Aberdeen (AAB), Pinetree (PNP), Northfield Capital (NFD.A)

All three companies hold mining/resource stocks and (likely) trade below the liquidation value of their assets.  All three are buying back stock.  Of the three companies, I like Northfield the best.  Management-wise, Northfield is clearly the best.  G&A is the lowest, insiders aren’t paid ridiculous salaries, and Robert Cudney (the CEO) has an incredible track record (compounding at over 20% AFTER tax).  While Northfield doesn’t necessarily trade at the biggest discount to its assets, superior management suggests that it is the stock to own.  It is the one-foot hurdle.

Aberdeen:  Too hard to figure out.  In addition to owning stocks in junior mining companies, they own warrants on them (because they originally bought the stock + warrants in a private placement) as well as loans, royalties, performance shares, and private companies.  They may be valuing their royalties too high, but I am not entirely sure because I haven’t looked into the expected mine life of the mines underlying the royalties.  And, the investments in private companies and the performance shares and the loans are hard to figure out.  But personally I don’t really like to see loans to their private companies since the loans may be propping up otherwise dead companies.

I don’t understand the dividend as it reduces the value of insiders’ options.  Not only that, insiders would make more money if the dividend wasn’t there.  With more assets under management, they have an excuse to charge higher salaries.  They also have more capital to invest in companies owned by Aberdeen… insiders serve on the board of directors of these companies and get to collect fees again. I’m confused by the dividend especially since Aberdeen’s presentation claims that they want more assets under management.

As a business model, Aberdeen seems to expose shareholders to a set of fees at the Aberdeen level and are hit again with fees in the stocks that Aberdeen owns (Stan Barti, the CEO of Aberdeen, is on the board of most of those companies).  Perhaps it is not surprising that Aberdeen come to market around 2007 at 80 cents (80 cents bought you a share and a warrant) and still trades below 80 cents.  And for some reason, the CEO was selling in January 2012.

Pinetree:  Pinetree has a “shotgun” approach and invests in a large number of junior miners and junior resource stocks.  Most of these companies are on the TSX Venture exchange and are highly volatile.  A sane person would not go past 100% leverage.  Pinetree… does.  This is why Pinetree’s portfolio crashed in 2011 and why they had negative retained earnings at the end of that year.

Management charges high fees and G&A is rather high.  If G&A were 0 historically then retained earnings would actually be positive.  So far, insiders have made money and shareholders haven’t really made money.

Northfield:  Of the three, Northfield by and far has the best investment track record and has lower G&A.

Historically, there hasn’t been a lot of transparency (e.g. stocks weren’t market to market and management didn’t really help investors understand that) while the CEO was simultaneously buying boatloads of stock on the open market.  The CEO no longer buys Northfield shares (he does personally buy shares in other companies which are more liquid) and the annual report does mention non-GAAP Net Asset Value, which highlights Northfield’s undervaluation.

Historically Northfield invested in private companies (wine, glass, environmental products, etc.).  Northfield is getting out of that and the only private business it is involved in is an unprofitable winery.

Northfield has almost always been undervalued and trading below liquidation value (theoretical liquidation value anyways… a lot of its holdings are in illiquid smallcap/microcap stocks).  Northfield stock is extremely illiquid and there are entire months where no trades occur.

Disclosure: Long Pinetree (only 200 shares currently), long Northfield (a lot more so than Pinetree).  Figuring out Aberdeen is not worth my time.

How to lose money in resource stocks

Outright scams

There are many pump and dump penny stocks on the OTCBB… many of these are simply outright scams.

Some “companies” issue misleading press releases that try to trick investors into thinking that there will be an actual producing asset.  A mining “company” may buy ore concentrate (this part will be divulged somewhere in their many pages of financial statements) and simply resell the ore concentrate.  They will try to make people think that the ore concentrate sales were a result of mine production.  I believe that this is what is currently occurring at Gold Resource Corporation (GORO)… of course the short sellers know this and the borrow on the stock is incredibly tight (I am not shorting it because I fear the buy-in).

Flawed assets

Sometimes mining companies will purchase mining assets with some kind of subtle flaw.  Typically investors are not very savvy (e.g. look at the market cap of GORO, Uranium One) and don’t spot the outright scams.  In less outrageous examples, there is actually a mine but some subtle kind of flaw to it.

Political risk is a big one.  Foreign companies rarely get treated as well as domestic companies.  Even in politically safe jurisdictions like Canada, foreign companies aren’t treated as well (e.g. evil foreigners weren’t allowed to buy Potash Corporation of Saskatchewan).  And of course there are many countries where there is corruption and where mining assets are stolen/nationalized.  Many of the most successful resource companies like Contango Oil & Gas and Altius Resources do not invest in foreign countries.

Some mines have veins that are extremely high grade.  However, the company won’t be so quick to point out that the high grades are in extremely narrow veins.  To actually mine the vein, you have to also mine and process significant amounts of waste rock around the vein.  This dramatically reduces the economics of the deposit.  Excellon Resources is an example of a mine with high grades that aren’t as economically attractive as one would hope.

Some mines are marginally (un)economic.  In that situation, everything matters.  There are many factors that determine whether or not a mine may be profitable.  Political risk, size of the deposit, grade, mining dilution, recovery, processing costs, cost of the proposed mining method, infrastructure, impurities, quality of final product (e.g. fines in iron ore), etc. etc.  Subtle changes in key assumptions can have a cumulative effect and make the deposit look way more attractive than it really is.  And I don’t believe that anybody will suffer serious consequences for making aggressive engineering assumptions and overstating the mine’s economic viability.  (You don’t even get thrown into jail for running an outright scam like Uranium One or Gold Resources.)  It’s simply way too hard to evaluate these deposits and these companies are almost certainly fudging the numbers.

“Production is going to follow this parabolic curve”

The proper way to build a mine is to do a lot of exploration upfront so that the engineers can build an appropriately-sized mine for the deposit.  And then you build your mine to a specific capacity that maximizes the net present value of the deposit (perhaps taking into account a reasonable internal rate of return).  Higher capacity mines benefit from economies of scale.  It rarely makes sense to build a mine and then realize that you should have built a higher-capacity mine in the first place (which is expensive and makes you less money than doing it right in the first place).

Also: In any mine, the highest grade ore will almost always be mined first so you can expect grades and production to fall in the future.

There are exceptions.  Many iron ore and potash deposits have huge reserves.  The mine operator may not even bother exploring the entire property if they know that there is already at least 15-30 years of reserves.  But because the price of both iron ore and potash has gone up so much, it can make sense to expand mine capacity.

The other situation is that very deep drilling may not be performed as it is very expensive.  The cost per ft increases the deeper you go.  Not only that, drillholes go more and more off course the longer it is.  There comes a point where it does not make sense to waste money on drilling.  But when the mine is built, it is possible to perform exploration from within the mine (and it’s cheaper to drill deep when the drill rig is located deep in the mine).  The mine operator may discover more ore.  A larger reserve and higher commodity prices could warrant a mine expansion.

But generally speaking, most mining companies that say that production at a mine will increase are making stuff up.

“We have all these reserves in the ground”

It’s so common for an oil & gas company to claim that they have a lot of reserves that they haven’t drilled yet.  Guess what?  Exploration is risky because it’s highly uncertain what’s in the ground.  A lot of oil & gas companies overstate their reserves.  When the property is drilled, there is much less uncertainty as the property will produce oil/gas.  However, it isn’t clear what the decline in production will look like in the future.  The engineers have to make an educated guess.  And of course there is room here to make extremely aggressive assumptions to fudge the numbers.

Related party transactions

Chesapeake Energy Corporation (CHK) would be an example of a larger capitalization stock with shady management.  Manual of Ideas has a good writeup on Aubrey McClendon’s shenanigans and how he has been lining his own pockets at shareholders’ expense.  I’m surprised that many value investors have gotten suckered into this stock (e.g. Longleaf, various VIC writeups like this one, etc.).  I’m sure some people have made money in this stock but you are better off holding something else in my opinion.

Bottom Line

I would listen to Warren Buffett:

  1. Stick to what you understand.
  2. Look for the “one foot hurdle”.  Stocks that are wildly mispriced with a large margin of safety.

If you can’t be bothered to read a mine engineering textbook, then why bother investing in mining stocks?  Just go to the mall instead and invest in Apple and McDonald’s (their founders also have biographies that are easier to read than some engineering textbook!).

Personally I think that resource stocks aren’t a great sector in general.  There are a lot of shenanigans going on and investors don’t always make as much money as they should.

Portfolio Update March 2012

By largest positions first:

#1 – QXM and XING (see writeup).

Very shady, very undervalued if it isn’t a complete fraud like most Chinese reverse merger stocks.

#2 – Premier Gold (PG.TO)

I own this because Hardrock Resources was taken under by Premier.  I plan on selling everything at a higher price than what it is now.  I don’t really see crazy undervaluation here and this is a bet on higher gold prices.  I am happy to make that bet, though higher gold prices haven’t worked out well for those who own gold stocks… not yet anyways.

#3 – KWG Resources (CVE:KWG)

Cliff’s (CLF) bought out Spider Resources after a bidding war with Noront (there is bad blood between the two companies… they snipe at each other in the press all the time).  Cliff’s was also trying to buy out KWG and they are almost certainly in negotiations to do so.  In the future, I would expect Cliff’s to buy out KWG and Noront to consolidate the area.  Noront is moving towards a plan to build a winter road to its nickel deposit with a slurry pipeline to move ore concentrate.  It is probably more economic for one party (e.g. Cliff’s) to consolidate the area and to build a railroad to Noront’s nickel deposit and the chromite deposits in the area.  According to a PEA (Preliminary Economic Assessment, which are usually fudged) the railroad would cost somewhere around $900 million.  Now KWG is saying that it will cost $2 billion.  So who knows what the NPV of their deposit really is.

However, Cliff’s has presumably done due diligence when it bought Spider Resources.  KWG has also sold a royalty to the chromite deposit to Anglo Pacific Group for $18 million… so there’s another party that has likely done its due diligence.  In my unqualified opinion, it is extremely likely that the deposit will turn into an economic mine (several years from now).

I like the management at KWG.  They are actually buying back shares, though they probably won’t buy back very many shares and have said so (because junior miners always find themselves undercapitalized).  Selling the royalty is a good move as it raises capital without diluting shareholders while the share price is so low.

#4 – Canada Lithium (CLQ.TO)

Their asset is a marginal lithium mine.  Hardrock sources of lithium typically have higher costs than producing lithium from brine sources.  In theory, Canada Lithium is highly leveraged to an increase in lithium prices.  If electric vehicles with lithium batteries proliferate, then demand can outstrip supply.  With only a few dollars worth of lithium in every car battery, there is a lot of headroom for the price of lithium.

As for the company itself… there is a lot of drama.  Its original resource estimate was performed by Michelle Stone.  (I get the feeling that companies hire her because she is very aggressive at fudging the resource estimates higher; just look at East Asia Minerals.)  Canada Lithium later had to issue a press release stating that there would be a “material reduction” in the resource estimate (and then the press release didn’t say much else… basically regurgitating old facts).  This happened not so long after Canada Lithium raised a huge amount of capital.

Currently, they have a lot of cash on hand and you aren’t paying a lot for the deposit.  Canada Lithium has been able to secure a $70 million loan to finance the project… presumably it is economic.

#5 – Long natural gas through shorting HND.TO

This is a large position because I have been getting killed on my short.  This is mostly speculation on natural gas prices.

#6 – Selwyn Resources (SWN.TO)

Their 50% share in their Yukon project may be worth $100 million.  (Their Chinese JV partner paid $100M for a 50% stake, though they sort of own more because they have certain rights in regards to concentrate sales as they own smelters and want to process the ore.)

Selwyn paid $10M for its project in Nova Scotia.

$100M + $10M = $110M.  Selwyn has a market cap of around $60M.

The CEO has been successful before (Selwyn split off from Yukon Zinc; Yukon Zinc was bought out and its project turned into an operating mine) and has previously bought shares of Selwyn on the open market.

#7- Northfield Capital

Excellent management… better than 99% of mutual funds.  Trades at around a 30% discount to liquidation value.

#8- Stocks I sometimes own

Contango Oil & Gas (MCF):  Excellent management.  The CEO invested his life savings of $400K into his company and now his net worth is a few hundred million.  Unfortunately, natural gas is getting killed and Ken Peak (the CEO) hasn’t been able to put capital to work.  If he has his way, he would’ve gone crazy drilling in the GOM and sold off producing assets (Contango’s historic bread and butter).  They were supposed to spud one of their wells several months ago.

Apple:  It’s hard to find a company that has grown faster than Apple (even in small cap land).  For a growth stock, Apple is cheap on a PEG basis.  At the Eaton Center here in Toronto, Apple and McDonald’s are the two companies with stores that are consistently jam packed (Sephora too is very busy).  Yes most of the people in the Apple store are there just to steal free Internet.  But, every employee is talking to a potential customer (unlike all their competitor’s stores).  They are the market leader and it’s usually the market leaders than make almost all of the money in a given industry (and have long periods of consistent earnings growth).  And unlike their competitors, people will line up to buy Apple’s latest products.  They have the strongest brand.

If I was smarter I would have bought Apple LEAP options when volatility was cheap and held onto them.

#9- Short term trades

POT calls.  Bet on the agricultural boom (with higher crop prices, more fertilizer increases yields and makes economic sense).  People in India and China will eat more food (more meat, which takes more farmland to produce) as wealth increases.  And the growing use of biofuels will increase demand for crops.
The economics of potash mines are attractive with potash prices so high… every potash miner is expanding their mine.  Eventually there will be a wave of overbuilding but I think that it is several years away.

RIMM.  They will lose to Apple and Android.  Their products aren’t getting as good reviews and they will lose the app/software ecosystem race because their platform is difficult to develop for (they are already losing the app race).  The Playbook has very mediocre reviews and was released too early.  But there is a price where a second-rate company is undervalued.  The ex-CEO is buying… and I am copying.  RIM generates strong free cash flow relative to its market cap (I ignore RIM’s reported profits as its patent settlement should be expensed, not capitalized).  And for a while it will probably continue to grow with the growth in the smartphone market.  If the company goes into harvest mode and returns earnings to shareholders, then shareholders should be able to make a reasonable amount of money.

QMI.TO (Queenston Mining).  Agnico Eagle has a strategic stake in Queenston (bought at $5.30) and their deposits will likely turn into a mine.  I dislike that management gave away free money by extending warrants.  I’m probably going to sell this if it goes higher and buy more KWG.

Short positions

#1 – St. Joe (JOE) puts.  Read David Einhorn’s presentation on the company.  I have nothing to add.

#2 – AGNC puts.  If interest rates go up or down a lot, they will lose money (it says so in the 10-K).  Otherwise their magical 17% yield will continue (after the 1% management fee; of course insiders aren’t going to put their own skin into the game and chase these magnificent returns).  This is a longshot bet.  Unfortunately for me, they keep raising capital and the party continues.

#3- TLT common stock and puts.  Short long-term US treasuries.  Duh.

—The following are very small positions—

#4- Tesla Motors (TSLA) common stock.  The negative rebate sucks.  Shorting this unprofitable company and trying to short the US consumer, which can no longer use their house as an ATM.

#5- Imax (IMAX) common stock.  RealD has a product with superior economics.  (An Imax setup has much higher capital costs and reduced seating.)  So how is Imax making money?  Free cash flow is very weak, insiders are selling, and Imax historically has negative retained earnings.

#6- DLR, IOC, PSUN, GMCR common stock.


Ugh.  These are Chinese reverse merger stocks.  (A reverse merger is a ‘bootleg’ method for companies to quickly get listed on US exchanges.  For whatever reason, most reverse merger stocks are frauds.  I haven’t seen any insiders get thrown into jail due to the complications of international law.  Regulators and exchanges shouldn’t allow this… but they do.)

The history is that originally XING IPOed an interest in its cell phone business in an IPO (which is QXM).  Later on, the stock price of QXM tanked and there was a lawsuit over the accounting practices at QXM (the financials had to be restated to show that QXM was not profitable in its early years).  Oh yeah… insiders steal from this company… read the related party transactions.  When XING was trading below the value of its ownership stake in QXM, insiders decided to merge XING with a mining company owned by the chairman.  Now if you read the financials carefully… you’ll notice that they capitalize the stripping costs of the mining operation.  This is rather inappropriate as stripping costs should be expensed; capitalizing them inflates earnings and EBITDA in the short term.  Management points out the EBITDA figure when XING bought the mine… but EBITDA is a terrible method for valuing any mining asset.  The most appropriate method would be Net Present Value (though it is easy to fudge NPV values).  Projections of expected production, grades, and free cash flow over the expected mine life would also be appropriate (though few people ask for these figures).

Riu Lin Wu and Real Gold (HKG:0246)

Riu Lin Wu is the former chariman of XING (he has now been replaced by his eldest son).  Real Gold is another Riu Lin Wu-related entity (Riu Lin Wu is the majority shareholder and pretty much controls the company).  There is a huge ongoing scandal with Real Gold because it has been secretly lending money to Riu Lin Wu’s companies.  The interest rates that it has been charging were presumably insufficient to compensate for the credit risk involved.  The auditors at Real Gold have resigned.

Now back to QXM and XING.  QXM is a cash rich company… so why do its financials show that it is borrowing money?  To be fair, there might not be anything shady in this department.  But I am a paranoid kind of person.

There are a lot of shenanigans going on with the various convertible debentures at XING and QXM.  The related party ones have been terrible deals for XING/QXM shareholders.

The underlying business

Unlike other Chinese reverse mergers, I believe that there is a real company here.  (Though I can definitely be wrong.)

VEVA makes high end cell phones.  There are user reviews of their cell phones on the Internet.  Here is one of their infomercials:

The infomercials are pretty slick actually.  The one above features Pace Wu (Pace who?), who is apparently a minor star in China (read the Wikipedia entry for her).  Veva has also hired Zhang Ziyi, who is definitely a star inside and outside of China.

QXCH (owned by XING, not QXM) makes indoor phones.  It has been losing money (or “losing” money) and has been sold.

Why I am long QXM and XING, not short

My original thesis was that insiders would try to pump and dump these stocks onto institutional investors, similar to how QXM was originally IPOed.  It seemed to make sense at the time because insiders sold the mine to XING for shares, not cash.  XING was also going to perform a take-under (or fake takeover?) of QXM, but this proposed transaction failed.  Unfortunately, insiders have not been trying to pump and dump these companies and the stock prices of both have fallen by about three quarters.  The websites for both companies are badly outdated and there has been little communication with shareholders.

Shah Capital Management is a major shareholder of both companies and has not been pleased with management (read their unhappy letter to the QXM board).

I have been in a world of pain because of these two stocks.