Who has ‘skin in the game’ in your gold junior? – Jeff Desjardins

You want managers who stand to win big if they succeed.

In a previous article, we highlighted one measure called the General and Administrative Expense Ratio (G&A). This measures how management puts shareholder money to work. A high G&A ratio means a company is spending a lot on overheard – little of investors’ money is actually going into the project, where the upside potential of the company lies.

There is a second important metric to look at: management ownership of the company.

‘Skin in the Game’

Management ownership represents the ‘skin in the game’ – the more they have to lose if things go bad, the more we can count on their decisions being good for other shareholders as well. This vested interest shows how much the team believes in a project.

If management has no ‘skin in the game,’ why should they care if the share structure gets diluted or if the stock is rolled back again? They can just re-price their incentive options when it looks like they can make a quick buck.

Using Q2 2013 data from 412 precious metals companies, mostly from the TSX and TSX-V, we looked at the average ownership of companies by management. This is an important benchmark for the industry.

It is impressive that such large number of companies – over 30% — is in the smallest slice in terms of management holdings. These companies especially could be ridden with conflicts of interest.

For instance, if managers discover that their project is not feasible –say if their resource is too small – will they divest remaining resources to shareholders? Or will they keep spending money on a project that is destined to fail, stringing shareholders along to keep making a six-figure salary?

How management ownership changes over time…

While a company advances, it will need to raise money to continue growing its project. If the managers deliver on advancing the resource, institutions and funds will often enter the story.

So let’s look at the “smart money” — the banks, mutual funds, investment advisors, hedge funds, or other investment companies. These investors can make mistakes too, but they have the resources to perform hefty due diligence. A small junior backed by a sophisticated financial organization can be a good sign.

Take a look at the chart below; you will see that as projects advance, the ownership levels tend to shift from management teams to funds and institutions.

Average management ownership is highest in the exploration phase. That percentage is diluted as the company matures and raises more capital from outside groups. Conversely, fund and institutional investment is at its lowest when the company is most risky and increases as it gets closer to commercial production.

Looking even further into the different stages of natural resource companies, we can see what the trends look like in more detail.

In our sample, management ownership stays fairly constant through the development stage. As projects move forward, they are de-risked at a steady pace. After the 43-101 stage, the project is established enough for funds and institutions to increase their ownership dramatically from 19.1% to 31.3%.

We also compared ownerships between small producers and medium producers.

We took small producers to be companies in commercial production with quarterly production below 30,000 ounces of gold or 1,500,000 ounces of silver. Medium producers were any that produced above those benchmarks but are not considered majors. For instance Osisko, B2Gold and First Majestic were medium producers.

As you can see, the smaller producers had larger management ownership and lower institutional ownership than medium producers.

So companies tend to start off with management owning a lot of shares and the rest owned by retail investors. But as the project becomes less risky, those initial investors see their ownership diluted out by “sophisticated” investors that enter the companies later on.

As investors, we want to own the companies where the management team is heavily invested in its success. The more early-stage and risky the project, the more important we expect management’s exposure to be.

As the project develops, ownership will likely pass from initial shareholders and management to more sophisticated investors with typically lower risk tolerance.

Depending on the stage where your company resides, the above guidelines should help to discern which companies have healthy levels of management interest, and which companies are too highly diluted to create substantial incentives for management, and to align their interests with shareholders.

Editor’s note: How important is management ownership?

I (Henry Bonner) took up the question with Jon Sebastian, an Investment Executive at Sprott Global Resource Investments Ltd.

“Management owning a big chunk of the company is fundamental,” he said. “Lack of management ownership is a fatal flaw for a natural resource junior and should be grounds for removal from your portfolio.

“There is no better way to ascertain that you can trust a management team to do the right thing for shareholders than if they are big shareholders themselves.”

Substantial management ownership is a ‘first-pass’ criteria for investors, but there are many other factors to consider before investing in any resource exploration company. You can contact Jon to discuss opportunities in natural resource exploration at 1.800.477.7853 or at [email protected].