Friday, July 12, 2013
The Hidden Edge of Junior Mining Companies
Rick Rule, Chairman of Sprott Global Resource Investments Ltd., has invested in natural resource projects for nearly four decades. I asked him what I needed to know about investing in junior exploration projects.
“That’s a very large subject,” Rick began, “but the first thing you should know is that the minerals exploration business is frequently mistaken for an asset-based business, but it’s really a knowledge-based business.”
What’s does this mean? The problem with investing in natural resource projects, says Rick, is that there’s a very low chance of success for any individual property. “When I was in university, some forty years ago, the experts claimed that roughly one in three thousand mineralized anomalies (exploration targets) would become a mine,” Rick explained. “With those odds of success, any particular property has a pretty slim chance of being worth something. The way people are successful in this business is by identifying the opportunities with the best characteristics – and having the ability to quickly figure out what’s in the ground.”
“Analysts and investors who participate in the sector would be well-advised to recognize that the entities whose shares we buy are similar to the small research entities in the research and development space in the technology industries,” Rick concludes.
Most analysts and investors don’t recognize this fact, and their mistake often results in poor investment performance in the sector. “The argument that these are asset-based businesses is responsible for most of the capital lost in public junior minerals equity markets. The equation offered up by junior capital markets is that investors take a one in three thousand chance in order to receive a ten to one return. That isn’t much better than the odds of success buying lottery tickets. But understanding the industry can, and does, improve the odds substantially.”
“The junior exploration industry today can be seen partly in the context of a broader economic trend today - outsourcing.” He continues: “The major mining companies today are increasingly financially driven, and the variability of returns from exploration, as well as the valuation and reporting challenges that accompany exploration efforts discourage major mining companies from being exploration focused. Their competitive advantages lie in scale, financial stability, engineering and construction capabilities, and production technologies, and less to the entrepreneurial acumen required for exploration success.”
Major mining companies prefer to avoid the exploration side, Rick says, because companies generally must pursue multiple fruitless endeavors before, if ever, attaining success – and this period of failures is punished by shareholders. This has led to increasing collaboration between juniors and majors, and the majors focus on the acquisition of successful juniors as a focus growth strategy.
What allows juniors to pursue exploration, which the majors avoid? Rick believes that the reason lies with a hidden advantage enjoyed by the juniors.
“They have an effective sub-zero cost of capital,” Rick says. “On the whole, the exploration industry loses between $2 billion to $10 billion per year, subtracting annual expenditures against income from corporate and property acquisitions, production income, or portfolio transactions.”
“Exploration on the whole is a capital destroying business,” Rick continues. “It costs more than you get out of it – and yet, it raises billions of dollars of fresh equity every year. Its cost of capital is thus arguably sub-zero – a fact that majors cannot ignore.”
But can this be sustained? How long can an industry which destroys billions in capital yearly survive?
“In order to play down the low odds of exploration success, juniors have begun to emphasize ‘market success’ instead – the value of their paper instead of that of their projects. One manifestation of this attitude is the juniors’ habit of recycling exploration targets that have failed in the past but can be counted on to yield decent confirmation holes. Another is their tendency to acquire hyper-marginal deposits and promote the ‘in situ’ value of the resources, without regard to the capital costs of developing these resources, the operating costs, or the net present value of operating cash flows that might occur in three decades time.”
So don’t let promoters swindle you into lousy stock positions, Rick advises. “The industry has been quite successful, during ‘bull market’ cycles, at causing allegedly sophisticated investors to focus on exciting but meaningless criterion. Successful investing and speculating in the sector is truly about discriminating amongst choices. If your broker convinces you to buy the entire sector indiscriminately, they will have lived up to their moniker: you will become ‘broker’ and ‘broker.’”
Rick Rule founded Global Resource Investments in 1994. Global provides brokerage and investment banking services to high net worth individuals, institutional investors, and corporate entities worldwide. In 2011, Global was acquired by Sprott, Inc., a public company based in Toronto, Canada, which has in excess of $9 billion in assets under administration in the resource and commodity sectors.