- Exploration company: These are small teams of geologists & mining engineers searching for minerals. They will tend to be pursuing grassroots 'conceptual' targets or attempting to expand or re-test an old target, whether demonstrated minerals exist, indicator minerals, proven ore zones, or perhaps have acquired an old treatment plant hoping to find more resources. These companies typically have less than $3mil in cash and tend to disappear when a boom collapses.
- Mining juniors: These are companies that have managed to discover, delineate, develop and commission a mining operation. Solely relying on cashflows from a single mine, these companies often have a limited life unless the discovery proves to be a 'company maker'. Bonanza discoveries are rare - except at the top of the resources boom when alot more money is being spent on exploration.
- Middle rank miners: These companies emerge through the successful developement of several mines or the merger of several mining companies.
- Multinational miners: These companies tend to arise from the merger of even larger companies. They tend to have their origins in important mineral centres like Broken Hill (BHP Billiton), Mt Isa (MIM) and Nevada (Newmont).
These 4 stages have some relevance to the share price performance of the company. Exploration companies are listed on the stock exchange in the middle to late stages of a boom when capital is readily available. Over time the quality of such listings deteriorates as good projects become scarce. Brokers are only too willing to place their clients money at risk to support a capital raising since they are earning commission on the listingg. If the broker is getting more than 5% commission, or offers free options, its usually a dog, or difficult market conditions. The level of over-subscriptions is also important, and such listings will usually enter the market at a 100-200% premium. New listings are attracting maximum exposure, and tend to fall from then on, unless they are able to maintain the momentum with successful drilling programs. Eventually these companies fall victim to investor impatience. It takes anywhere from 2-5 years to get a mining project into production. In that time there is alot of money to spend, and considerable potential for surprises. Eg. Samples could be tampered with, the orebody could be faulted, the metallurgy could be difficult, metal prices might collapse.
Successive drilling programs see the share price of the best stocks go sideways, and the less compelling stories go down. Generally they are not worth touching until the results of the Bankable Feasibility Study (BFS) are released since that is the point the project can be financed - as long as the Internal Rate of Return is over 24% (before tax, equity basis). Ensure that the sponsors are using conservative parameters for currency & metal prices. The release of the report is a good selling opportunity. If its a bad report, hold off selling because metal markets might move in your favour, and often the project can be re-engineered to reduce costs. eg. Using 2nd hand plant, production of a concentrate rather than a finished product, etc.
After the BFS is completed, its not worth investing until the mine is close to production. Even then the company is often a long way from paying dividends because most have to carry alot of debt. The upside on metal prices is restricted by hedging metal prices and the Forex rate. Many companies also have further capital commitments if they have to go underground.
Since there are a multitude of opportunities to invest in the mining sector, we are looking for the most attractive companies and projects. Small companies have attractive features (like capital gain), but large companies offer diversification and have regular cashflows and dividends. Small companies tend to be more cyclical, but in absolute terms the large companies have more to loose, and the small companies more upside. Each investor needs to consider their risk-reward exposure.
Assessment of these 4 stages of a mining company are very different, but are highlighted below.
The factors pertinent to assessing the merits of an exploration company are:
- Capital structure: Its preferable that they have a low market capitalisation. The lower the better. Any discovery will result in a larger gain in the share price.
- Cash: You don't want an exploration company to be under-capitalised (less than $1mil cash) or over-capitalised (>$4mil cash) because this exposures you to dilution, or reduces the upside. Established investors would prefer new shareholders buy in at higher prices to lock in a share premium.
- Management: Its preferable that they have experienced & ambitious management. They should have an applied background rather than an academic one. The CEO should be a geologist with commercial skills not an analyst or accountant. He should be well connected and competent.
- Targets: The quality of a company's exploration interests can say alot about the quality of the management.
- Focus: The commodities upon which they are focused should be of interest to the market NOW - not in 5 years. Otherwise you should buy later. But ultimately the investment decision depends on the value of the project. A great project will be valuable at the depths of the commodity cycle, and likely worth waiting for. Use charts to pick an entry point.
Most exploration companies target low grade haloes to old mines, the depth extensions to them, or they might seek virgin 'grassroots' exploration areas. Given that most developed countries are over-explored by comparison to South America, Asia & Africa, a great many companies are exploring in these areas. This is a benefit to shareholders because the exploration impediments are often lower, and the areas are more prospective for larger discoveries. Thats not to say Australia is depleted - far from it. Large discoveries are sometimes made after a multitude of explorers passed an area off, and there is still potential at depth as more sensitive instrumentation and improved software allow better detection of 'concealed' orebodies with only a geophysical expression.
Minerals are usually discovered in established areas, though every so often an explorer will make a fresh discovery, often based on a conceptual target established by a mineral province elsewhere, which suggests a mode of formation applicable to other areas. Other explorers peg claims in similar or nearby areas hoping to identify repetitions. Mineral deposits with a lithological or structural control pointing the way. Many companies will target grassroots targets offering several prospective models for mineral accumulation.
Once a mineral deposit is identified we are concerned with the following issues. The less we know the more the risk, and the greater discount we apply to the discovery. Net sum we consider:
- Potential size & grade of the mineral deposit to determine the in-situ mineral content
- The distribution of the ore zones to determine if they will readily fit into a mine plan, as well as impacting on the scale and cost (selectivity) of mining. Is the orebody offset by faults?
- The geometry & depth of the deposit to determine the cost of accessing the minerals. Deeper deposits are more costly to drill define, acess with development drives and expensive to operate. Very deep mines require underground air cooling systems. eg. Fiji volcanic zone
- The metallurgy of the ore to determine how much can be recovered and a rough idea of the costs of mining, processing & transporting the ore to customers.
- Vested interests that pose a threat to the project, eg. environmental, land rights, export licenses, royalties, sovereign risk (political stability).
- Market prices for the contained metals to determine the value of the ore and the availability of customers
- The likely scale of mining to determine the life and scale of production (cost of mining).
- The political stability of the country so we can be assured of the security of the company's title.
Most of this information will come over time. The initial focus is on the distribution of minerals and the strategic importance of the mineral deposit. A new discovery does not always sit in isolation. The commercial viability of a mineral deposit is much improved by the availability of a nearby processing plant. If a small project sponsor can commission a mine without building a new processing plant - it can pose a huge saving. W need to consider the location of each drill hole, the grades and their distribution downhole. We would prefer to see homogenous ore zones for easy mass-mining rather than multiple ore zones surrounded by barren material. This would require more costly selective mining. We would prefer little overburden and flat tabular deposits so the overburden ratio is minimal. We would like to see a higher grade zone near the surface to offer a rapid cashflow - perhaps to finance expansion or pay off debt quickly. We hope their will be alot of ore amenable to Open Cut (OC) mining, so we can delay underground (UG) development. If there is UG development better that the project is in the mountains where we might be fortunate to get horizontal access to the ore zone quickly.
Junior miners trade at a premium to explorers because they have an established cashflow which can be used to finance new projects or expansions. This means shareholders are free of issues diluting their equity, but they are somewhat exposed to 'technical' and 'market' surprises like falling commodity prices, or disappointing drilling results. Better if there are a number of projects so the companies interests are diversified if the shareholder is not. The focus on these companies are of a more commercial nature, as the risks shift from technical to earnings-yield concerns since the technical risk has been diversified. Consider the following:
- Cash costs: After they have paid off the debt their cashflow is basically profit after exploration, amortisation, depreciation, administrative, royality and expansion costs
- Hedging: Investors want exposure to the upside. Unfortunately companies with few assets need to hedge a portion (50%) of their reserves to secure project funding. Typically all the debt will be repaid in 3-5 years. As a consequence unhedged producers are more attractive in rising prices, and hedged produces more valued when metal prices are falling. Some companies like Sons of Gwalia have gone backrupt because of dubious hedging programs.
- Forex rate: Its an unfortunate fact that when commodity producing countries like Australia, Canada and RSA benefit from higher commodity prices, local investors don't benefit as much because the higher commodity prices are neutralised by a rising local currency. For this reason miners situated in non-traditional commodity producing markets like Thailand (Kingsgate Consolidated) or Sweden (Dragon Mining) offer an added attraction. In contrast, gold miners in South Africa were going broke on recent high metal prices because the Rand rose too high.
- Metal prices: A 10% rise in metal prices might well have a 30% impact on project earnings since profit margins rise faster. The impact is even greater on large-scale miners with high costs, eg. Emperor Mines in Fiji.
- Mine Life: Investors, particularly fund managers, are very concerned about the stability of earnings. The biggest factor affecting mine earnings is mine closures, so its important that a company is able to expand its earnings and replace diminishing production capacity, either with new projects or expanding reserve inventories. This means that companies have to drill up areas years before they will be mined. For mine planning reasons, this is sensible anyway. Those mines with high capacity & long life are vert appealing takeover targets for the multinationals too.
These companies include Rio Tinto (RIO) and BHP Billiton (BHP). Such companies tend to be listed on a multitude of exchanges and have a highly diversified geographic presence. These companies have a very different strategy to the others - focused on the right strategic asset mix and assemblage of the right assets. The share the following characteristics:
- Acquisition focus: They are less interested in maintaining exploration teams, preferring to finance small companies which operate on smaller operating budgets. Instead they will retain generous buy-in rights if the exploration area yields a resource of sufficient size to meet their criteria, eg. strategic asset, long life (20+ years), lowest cost quartile, profits over $30mil a year potential.
- Metal mix: They are interested in having exposure to a diversified suite of minerals, in a broad range of areas. This allows them a stronger price negotiating position, as well as offering them the opportunity to reduce transport costs.
- Sovereign risks: They have little sovereign risk
- Value adding: They are interested in downstream processing opportunities like ferroalloys, powdered metals if that comes within their area of core expertise.
Because of the more secure earnings stream from these companies, they are more highly valued by institutional investors, particularly since there are very few resource companies which offer the stock liquidity to attract sizeable investments - apart from the oil industry. eg. Exxon, Chevron, British Petroleum and Shell.
- Andrew Sheldon www.sheldonthinks.com