This (long) post details my thinking on how I currently approach the industry.
The evolution of my investing framework
Level 1: Assume that technical reports are accurate
At first, I was very naïve and thought that I could take NI 43-101 technical reports at face value. This is a very bad idea. Engineers have incentives to publish aggressive reports to make their clients happy. The reality is that 90-99% of technical reports are quite inflated. The consequences of publishing inflated reports are close to non-existent. In general, expect extremely high levels of fraud in areas where fraudsters face little or no consequences for their actions.
Level 2: Look at what companies’ actions imply.
The next step in my thinking was to look at the actions of those who have “performed” their due diligence. When a large mining company takes a stake in a junior explorer, it will often perform due diligence before completing its acquisition. I thought that this was enough to be sure that a junior’s flagship project was real and that there was value in the junior. However, this is still not a great idea. In the past several years, it has been common for large mining companies to overpay for assets. Senior gold miners have all performed poorly relative to physical gold because they have been consistently overpaying for assets. Trying to ride this bubble is not a great idea. Secondly, not all acquirers perform due diligence or make totally idiotic acquisitions (e.g. USA Silver and Gold should never have bought RX Gold).
Level 3: Do my own back-of-the-envelope engineering work
My idea is to research similar producing mines to try to guess the economics of an undeveloped deposit. This provides information on what things actually cost so I can do my own valuation work. Inflated technical reports are worth reading as they will often highlight technical issues that can affect a mine’s economics. However, I basically need to do my own technical report. Because I don’t have a team of specialized engineers or access to technical data, my own “technical report” will have low accuracy and precision. So, it is a good idea to demand a very large margin of safety.
I believe that very, very few institutional investors and investment banking analysts do this level of due diligence (or a higher level of due diligence).
Level 4: Actually perform due diligence.
- A team of specialized engineers.
- Access to data, drillcore, etc.
Clearly I do not do this.
The “people with integrity” shortcut
The idea behind this is to buy into companies with honest people and to take their word about the economics of a deposit or mine. I think the only people I would trust are those working for Strathcona.
I don’t think this is a great idea because there is so much poor behaviour in the mining industry. It has a strange way of warping people, some of whom who would otherwise be honest. There are so many people who are complicit in the rampant problem of inflated technical reports: the engineers, the engineering societies, the management teams of the juniors, the TSX Venture and TSX exchanges, the boards of directors, the investment banks and underwriters, etc.
Perhaps mining is simply a truly awful industry
On average, the economics of junior exploration are abysmal. Far too much money is wasted on stock promotion, the salaries of the part-time CEOs and CFOs, corporate excess/thievery, flying analysts out on useless tours of a property, D&O insurance, dumb exploration, etc. etc. Far too many companies are undercapitalized and have to fight the headwinds of their corporate overhead (usually $200k and above). In aggregate, I believe that the junior explorers have lost money every year even during the commodities bull market. This is an industry for gamblers, not investors.
The economics of senior miners are a little better but they are still bad. Almost all of them are playing the pyramid scheme game and are constantly issuing stock. Even Goldcorp, one of the better managed senior miners, has been paying for shills to promote their stock (see my previous post on the subject).
There is a reason why Warren Buffett hoarded physical silver in the past instead of buying shares of silver miners. He probably couldn’t find a silver miner he liked.
Opportunities in the mining sector
The mining sector is not a good place to look for longs. On this blog I have written about the few opportunities out there such as Altius Minerals and companies trading below the market value of their stocks and cash. I don’t even like the net-nets. Many of them have horrible CEOs who are mainly interested in lining their own pockets. Good management makes a huge difference.
There are opportunities in shorting the sector. Unfortunately, I held off on shorting the stocks in the past due to a misguided view that we are in the middle of a commodities supercycle. Maybe we are. It doesn’t matter. I think some stocks are so awful that the share price will likely go down in a bull market.
Producing miners that are losing cash
This is my favorite setup. There are mining companies out there that intentionally burn cash. They should mothball their mine but they don’t. Insiders don’t care because they get to collect a paycheque.
These companies aren’t too hard to figure out because they have negative cash flow. They are much easier to analyze than others. The cash burn itself is a wonderful catalyst.
Examples on this blog: Yukon Nevada Gold / Veris Gold and Metanor Resources (Metanor may currently be cash flow positive).
Awful projects that are about to come into production
This is the same idea as above except these situations are harder to analyze:
- Uncertainty is greater in the earlier stages of the mining/exploration process. This is the nature of mining.
- The technical report for the project is presumably garbage, which means you have to do your own work and have to make your own prediction about the project’s economics. It is much more difficult to accurately predict future cash flow than it is to look at a balance sheet to figure out historical cash flow. It is very hard. It is necessary to look for a very large margin of safety.
Because the mine has not yet been built, the catalyst isn’t as immediate and management has time to pull themselves out of their predicament. Management may be able to change tracks and use their overpriced stock to ‘trade up’ and buy better assets.
On the short side, you especially want to see signs of desperation. The company may be selling shares at terrible prices and issuing debt at very high interest rates (e.g. above 10%). I also see any streaming deals with Sandstorm Gold / Metals and Energy as a slightly negative sign. Sandstorm’s counterparties tend to be questionable. (Because Sandstorm has a promotional pyramid scheme element to it, it wants to book deals that seem great. The only way they can do that is by doing deals with questionable companies.)
I don’t think shorting these is a great idea. The problem is that they might actually discover a real deposit, causing the stock to skyrocket. Sometimes, the charlatans like Robert Friedland will get lucky. For risk management purposes, you have to use smaller positions. This reduces the upside. Because these companies can be very difficult and time-consuming to analyze, the time spent researching shorts may not be really worth it.
You could try shorting a basket of these companies but again you’d have to be careful about risk management. All of the promotional stocks may go up at the same time as speculative money flows into the junior sector and/or commodity prices rise. The potential for all of these stocks going up 2-4X times as a basket can pose risk management problems.
Some ideas for putting together a basket:
- Find juniors with very high G&A relative to exploration spending. Excessive G&A usually goes towards stock promotion, “travel and entertainment”, corporate waste, and other nonsense.
- Find juniors who hire the worst technical report authors (e.g. Peter George, Michelle Stone). If a company hires Peter George, it is probably truly desperate to raise cash. While most technical report authors are overly aggressive, Peter George is in a class of his own. You need to be careful here however as these individuals might one day write a report for a company with a real project. For example, Behre Dolbear writes some pretty aggressive technical reports (their commodity price assumptions are obviously bad) but they did work for Talison Lithium, a company that was taken over for a large premium.
The ideal basket would have as many Barkerville Golds as possible (their G&A is ridiculous and their stock was halted because Peter George’s report was so inflated). Currently, I think that this strategy would be a bad idea since the junior market has been beaten down so much. This is not the time to try a basket shorting strategy. I’m not even sure if it’s a great strategy.
Put options and other asymmetrical trades
The worst companies tend to be extremely volatile so the puts are very expensive. I don’t see great opportunities in put options. I don’t know of (or have access to) any other great ways of shorting mining companies.
From an honest business perspective
If you are looking to good longs, then you need to know what an honest company would look like. Here is my opinion on how things would work in a theoretically honest world.
Firstly, underwriters would try to make money with their clients instead of from their clients. One step they could take is to ensure that the stocks they underwrite have competent people. The sign of a competent geologist is one who was responsible for discovering a profitable mine. Most/many geologists have never discovered a profitable mine in their career so far. I would not give them a chance to be the head geologist of an exploration company. This is a Catch 22 but many industries and unions are like this. (The way this Catch 22 would resolve in mining is the fact that geologists work in teams where the successful geologists mentor those under them.) The sign of a competent CEO is one who has actual experience in developing a profitable mine. Most of the management teams of exploration companies out there do not meet this criteria.
Secondly, underwriters and investors should deal only with people of integrity. This is extremely important because investors have few safeguards against being defrauded. The industry is a magnet for fraud because nobody ever gets punished.
Thirdly, the junior exploration company should be at least a certain size. The overhead of a public listing is high. Any company seeded with less than $50M of cash to spend doesn’t make sense in my opinion. Assuming that a company has $200k of unavoidable overhead that generates zero value, a $50M company will burn through 0.4% of its assets a year on costs related to its public listing. The vast majority of juniors in the real world started out with much less than $50M and have overhead much higher than $200k. To determine the overhead related to a public listing, add up the following costs:
- “Investor relations” (usually an euphemism for stock promotion, some of which is very sketchy)
- Transfer fees
- Listing agent fees
- Audit fees
- Fees related to the board of directors
- D&O insurance
- The cost of the time spent by the CFO and other employees in preparing the financial statements. For simplicity’s sake I often do not factor this in. Usually it’s just obvious that G&A is excessive.
Fourthly, more information should be disclosed to investors. It is extremely unfair that insiders have a huge informational edge and regularly use it against their investors. Companies should provide more information on the cash flows of producing mines (historical and projected).
Lastly, institutional investors should perform more due diligence. Instead of flying out to a property on useless tours, they should hire geologists and engineers to double-check a company’s figures and projections. In general, the financial industry would be much smaller, far less parasitic, and would generate more value for its customers and society.
From a dishonest business perspective
See my post on “How would a sociopath fleece investors in mining?“.
Does a company’s actions make business sense?
When analyzing a mining/exploration business, I try to analyze whether or not the company’s actions make business sense. Oftentimes it doesn’t. And I have probably made mistakes in ignoring too many red flags.
Some companies will continue to pursue an exploration project even though initial results are not promising. Insiders do this to keep the stock promotion going, not because the activity has a positive expected return. If a company issues a press release announcing that it has hired an investor relations firm… they are basically announcing to the world that they are a bunch of pump and dump stock promoters. Most of the time, “investor relations” is an euphemism for very questionable stock promotion.
The bottom line
Part of me wishes I had spent more time learning about a different industry. The long side is very difficult because the industry is chronically flooded with too much capital chasing too few opportunities. The short side is more difficult than other industries because of risk management (and the short side is already difficult enough as it is!). The short side is still interesting to me because mining is one of the areas of the stock market where fraud is extremely high. However, it still isn’t a great place to make money.
*Disclosure: I have positions in the companies mentioned in this article.