Mining’s old guard needs strong medicine
A new report details subpar investor returns in the mining industry over the last decade, particularly big cap diversified companies which have not adapted to new realities.
If now is the time to accumulate deeply discounted companies with strong fundamentals in advance of a hot junior market in 2015, how can an investor tell if a company is a black hole or a shining star? Exploration Insights Publisher Brent Cook shines a light on the all-important due diligence process in this interview with The Gold Report and gives seven examples of companies that pass his litmus test.
The Gold Report: You recently wrote a piece called “A Light at the End of the Tunnel” that outlined the rules of thumb for junior mining speculators and concluded that the fundamentals are pointing to an improving investment climate for junior miners. Why are you so optimistic when people like Harry Dent are predicting deflation and recession?
Brent Cook: I look at the fundamentals behind the mining and exploration industry. We have seen a significant decline in legitimate economic mineral discoveries. At the same time we’ve seen a continuing increase in copper, silver and gold mine production. Those two things are diametrically opposed. With the decline in metal prices, particularly gold, the mining and exploration companies are not putting money into finding the next deposit. That is why although I don’t particularly think this year is going to be a great year for the junior mining sector in general, I think it’s setting up what will be some great returns in 2015 and beyond.
TGR: Is this a classic supply and demand adjustment? If companies are spending less in exploration and development now, is there going to be a lack of supply later?
BC: There is going to be a dearth of new exploration discoveries coming on to replace the 85 million ounces (85 Moz) of gold and 18 million tons of copper we are producing each year.
TGR: What impact does high grading have on future production?
BC: All-in sustaining cash costs for gold mines are between $1,200/ounce ($1,200/oz) and $1,500/oz. At current gold prices, producers, on the whole, are not making much money and are therefore being forced to cherry pick the high-grade portions of their deposits, leaving behind the lower-grade material. When they do that, a lot of the resource previously classified as reserves—the lower-grade material—becomes uneconomic.
By high grading, companies are sterilizing what used to be classified as ore and turning it to waste. The difference between ore and waste is simple: ore makes money, waste loses money. In this coming year, a number of companies are going to announce a decline in their reserve base because of high grading and lowered metal price assumptions.
TGR: What is the impact of mining the best material at a time when it is selling at low prices?
BC: Companies usually try to maximize their profits by mining the better portions of an ore body when prices are high. With lower prices, many companies will be forced to produce from the better part of their deposits just to stay in business; they don’t have a choice. They have to high grade these deposits to keep the door open. The end result is that quality reserves are being depleted faster than they can replace them.
TGR: You called the inevitable point where there isn’t enough supply based on a lack of investment in exploration and development a “pinch point.” When is this pinch point going to come?
BC: I hope it will be soon because that is the point when the price of gold, and more important, gold deposits, will go up, but I suspect we won’t see anything until next year. We really don’t know when the companies are going to wake up. By the end of last year, most mining companies were focusing on proving to the investment community that they can actually make money mining. They may temporarily pull it off, but it’s going to put them in a really tough situation one or two years down the road when they’ve got no new ore bodies to replace what they’ve pulled out of the ground.
TGR: You talked in your article about some of the ways that investors who are looking to find some bargains now can tell which companies could really be successful when the market turns. The first thing you suggested was doing a desktop review to screen as many as half of the companies out of contention for investment. What are some of the red flags you look for when you are reading a company website?
BC: We know the odds of exploration success are extremely low. On average 1 in 1,000 exploration projects turns into an economic deposit. What I spend most of my time doing here at Exploration Insightsis screening technical reports for fatal flaws. Some less technical signs are more obvious than others.
TGR: Another screening tool you mention is management ownership. We interviewed Ted Dixon of INK Research about this last year. How important is it to know what company employees are buying and selling?
BC: If a person running a company is invested, then it sets up a scenario where if he or she makes money, the investor makes money through share price appreciation. It is also important to know what price the employee actually paid for the shares. A lot of these insiders can buy in at $0.01 or $0.05/share and it looks as if they own a lot, but in fact their cost basis is almost zero. On the other hand, not everyone can own 5% or 10% of a company. A lot of these people just don’t have the financial ability to buy in big at the start. Look at ownership relative to net worth, but having a shared stake with management is critical.
TGR: What if management is selling the stock?
BC: Generally that’s not a good sign, but there are reasons people have to sell stock. A number of these company presidents don’t make a lot of salary. They may need to buy a house or send a child to school. It is important to understand why someone is selling.
TGR: A lot of stock is bought based on drill reports. Press releases can be confusing. What are the tricks some companies use to make drill results look better than they really are and how do you know what they are really saying?
BC: One tool that I’ve developed along with Corebox is called the Drill Interval Calculator. Often a few narrow high-grade intervals are smeared across low-grade material to give the impression of a large homogenous mineralization over what is essentially barren rock waste. The Drill Interval Calculator will make that spin apparent.
It is also important to research historic drilling of other holes in the general area. Some companies will re-drill or twin a previous hole that had great results. If the previous company drilled all these holes and walked away because the rest of the holes were no good, then what value is it for the new company to re-drill the one good hole and publish a press release of the fantastic result? I want to see what else has been drilled to get a sense of the size and style of mineralization. Basically, we need to know the history of the prospect: what was drilled, results, interpretations and why the current program is different from previous exploration campaigns.
TGR: A lot of investors go on site tours that to the untrained eye look like sage brush safaris. You are a geologist. What do you look for on a site tour?
BC: This is really critical. People have to come away from a site tour with an understanding of whether the type of geologic system the company is reporting fits the geology. That determines what size of deposit will be required to make money. That includes estimating capital costs for infrastructure and processing.
When I visit a property, it’s all about turning the rocks into money. To do that you need to mentally build a mine from day one. Assess the likely operating expenses, capital expenditure (capex) costs based on the location, strip ratio, metallurgy and then, how much it will cost the company to address those issues. Then the investor can formulate an investment thesis. That is what sets the successful speculator in this industry apart from the crowd. Even after all this research, 9 times out of 10, subsequent drilling doesn’t confirm the thesis and the investor should sell. That’s key. Once it’s not working, sell. Hope hasn’t proven to be a very good investment thesis for me.
TGR: Let’s talk about some examples of companies that passed these screens.
BC: From almost the first drill hole, we have been invested in Reservoir Minerals Inc. (RMC:TSX.V), which made a major discovery in a joint venture with Freeport-McMoRan Copper & Gold Inc. (FCX:NYSE) in the Timok project in Serbia. Before it drilled the property we knew conceptually what success looked like, in part because there’s another deposit just like it up the road. It’s a copper-gold porphyry system with a high sulphidation component.
The first drill hole hit a long interval of about 1.23% copper equivalent and the geology confirmed our conceptual idea that Reservoir is into a major porphyry copper deposit. Subsequent drilling continued to confirm our thesis; it showed us that there is size and grade. Now we’ve got a $5 or $6 stock and when we jumped in it was $0.60/share. We’ve stayed there because subsequent drilling continued to confirm our thesis that it is onto a major mineral deposit that will make money. Freeport has the option of earning 75% of the project by producing a bankable feasibility statement. Until that happens, it doesn’t cost Reservoir a dime as Freeport assesses the economics of the deposit. At some point it is possible Freeport will decide it makes more sense to buy Reservoir out.
Another one that passes the test is Fission Uranium Corp. (FCU:TSX.V). I held back when the first drill hole showed that the company had hit uranium mineralization in the Athabasca Basin because I was concerned that most of it could have been eroded. Subsequent drilling down trend showed a lot of mineralization left in the ground, so we bought in. It has performed extremely well also. Fission is onto a major discovery. All subsequent drilling confirms that this thing is getting bigger and it has the grade and mining characteristics to make money. Fission has 90 drill holes planned this winter, so there’s certainly a chance for even more discoveries this year.
TGR: Both of those companies are unique in that their stock prices actually went up last year. How do you know if a company still has upside left?
BC: That goes back to the first day on the ground, looking at the rock and building a conceptual economic mineral deposit in your head. You have to have a sense of what this thing is going to be worth on a net present value (NPV) calculation. I could give you the names of 20 companies whose stocks went up and collapsed. They collapsed because subsequent drilling either limited the deposit or disproved the concept. We made money on some of those because we got out in time. Investors can make money on things that ultimately fail, but they need to have that model built in the back of their minds that tells them whether the geology is working and whether the economics are working.
TGR: What are some other companies that pass the smell test?
BC: Much safer and more advanced is True Gold Mining Inc. (TGM:TSX.V), which has a large deposit in Burkina Faso called Karma. The company has focused on the superficial part of this deposit, the oxidized part. It has almost 1 Moz gold, a feasibility study that shows some very good numbers, an internal rate of return (IRR) of 40+%, an after-tax NPV of $180 million ($180M) and a market cap of about $96M. What I like about it is that the jurisdiction is good. The capex is relatively low. The processing costs are low and it’s a very simple operation. It will make good money and has a lot of room to grow. True Gold may not be a tenbagger, but I think it has 20% to 50% upside and the downside is limited to the gold price.
TGR: The stock jumped up after the feasibility study came out in December. What did investors like about the study?
BC: A lot of the larger institutional investors want to see hard data from a third party about the deposit’s worth. An IRR of 44% after tax is a very good return on investment. That’s a stock that makes money that they want to own.
TGR: What about some other names?
BC: One that’s not as advanced as True Gold is Midas Gold Corp. (MAX:TSX). The company has a very large deposit in central Idaho. I know the area well; I used to run around there as a kid. The Yellow Pine District is an old mining area that was left with environmental issues from previous work. Midas has drilled out about 7 Moz at about 1.6 grams per ton gold. It’s got some byproduct, antimony as well. The preliminary economic assessment came up with an after-tax NPV of 5% of about $1 billion using $1,200/oz gold. The company’s market cap right now is $124M. I think there’s a lot of concern associated with permitting, but ultimately I think it is possible. It’s going to be three to four years before it actually gets approved and there is a lot of work to do up until then.
The company is putting together a new resource estimate that will go into a new economic study. I think it is going to decrease the number of ounces that go into the study, but focus on the higher-grade portion of these deposits, which will probably net the same, but it’s going to be a better deposit at a bit lower capex. I like this one because it’s trading at almost a 90% discount to what the economic study indicates it is worth. Now we’ve got a long way to get from A to B, but it is a nice deposit and it is rare to find something that large in a relatively stable jurisdiction.
TGR: What about a couple of others?
BC: I like prospect generators because the business model is that they develop the ideas and then bring in somebody else to spend the big money testing those concepts. Given that statistically at least 90% of these projects are going to fail, it makes a lot of sense to bring in someone else to spend the exploration dollars and fail rather than the junior company spending the money. My piece of the company—which is really an intellectual capital company, people generating ideas—is not diluted. One that I think is worth looking at is Mirasol Resources Ltd. (MRZ:TSX.V). The company is active in Chile and Argentina and has been successful in the past. It has a good cash and equity position of around $35M, and at CA$1.20 is trading for not much above that.
Another one I like is Lara Exploration Ltd. (LRA:TSX.V). The company has a number of projects going on in Brazil, Peru and Colombia. It is filled with smart people doing smart work with other people’s money.
Another one would be Riverside Resources Inc. (RRI:TSX); which is active in British Columbia and Mexico. The company has a number of projects being operated by partners and Riverside is just generating the ideas. I think those are smart ideas.
That’s a smart way to get into this sector, a very high-risk sector, with relatively lower risk.
TGR: You are a geologist. You look a lot at the rocks and you look at the business of whether the project can be brought to completion successfully. Do you spend a lot of time considering the politics? You mentioned a number of companies in South America and Riverside is in Mexico, which recently passed a new royalty tax. How much of an impact on success is the jurisdiction that a company is operating in?
BC: The jurisdiction is critical. There’s no point finding a deposit in a place that the company is never going to get to mine. That’s just a waste of money. There are a number of places I wouldn’t go. Even within Colombia there are certain areas that an investor doesn’t want to be for social, environmental or political reasons. Once an investor assumes that a country is okay to develop a deposit, then he or she must look at the exact locality. What’s going on there? Is a company drilling out a deposit sitting above a historic church and graveyard? Well, that isn’t going to work no matter where it is. That is what a desktop review screens out.
TGR: Are you still comfortable with Mexico in general?
BC: I think Mexico is still a good place to be exploring. The government has raised the hurdle as to what makes money, but the tax regime there is still competitive on a global basis, just not as good as it used to be.
TGR: We have covered a lot of ground. Any final words of wisdom for our readers who are looking for that light at the end of the tunnel, but don’t want to get burned on the way?
BC: Investors have got to do due diligence. Follow the rules of thumb. This is going to be a prime year to accumulate a few companies with deposits that work or exploration companies with competent management and the money to survive. Those are the two things I’m going to be buying this year. This is where investors make money. The Market Vectors Junior Gold Miners ETF (GDXJ) is down more than 70% over the past two years. A lot of the stuff that’s down should be down and will go lower, but there are some companies that have been taken down that are worth buying. I think this is a time to accumulate in anticipation of 2015 and 2016 being much better.
TGR: Thanks, Brent, for your insights.
Brent Cook brings more than 30 years of experience to his role as a geologist, consultant and investment adviser. His knowledge spans all areas of the mining business, from the conceptual stage through detailed technical and financial modeling related to mine development and production. Cook’s weekly Exploration Insights newsletter focuses on early discovery, high-reward opportunities, primarily among junior mining and exploration companies.
Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you’ll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.
