Thoughts on mining (2017 edition)

Some key lessons on mining companies:

  1. They regularly withhold key information from investors.
  2. Technical reports should not be relied upon because many of them are disconnected with reality.

Without key information on a mine’s economics, these companies cannot be accurately valued.  So… mining stocks aren’t a great place to look for longs.  You might spent a lot of effort trying to value a mine and still fall short of being able to find reliable information on that mine.

On the short side, there are some opportunities.

How much do mining companies withhold?

A mine engineer’s job is to optimize a mine’s economics.  For example, we can look at the capacity/throughput of a mine.  A larger mine will get the ore out of the ground faster, bringing future cash flows closer to the present.  Because a dollar today is worth more than a dollar in the future (since money can be invested and therefore grows over time), this increases the net present value of a mine’s revenues.  A larger mine also creates minor economies of scale, lowering operating costs slightly.  The downside to a larger mine is the higher capex cost.  In school, mine engineers learn the basics of calculating the optimal size for a mine.  Mine engineers are taught about using discounted cash flow (DCF) models to project a mine’s economics.  Making economic projections is part of a mine engineer’s education.  After a mine is built, real world results may not necessarily match up with the engineers’ projections and estimates (e.g. recoveries may be slightly off due to uncertainties inherent to mineral processing).  Mine engineers may be able to further optimize a mine’s economics based on new information coming out.

The DCF models created by mine engineers would be fairly useful for investors.  Some mine engineer has already done all of the work in valuing a mine.

A DCF model might look something like this. (*Don’t take this DCF model too seriously… this mine won’t be built anytime soon, if ever.)

Of course in practice, mining companies generally withhold this information from investors.  This has to do with the politics between management, analysts, and investors.  In general, management teams generally withhold information so that they can bullshit investors.  Mining is a messed up industry.  Management teams regularly spend hundreds of thousands of dollars (or more) each year on so-called “investor relations”.  But instead of providing investor transparency, this “investor relations” spending is often focused on pumping the stock price.

When management teams do provide economic projections to investors, the numbers often turn out to be inflated.  Consolidated Thompson, one of the first owners of the Bloom Lake mine, projected “cash operating costs of US$24.18/tonne concentrate over the mine’s first 5 years” (2008 press release).  When Bloom Lake was operating, its cash costs were around US$85-95/ton.  The Cliffs Q2 2013 press release stated US$87 per ton for that quarter.  While inflation in mining costs was high during the intervening years, inflation (along with different definition of cash costs) can only explain a fraction of the gap.

The current owner of Bloom Lake is projecting “Life-of-mine average operating cost of production of CAD$44.62 per dry metric tonne, FOB Sept-Iles;” (FOB means that this definition includes freight charges to the port city Sept-Iles).  Page 10 of Champion Iron’s investor presentation cites operating costs of US$34/t based on a 0.80 CAD$/US$ exchange rate.  Presumably, there will be some faerie dust that will be sprinkled on the mine to magically lower operating costs.  And here’s the crazy part… the current owners have been successful in raising financing to restart Bloom Lake (though they are not fully financed).

This is why I find that going long mining stocks to be too hard.  The ‘return on brain damage’ is rarely compelling.  While I have gone to the library to read university textbooks on mine engineering, it wasn’t necessarily that helpful.  Knowing about mine engineering and mineral exploration doesn’t overcome the issue of management not providing accurate information to investors.

Counterpoint: an argument for low investor transparency

Outside of mining, low investor transparency may be beneficial to investors… or at least immaterial (and benign).

Sam Walton’s ghost-written autobiography talks about how he did not disclose Wal-Mart’s shrinkage metric (the amount of inventory lost due to employee and customer theft) to investors.  He did not want competitors to figure out that Wal-Mart’s anti-shrinkage efforts were effective.  In the technology sector, Microsoft inappropriately smoothed its earnings from 1994 to 1998 (according to the SEC).  Microsoft stock has done quite well since then (and since its IPO).  By misleading investors, management teams like Microsoft’s can get investors to leave them alone… allowing management to create shareholder value in a manner they see fit.

When management teams don’t keep their shareholders happy, unhappy shareholders can look for scapegoats and throw out perfectly good management teams.  At Cliffs Natural Resources (now renamed Cleveland-Cliffs), Gary Halverson was doing a pretty good job at cleaning up the company.  But then activist investors pushed for Lourenco C. Goncalves to be the CEO of Cliffs.  Goncalves is a character.  On a conference call, he refused to answer an analyst’s question because the analyst had a sell rating on the stock.  Goncalves also sold Cliffs’ Bloom Lake and chromite assets at firesale prices (you generally do not want to sell assets when mining stocks and commodity prices have crashed).  And because Wall Street is crazy, Goncalves is still Cliffs’ chairman and Clown Executive Officer.

Overall, mining needs more investor transparency so that investors can value the assets with some semblance of accuracy.  Investors don’t need to know Wal-Mart’s shrinkage rate to value the retailer, but they do need a single spreadsheet of estimated cash flows to value a mine.  This is even more important if a mining company wants to do a secondary offering- the unnecessary information advantage that mining companies hold is harmful for investors.  Unfortunately, the mining industry tends to destroy a lot of the capital that it raises from investors.

Shorting mining stocks

The first issue with shorting mining stocks is that the shady exploration companies are like lottery tickets.  While the expected return may be negative, there is a chance that the stock does incredibly well.  For example, a company called Diamond Fields Resources did not find any diamonds but stumbled across a multi-billion dollar nickel deposit named Voisey’s Bay.

But even on a diversified basis, I would be hesitant to put too much of a portfolio into shorting mining stocks.  The TSX Venture consists mostly of junior mining garbage, so it’s close to being a pure play on junior mining.  The chart below shows a Google Finance plot of the S&P TSX Venture Index (JX, in blue) versus a physical gold ETF (GLD).  Over time, this index has underperformed metal prices and risk-free treasuries.  The Venture exchange’s track record is pretty poor.

However, there have been multi-year stretches where the TSX Venture has done incredibly well.  From a risk management perspective, the volatility and multi-year stretches of outperformance suggests that mining exposure should be limited.

Lastly, it takes a lot of time to research these companies.  Because many of these companies withhold key pieces of information, it can be very time consuming to try to glean information from (inflated) technical reports and investor presentations.  Sometimes key pieces of information are in obscure investor presentations or transcripts.  Finding operating margins for comparable mines can also be somewhat time consuming.

Cash flow negative miners

In my opinion, the most compelling place to look for shorts in mining are money-losing mines that haven’t been shut down.  Some people are just crazy (e.g. some people in the world will always have crazy viewpoints such as vaccines causing autism).  Some stock promoters will intentionally lose money on an unprofitable mine to keep the story around the stock going.  Or, they may buy an old mine and re-open it.  It doesn’t happen often, but it does happen.

In my old post “Mine economics explained“, I explain that a mine’s economics will decline over time since mine operators will try to mine the most economic ore first.  If a mine’s cash flow is currently negative, it is extremely likely that the future cash flow will be even more negative.  This puts the company on track to bankruptcy; bankruptcy is a good catalyst for a short position.  In practice, not all of these shorts will work out.  Occasionally there will be a greater fool that buys out these companies with a takeover premium.  It is also possible for commodity prices to rise and cause a mine to suddenly become profitable.  Nonetheless, these stocks are some of the more compelling shorts in the mining space because:

  1. They are easy to figure out.  An old mine is the easiest to figure out whereas a greenfield exploration project is extremely difficult to figure out.
  2. They don’t have much lottery ticket potential.
  3. The path to bankruptcy can cause the short to work out quickly (which leads to a better rate of return on the short).

To determine a mine’s cash flow, you can look at the statement of cash flows.  Calculate:

  • Cash flow from operations before changes in working capital.  (Changes in working capital don’t affect how much money the mine is generating or losing.)
  • Subtract capex spent on the mine.
  • Strip out cash flow and capex unrelated to the mine, such as greenfield exploration projects.  The financials for a junior miner will almost always clearly state what the exploration expenditures were.
  • How you handle corporate overhead like “travel and entertainment” is up to you.  As a shortcut, I would not strip these expenses out.  Companies with bloated overhead due to sketchy insiders deserve to trade at a discount to what its assets are worth, much like how closed end funds trade at a discount to net asset value (NAV).

Mines that are about to go into production

This may also be a decent place to look for shorts if you can identify the fatal flaw of a project.  Finding operating costs of comparable mines is often the key to identifying mines that will fail.  Unfortunately, there are many variables that affect the operating costs of a mine so they can be difficult to value accurately, especially when management withholds key information or provides inflated technical reports.

Silly analysis in the mining space- why growth is a trap

Outside of mining, growth is a good thing.  Stocks that grow their earnings deserve to trade at a premium relative to other stocks.  What investors are actually looking for are the companies that can invest their capital at high rates of return.  In general, mining companies can’t really do this.  Nobody really creates unusual amounts of value in the mining space mainly because it is a commodity industry.  But, there are investors who haven’t figured this out.  They get entranced by the idea that a “good” management team can consistently grow production.  In reality, this is a backasswards way of operating a mine.  What silly management teams do is to expand capacity at a mine after it has been built, therefore demonstrating “growth”.  In reality, they destroyed shareholder value because they did not maximize the NPV (net present value) of the mine.  The optimal strategy is to build the mine at the right size in the first place.  The mine expansion likely has a poor (and potentially negative) rate of return.  (These kind of situations aren’t the best shorts because the company likely will not go bankrupt.  As well, miners that actually have cash-flowing assets tend to be some of the better mining stocks out there because they are surrounded by garbage stocks worse than them.)

When commodity prices rise dramatically, mine expansions can potentially make sense.  They may have an opportunity to invest capital at a very good rate of return.  (Though what happens in practice is that supply catches up with demand can causes prices to fall, making some of the previous mine expansions look dubious in hindsight.  Cliffs’ Bloom Lake expansion was dubious in hindsight.)

When it comes to the management teams of large mining companies, there can be a dangerous obsession with growing production- regardless of whether the rate of return is positive.  There are investors who want production growth… and management teams that will pander to institutional investors’ stupidity.  This leads to some senior miners overpaying for assets and chasing silly projects (e.g. Cliffs’ purchase of Consolidated Thompson and chromite assets).  The underlying problem is often because the Clown Executive Officer wants to be seen as “creating” shareholder value by having “vision” and doing something rather than nothing.  In most cases, doing nothing leads to more shareholder value than doing something.  By trying to outperform the markets, institutional investors often sow the seeds of their own destruction.  There is value leakage when miners follow through with poorly thought-out ideas.

Why it’s hard to create value in mining

On the exploration side, too much money is spent on exploration.  See the price chart of the TSX Venture displayed earlier.  But even if a company is good at exploration, the luck factor is overpowering.  Because exploration discoveries are so rare, it is so difficult to actually see a return of capital.  For example, Altius Minerals’ “prospect generation” model hasn’t led to a single profitable mine.  However, their prospect flipping has done extremely well despite zero underlying value creation in their prospect generation business.

As far as producing mines go, it is a commodity industry where products lack differentiation.  It is difficult to cut costs more than peers- there isn’t a lot of room to create value by operating a mine more efficiently than your peers.

Wrapping it up

For me, the short side is much easier than the long side.  To identify a good mining short, I would only need to identify a single fatal flaw that kills the economics of a project (e.g. resource estimation, bogus operating costs, politics, metallurgy, etc.).  To identify a good long, I would need to check a long laundry list of things to verify that there is no fatal flaw to a project.  Often it is impossible to do this since the mining company withholds information and releases inflated technical reports.

Overall, I’m not too excited by mining at the moment.  There are opportunities on the short side, but I am scared to go overboard with shorting them since mining stocks can have multi-year stretches of outperformance.

If I had a time machine, I would have instead focused on oil and gas.  Relative to mining, oil and gas stocks are a lot easier to analyze.  It is easier to estimate the value of the producing assets since the annual report has cash flow information.  The rest is an exercise in guessing the decline curve of the assets (or putting the value of the asset in a range, since decline curves don’t vary excessively).  Oil and gas stocks have very little lottery ticket potential.  But like mining, there is occasionally the crazy management team that will drill at a loss (e.g. ATPG, which went bankrupt in a bull market for oil).  Better still, a lot of institutional investors fall for the oil and gas scams and lend their shares out.  Oil and gas is like mining but a lot easier.

 

*Disclosure:  No position in Cliffs or Champion Iron.  I may short Champion Iron in the future.

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