This Time Is Different

We all know that the market for junior resource companies is in a terrible state. We also know that this industry is cyclical, and no matter how bad it gets, it eventually turns around.

I have experienced a few cycles in the resource industry. In some ways, this is the worst situation that I have ever seen. But, this time is different and it is important to understand those differences to know what to do next.

In 2008, the resource industry was clobbered, along with most investments around the world. That sharp selloff was driven by external forces. Everything went down sharply, but then everything rebounded in tandem. Over the next two years, the TSX Venture index tripled.

If we look back a little further, 1999 through 2001 was considered the “nuclear winter” of the mining industry. At that time, the mining industry was still in the classic era, when high metal prices led to increased production which led to oversupply and declining prices. Several big new mines had just come on stream and demand for metals was sluggish. At that time, nobody dreamed that China and the rest of the developing world would soon begin to take off. Metal prices were down: copper, at $.60 a pound, was at the lowest price ever in real terms; gold hit a low of $252 an ounce. The producing companies were losing money.

Market commentators called mining a “sunset industry”, implying that the world’s need for metals was going to suddenly evaporate.

It took real courage at that time to look beyond the moment. To be an investor, you had to believe that there would be a fundamental change in the mining industry – that metal prices would eventually rebound to a level that would make it profitable to develop and operate mines.

Some people had that vision and courage. Ross Beaty bought 12 big copper deposits in Lumina Copper, mostly deposits that were castoffs from the majors. Lumina’s investment of a few tens of millions of dollars turned into a multi-billion dollar payoff for investors.

Bob Quartermain did the same thing with silver deposits in Silver Standard, buying silver in the ground for a pennies an ounce.

The Hunter Dickinson group also accumulated assets at that time and again generated billions of dollars in value for shareholders. In one case, they were paid $16 million by a major mining company to take ownership of a shutdown copper mine. That mine has since generated hundreds of millions of dollars of operating profits.

I started Resource Opportunities during that period, with the firm belief that there was money to be made in buying shares of resource companies at a time when so few people wanted anything to do with the mining industry. Demand for metals was not going to go away, and the industry would come back.

Of course, the decade following that “nuclear winter” produced the biggest, richest bull market in resources ever.

In some ways, the current situation is even worse for the junior resource companies than that “nuclear winter”. This time is different because of the disconnect between share prices and fundamental values. The mining industry is still generally profitable. Demand for metals is continuing to grow at a time when new supplies are severely constrained. Metal prices, for the most part, are well above long term averages.

At this time, you don’t have to be a visionary with a long term perspective to see the extraordinary values available in the junior markets

The challenge now is to differentiate among the companies. While there are many companies which are irrationally undervalued, there are even more juniors which are irrationally overvalued.

In a moment, I will discuss how the valuations have become so seriously distorted.

Let us start with the overvalued companies: a lot of companies raised money, lots of money, in that period of euphoria from 2009 to 2011. Much of that money was spent on rent and salaries and investor relations. Some of the money when into the ground, but the vast majority of the exploration spending failed to produce meaningful results. In short, billions of dollars of shareholder money was burned up with little to show for it.

For some of those companies, those which have no cash and no assets, it is like holding a lottery ticket the day after the draw. Many of those companies are basically shells, and there are so many shells around that they have little value.

As to what happened: There is a lot of talk about risk aversion and concerns over global growth and metal prices being down.

In reality, the most significant reason why investors hate mining companies at this time is the terrible performance of the mining industry itself. The majors have taken write-offs of more than $60 billion over the past 2 years. At least 7 major company CEOs have been axed.

The performance of the juniors has been even more appalling. Companies listed on the TSX Venture exchange from 2010 to early 2013 took in $26 billion of new shareholder money. Unfortunately, most of that money was spent without creating much value. As a result, the holders of all those shares want out. They want to sell all of their resource shares, they don’t care about the price and they want to forget they ever heard of mining. Everything has been knocked down, the good along with the bad.

But, let us remember that for every share sold, there is a buyer. However, the buyers have been a lot more discerning than the sellers.

Here is an interesting way to look at mining companies. We have all seen variations of this chart. Simply put, the value of a metal project increases as it advances toward production. At least, that is what happens in a normal market. This is not a normal market.

Here is what is happening at this moment. Early stage exploration projects are given very little or no value. In fact, in some cases investors are giving exploration projects negative values. Some companies with exploration projects are trading for less than cash value.

It may seem attractive to buy cash at a discount, but you have to factor in salaries, rent and travel to conferences. That cash has value only to the extent that management will do something useful, like advance a metal deposit. Exploration spending has been slashed, but rent and salaries continue to be paid.

At the other end of the scale, high quality production or near production projects are trading at roughly 20 to 40 percent discount from realistic values.

Most people are saying that there is no money for junior mining companies at this time. The reality is, there is an enormous amount of money available. Various funds and private equity groups are sitting on billions of dollars of cash and are salivating over the exceptional values available in the mining industry.

The only problem is that they are focused almost entirely on the right side of that chart. They want assets at the right side of the chart, and especially they want cash flow, but they want to pay the prices on the left side of the chart.

Over time, those investors will move into that middle ground: projects that are a couple of years from production, but which can be acquired for pennies on the dollar. When those big pots of money move to earlier stage projects (prefeasibility and feasibility), the values will start to move toward rational values.

That is where investors should focus at this time: Companies with good assets which can be bought for pennies on the dollar.