Thoughts on mining and exploration stocks #1

My current thinking is that the majority of these stocks are inappropriate for investment.  There are simply too many companies out there trying to mine the public markets!

The problem with mining is that you need to value these companies based on their future discounted cash flows.  If you have a producing mine that has been in operation for a few years, figuring out the future cash flows isn’t ridiculously hard provided that management provides data to help investors. But for projects at earlier stages of development (e.g. exploration), you have to make projections about the future and have little past data that would be helpful in such projections.

The uncertainty is very high and you end up depending on the honesty and integrity of company management (as well as their employees).  The publicly listed mining companies have a history of not disclosing factors that make a project uneconomic, overstated economics and reserves, title issues, outright fraud, delayed reporting of deaths and strikes at mines, etc.  Reliable information is difficult to come by as mining companies will rarely disclose negative information (or try to rephrase it in a way to make it sound positive).  Because developing a mine takes several years (more in certain jurisdictions), it can take several years for investors to realize that they have been duped.

#1- Almost all mining companies are very promotional

“That’s just the way it is.”  This wouldn’t be that terrible of a problem if you could perform due diligence.

#2- It is very difficult to do due diligence

If you really want to do due diligence on a mining company, you would:

a- Take a portion of their drill core and run your own assays on it.  This is how the Bre-X fraud was discovered.  Actually, Bre-X ground almost all of their drill core so that the fraud would take longer to discover.  The company that wanted to buy out Bre-X re-drilled a few holes (it was not cheap).  NI 43-101 regulations are supposed to prevent/reduce similar frauds.  However, outright fraud still occurs.  At Bear Lake Gold, the geologist decided to enter in higher values for the assay database.  A NI 43-101 technical report on that property did not catch the fraud, though it did note that its own assays of the drill core was consistently off by ~20%.

b- Get a copy of their assay database and geologic model.  Drill holes only sample a very small portion of the actual ore body.  You have to make an intelligent guess as to what is around and between the existing drillholes.  Sometimes companies get extremely aggressive in their geological interpretations.  With a copy of their database you would be able to form your own opinion on whether the resource/reserve estimation is reasonable.  This is something that senior miners usually (though not always) do as part of their due diligence when buying a junior.

c- Check engineering data relevant to the economics of a mine/deposit.  This may require a team of specialized engineers (infrastructure, metallurgy, mine engineering, etc.).  In the case of KWG Resources, a Preliminary Economic Assessment on their deposit assumed that a railroad to it would cost $900M.  After performing studies, the current figure for the railroad is around $2B.  Little details can matter a lot.

d- Have a lawyer check for title issues.  e.g. Bre-X had serious title issues.

I would guess that very few institutional investors are doing this level of due diligence.  Even where analysts at an investment bank have an opportunity to visit the mine site, none of the banks which covered Bre-X were adept at spotting red flags (destruction of drill core, lack of drill core with visible gold, unusual drilling practices, etc.).  Very few people are doing due diligence at the same level as some senior miners.  In my opinion, the overall level of due diligence is very low compared to other areas of the market such as Chinese reverse mergers (I’m impressed at some of the investigative work that people are doing to uncover fraud).

#3- The Ponzi scheme element

Some exploration companies spent very little money on actual exploration.  The focus may be on raising a lot of capital at high prices.  More capital managed means higher salaries for company insiders.

Companies pay large fees to underwriters and brokers (e.g. usually at least 6%).  There is a mutual relationship whereby brokers promote the stock and help raise the stock price.  In exchange, they collect large fees when they raise capital.  Sometimes mining companies will extend the expiry date on warrants that are about to expire worthless.  This is sort of like giving free money away (the new extended warrant is worth more than the old one).  “That’s just the way it is.”  Doing this makes the brokers happy (because their clients got a freebie) and in exchange they may return the favor by promoting the mining company’s stocks.

#4- The business models don’t always make sense / uneconomic behaviour
Some explo

a- The small market capitalization of many exploration companies mean that overhead costs (audit, regulations, exchange-listing fees, etc.) are a very significant expense.  This is one of the reasons why juniors don’t always spend that much money on exploration (supposedly their core business activity).

b- Insider compensation is sometimes excessive.  Many of the CEOs and CFOs are involved in a few to several different juniors at once (they receive six figure salaries for each of their part-time jobs).

c- Undercapitalization.  Juniors will raise capital at low prices because they have to.  And to raise capital they have to pay brokers and underwriters significant fees.  A rights offering would be fairer to shareholders in some cases but they are expensive and brokers will not promote the stock if they aren’t receiving underwriting fees.  So usually juniors will go to the brokerage community and pay the high fees.

d- Lack of expertise.  Some juniors do not have the in-house mine engineering expertise needed to bring a mine (close) to production.  If exploration results are promising, it makes sense to start doing metallurgical studies, think about grabbing a bulk sample or drilling an exploration shaft, work on permitting, work on engaging the local communities, etc.

e- Promotional excess.  Juniors may promote the mineral “resources” at a property even knowing that it is uneconomic and about to be written down to 0 / even if they intend on letting the lease expire.  Almost all juniors will have disappointing exploration results (that’s the nature of high-risk exploration), yet very few will be honest about it.

f- Juniors may promote projects where it is known that the economics don’t make sense.  They may buy projects where the previous owners gave up because of some flaw in the property (e.g. veins too thin, costs too high, reserve depletion, etc.).  They then turn to the public markets and try to raise capital.  There is a continuum here as some projects are marginally (un)economic and the economics aren’t obviously terrible.

Closing thoughts

I am Canadian and I understand that this describes a large swath of the Canadian stock market.  I guess my opinion is that shareholders in many miners and explorers aren’t going to make as much money as they should.

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One thought on “Thoughts on mining and exploration stocks #1

  1. Pingback: Thoughts on mining and exploration stocks #2 | Glenn Chan's Random Notes on Investing

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