly always delayed, for a host of reasons: problems with permitting, lack of adequate capital and the like.
The net result is that expanding metal production is much more difficult than just assuming a production increase, as the economists tend to do. Geology doesn’t follow basic economic theory: It is getting harder all the time to expand metal production. The big, high grade deposits that were once sticking out of the ground have long since been developed, and are now largely mined out.
New deposits are lower grade, more remote, metallurgically challenging, and often in places where investors don’t want to put their money. The last year when the gold industry found as many ounces as it mined was in 1998.
Mining Companies Are On A Shopping Spree
While investors continue to shun the junior resource companies, the larger companies are actively shopping. Recently two companies – Galway and Inter-Citic –received takeover offers. Both are cash offers, one worth $250 million, the other $300 million.
A really interesting point is that both offers came from companies in emerging markets. Last year, over half of all M&A activity involved companies in emerging markets. That trend is going to continue.
In Europe and North America we moan about the slow pace of economic growth, and therefore avoid resource companies. In the developing world, people look at what is happening around them and wonder how they will find enough resources. I recently participated in resource investment conferences in China and Hong Kong. There is a feeding frenzy for projects ready to go into production. Investors and mining companies are gaining awareness of the earlier stage projects and beginning to actively shop.
Is This The Right Time?
It’s not hard to understand the longer term fundamentals of the resource industry. The important question at this time: Is now the time to invest in junior resource companies?
The answer is: Yes! But, very, very selectively.
As I noted earlier: Probably the majority of companies will continue to decline in value. Tax-loss selling is further depressing share prices, which can provide good entry points for investors, in carefully selected companies
On the other hand, a few companies are already moving up. Some of the companies with good deposits, strong management and access to cash are being accumulated by knowledgeable investors.
One of the important criteria at this time is to identify companies that are potential takeover targets: That means deposits that are large, advanced stage and well located. Identifying these potential targets for subscribers will remain a priority for me.
By the time someone rings a bell to tell us that we are at the bottom of the market, the better quality companies will already have enjoyed big gains.