“Investing” in junior mining… a recap

Here’s how I see junior mining.

The promotional game

Almost all junior mining companies are promotional to some degree.  All of the explorers have pretty much zero cash flow and are dependent on raising capital to fund their operations and the insider’s salaries.  Most juniors are usually some mixture of a pyramid scheme and a genuine business.  Here are some of the things they do:

  1. Pump their stock to retail investors.  You may uncover the various websites that the junior is advertising on through some Google sleuthing (e.g. search for the name of junior + “sponsor”).  Even “reputable” senior mining companies like Goldcorp (!!) do this… Goldcorp sponsors the website theaureport.com.  Some of the money goes towards outright shilling and it’s disgusting.
  2. Pay for analyst visits to their mine site and other organized ‘dog and pony’ shows.  Ironically, many scam companies do this and the analysts still get sucked into the scam.  Take Bre-X for example.  It did not bother any of the investment banking analysts that Bre-X destroyed their drill core so that other parties could not do due diligence by assaying splits from the drill core.  (Freeport Mcmoran, the senior that wanted to buy Bre-X, redrilled holes at great expense to do their due diligence.  They uncovered the fraud.)  They also weren’t bothered that the site geologists did not seem too interested in the drill core coming out of the ground.  Normally, you will have a geologist baby sit a drill rig to see if the core coming out of the ground is mineralized (i.e. does it contain valuable ore).  If not, they might stop drilling and rethink where they want to drill next.  See these comments by Graham Farquharson.
    At the end of the day, the problem with these analyst visits is this: If the analysts are gaining useful information… then they have inside information.  And if the analysts aren’t gaining useful information, then it’s all an incredible waste of money.
  3. Sometimes juniors will give away free money by extending the expiration date of warrants.  Why?  First off, it makes brokers’ clients happier and therefore it makes the brokers happier.  It makes it more likely that brokers will pump the junior’s stock.  The second reason is that raising capital is expensive.  If you go through brokers, the underwriting fees will be several percent.  On top of that, there are legal, paperwork, and filing costs.
  4. Beautiful websites, beautiful annual reports.  Again, they gotta pump that stock.
  5. Conferences.  If the attendees get in for free, it’s the exhibitors who are ultimately paying for them.  At the end of the day, the pattern in many juniors is that a huge chunk of expenses go towards G&A.

These are not things that you can learn from reading a book.  I’ve read Pierre Lassonde’s and Seymour Schulich’s books (both made fortunes in mining royalties)… they don’t really explain the shady side of the mining business/casino.  Lassonde’s book is a little unfortunate as it recommended an allocation to gold and was published at the very beginning of a gold bear market.  Rick Rule is one of the few who are more honest about the industry (e.g. junior exploration is a consistent destroyer of capital).

Adverse selection

Private investors are much savvier than the public markets and do much more research than institutional and retail investors.  Freeport Mcmoran didn’t get completely burned by the Bre-X fraud while many institutional investors did because Freeport actually did their due diligence.  The public markets are filled with junk because institutional investors often don’t know what they are doing (e.g. look at the shareholders of Yukon Nevada Gold… there are some big names there including Rick Rule’s employer).

Some traps

Mine restarts:  Mines shut down because they aren’t economic.  If a public company wants to restart a mine that was shut down in the past few years… this is a red flag.  For example, Yukon Nevada Gold did a mine restart and lost a lot of money.  Public markets are stupid and gave them the cash to do this.  There are also a lot of bullish writeups on YNG on valueinvestorsclub.com and on value investing blogs.

High grades, very narrow veins:  Narrow veins are really expensive to mine and the process cannot be mechanized.  In public markets, management will convenient forget to explain to you the economics of mining narrow veins.

Mines nearing the end of their lives:  Investors need to look carefully at free cash flow and predict future free cash flow, which is likely to decline since miners try to mine the most economic ore first.

Mining stocks in general:  You may make three times as much money in commodity futures according to one study.  While I am leery of backtesting, I would be inclined to agree that mining stocks are not a good asset class.

NI 43-101 technical reports

In theory, these are supposed to protect investors.  In practice, the majority of them are inaccurate.  Here’s one way of looking at it.  Very few juniors will have a project that will result in an economic mine… that’s just the nature of mineral exploration.  Yet most of them claim that they do have such a project.  It seems that almost everybody has at least a million ounces of gold in the ground and has a NI 43-101 report saying that they do.  Most of them are making stuff up.

There are three main ways you can inflate the size of a deposit:

  1. Geological interpretation.  If you are dealing with complex geometries such as gold veins (or veins of anything), then you often aren’t sure which intersections in one drill hole correspond to which intersections in another drill hole (or if they even connect).  There is room here to make some very aggressive assumptions.
  2. Use a lower cut-off grade.
  3. Use a very large search radius.

Major things to look for in NI 43-101 reports

In resource estimation:

  1. Geological interpretation.
  2. Cut-off grade.  You’d have to know something about what reasonable cut-off grades are.  The company will tell you the likeliest mining and processing method.  Then you go find figures on what the operating costs are likely to be.
  3. Search radius.
  4. Commodity price assumption.  Assuming a high price will inflate the size of the deposit since it would lower the cut-off grade.  The standard is to use the 3-year trailing average… if something else is being used, pay attention.

In economic assessments:

  1. Many estimated costs are just flat-out wrong.  For example, you could take a look at Micon’s PEA for KWG Resources.  The report estimated the railroad cost to be $900M.  Currently KWG estimates the cost to be $2B.
  2. Commodity price assumption. If the price assumed is higher than the 3-year trailing average, then the report is being overly aggressive and is suspect.  Sometimes report authors will use a price lower than the 3-year trailing average.  I think this is the reason why… almost all industry analysts are extremely bearish on the price of gold and iron ore.  So the report authors will use a very low commodity price assumption (this is conservative) and assume very low operating costs (this is extremely aggressive).  If they didn’t balance out their aggressive assumptions on the operating cost side then the NPV figure might start to seem too good to be true in press releases.  Analysts will blindly plug the technical report’s numbers into their models and find that the net present value (NPV) of the project is still high enough to recommend the stock as a buy.  If the technical report didn’t claim very low operating costs, then the analyst community may not recommend the stock.  So basically the juniors are playing a stupid game where they pander to the analysts.  If you look at the numbers for Bloom Lake in BBA’s technical reports for Consolidated Thompson and from Cliffs (which is currently operating the mine), there is a HUGE discrepancy in operating costs.  BBA wasn’t even remotely accurate.  So in my world view, there probably isn’t any reason to trust any technical report.
  3. Do operating and capital expenditure costs remotely make sense based on similar operations.  Basically, do some back-of-the-envelope calculations yourself.  However, you really have to know something about mining as costs vary wildly depending on a large number of factors.
  4. For many commodities, the purity of the shipping product affects its price.  Hopefully they provide assay results for the shipping product.  You can be pretty sure that they assay for everything that matters because assays are cheap.  If they do not release assay results for deleterious elements, this may be an intentional omission.
  5. Metallurgical risk.  Some ores are really expensive to process, e.g. anything labelled as refractory, sulfide gold, etc.  You just have to know something about the commonly-used recovery processes (e.g. where heap leaching works well and doesn’t).
  6. Metallurgical risk.  If the company proposes some new technique that is not tried and proven, you need to be very very careful.  Nobody knows how how much it will actually cost until the processing plant is operated on a full commercial/production scale.  Scientific models to estimate costs are not perfect.  Before they go build the processing plant, you want to see them build a pilot plant that is at least 1/10th to 1/100th of the scale of the production plant.  And even then, bad things can happen.  The Goro nickel project for example has had many delays and accidents as it has entered commercial production.  Baja Mining proposed a novel recovery technique (with a feasibility study to back it up) and will likely never make it to production.
  7. In general, anything novel such as placer deposits and underwater mining should probably be avoided.  These things usually have a terrible history.

Little things to look for in NI 43-101 reports

  1. Does the author use a (reasonable) cap for outlier grades.  If you want to understand this, read Introduction to Mineral Exploration or the SME Mine Engineering handbook.
  2. Does the author cherry pick interpolation methods between nearest neighbor, ID2, ID3, ID5, ordinary kriging, etc.  If they list the results for most of these methods then they probably aren’t cherry picking.

Other factors

– Political risk.  You have to know something about political risks in that particular country.  Things are simpler if you stick to only US/Canada/Australia, though there are First Nations issues, NIMBY, and environmental NGOs to watch out for.  Many major projects have been delayed due to these issues.

– Some deposits may be the “tip of the iceberg”.  (This mainly applies to high-margin deposits only.)  The existing deposit may extend further with follow-up drilling.  The surrounding area may also host similar deposits.  High-margin discoveries often lead to mines that operate well beyond their original mine life and to other mines in the surrounding area because they keep finding more economic ore.  If the deposit is low-grade, then it’s no use if the deposit extends deeper since mining deeper costs more money and therefore this ore may not be economic.

– Read insider trading reports on canadianinsider.com (*I wouldn’t use your real email for financial sites because you may get pump and dump spam) and sedi.ca.

– Check if the management team has experience in bringing mines into production.  (Because often they don’t…)

At the end of the day

It’s probably just easier and more profitable to buy Altius Minerals and Northfield Capital when they are buying back their shares.

*Disclosure:  Long Queenston Mining, Noront, KWG Resources, Altius, and Northfield.  Yes, I own juniors directly and don’t feel like it’s the smartest thing to do.

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One thought on ““Investing” in junior mining… a recap

  1. Pingback: Reading round-up: books on mining « Glenn Chan's Random Notes on Investing

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