Thoughts on mining and exploration stocks #2

As somebody interested in investing, I want to figure out how to generate unusual returns from mining stocks.  Here’s a look at what “worked” in the past.

#1- Bet on the right commodities

Make a macro call on which commodities are likely to go up the most.  Personally, I don’t believe that macro investing is a reliable way of making money as even good investors make the wrong macro call a lot of the time.  Warren Buffet dabbled in physical silver and he didn’t really make money on it.

Even if you identify the right commodity, it’s not so easy to make money.  If you thought that gold was going up, you could have still lost money if you had invested in the wrong gold exploration stocks.  Production of gold has remained flat despite skyrocketing gold prices because it’s been really hard to find economic deposits of gold.

#2- Find really good explorationists

Mining is a commodity business.  The only way to create value is to be the lowest cost producer.  Exploration is an area where there is the most room to have lower costs as exploration is the most open-ended and riskiest part of resource extraction.  However, the problem in mining is that there is a very low chance of finding an economic deposit.  Many geologists will never find an economic deposit in their entire professional careers.  Very good explorationists can increase their chances of finding a deposit through the joint venture model.  By finding a JV partner to share the risk and put up capital, the explorationists can participate in a larger number of exploration projects and therefore increase their chances of finding something.  This is a core part of what Altius Minerals (ALS.TO) does.

#3- Invest in miners that may discover resources cheaply

a- Generally speaking, one of the best places to go looking for a mine is by a mine.  The area underneath the mine and in surrounding regions will likely have similar geology that would result in an ore deposit.  In the past, Franco-Nevada bought up large tracts of land in the Carlin trend when it was cheap to do so.  They subsequently got joint venture partners to explore the land (and did a small amount of exploration themselves).

b- There is a saying that “a good mine dies hard”.  Mines with good economics and high margins may end up staying in production for a long time, sometimes decades.  If any new ore is found, it will likely be economic because all the mine infrastructure is already in place.  Marginal mines will not experience this as the lower margins makes it less likely that any new ore found is economic.  There usually aren’t unusual returns from this as companies are usually quick to point out exploration potential and inferred/probable resources.

c- When a major new discovery is made, the size of the deposit may grow rapidly as more and more ore is found.  There will also be a crazy staking rush for surrounding areas with similar geology as those areas are good places to look for ore.  Investing in a major discovery could be a potential method of making money if other investors/traders are underestimating the exploration potential.  However, this is a tricky game as usually it is the case that investors wildly overestimate the exploration potential of a deposit (and management wildly overstates it).

#4- Joint venture deals

Joint venture deals can be used to take advantage of junior miners.  A lot of juniors don’t always engage in economically sane behaviour.  They may make not-so-great deals if it helps them to promote the stock and raise capital.  A promotional company can conveniently fail to mention any overriding royalties and back-in rights in corporate presentations.

Often, juniors will explore even if it is not economic to do so.  Some senior miners will joint venture off most of their properties and spend very little on exploration themselves when there are juniors willing to do it.

#5- Royalty deals

Sometimes it is a lot better to own a royalty on a mine than to own equity in the mine.

a- If the mine owner decides to spend capital on expanding output at the mine or exploring for more ore, the royalty holder doesn’t pay anything and receives benefits for free.

b- If the mine is owned by a public company, the company may decide to keep mining even though it is not economic to do so.  The shareholders lose and the royalty owners gain.

c- You don’t have to worry about management getting paid too much, shareholder dilution, etc. etc.

Royalty deals are a form of wheeling and dealing and some companies have made a lot of money from them (e.g. Franco-Nevada, Altius).  The downside to royalty deals is that the mine owner may try to underpay the royalty, which would leads to a lawsuit (this happens from time to time).  If the royalty is too high and commodity prices fall, the mine owners may shut down production even though the deposit would otherwise be profitable to mine.  The royalty holder and the mine owner may renegotiate the royalty deal so that mining can restart with the royalty holder taking a larger share of the upside.

Some publicly-traded entities own significant royalty deals on mines (e.g. Labrador Iron Ore Royalty Corporation).  There are also companies that specialize in royalties (e.g. Anglo Pacific Group).

#6- Companies that buy back shares when they are cheap (and sell them when they are expensive)

It helps long-term shareholders if the company in question buys back its shares when they are cheap, e.g. in 2008 and 2009.  And it doesn’t help if the company was buying back shares before 2008 and suddenly stopped in 2008.  Altius Minerals and Northfield Capital are two good examples of companies that buy back their shares intelligently.

#7- Promotional ‘Ponzi’ stocks

Some companies are very good at promoting themselves and raising capital (or using their stock as currency) at ever increasing prices.  Personally I don’t like trying to do this type of investing and think that one day this will all end really badly.  But this factor is responsible for the share prices of a lot of mining stocks out there.

*I do own stocks like Queenston Mining (they extended warrants for free so that the brokers will be happy and pump their stock), Canada Lithium (raised capital based on inflated reserves), Northfield Capital (it owns the former two stocks), etc.

To summarize

It seems like the easiest way to make money in mining stock would be to:

a- Avoid 99% of the stuff out there.  See the first post in this series.
b- Stick to the best managed stocks out there (Altius, Northfield Capital).  Buy them when management is buying back shares and sell them when the company is doing secondary offerings.  Altius is probably the better managed of the pair (see this writeup on valueinvestorsclub.com where I first learned about the stock).

(Disclosure: I own shares of Altius and Northfield.)

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