Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.
In about a year or so, half the junior resources stocks traded on the TSX Venture Exchange will be reborn. Say goodbye to Giddy Gold Corp., say hello to Brilliant Biotech Inc. or Tantalizing Tech Ltd.
Such is the cycle – the Street needs product and money needs a home, and given what appears to be growing indifference toward early-stage commodity plays, this seems like a pretty safe bet. Investors who like to roll the dice on emerging firms can benefit from this change in a couple of ways.
First, there’s the possibility to rummage through the slagheap that’s the junior resource sector looking for bargains.
Many of these companies have what’s called a net present value (NPV) that’s substantially higher than their market value. The NPV is just a calculation of the value of the company’s known resources using commodity-price, mining-cost and discount-rate assumptions. These values are often found in regulatory filings, and while they’re subject to a big margin of error, they’re not a bad place to start.
Once you find stocks trading at a big discount, which isn’t hard these days, you have to ask yourself whether that discount is justified or not. There are dozens of moving parts, but the biggest question, in my view, is whether they’re producing or not. By and large if they’re not, you should consider giving them a wide berth. But if you insist, the next question is what do they need to take them to production. How much time? What’s required? Do they need a big road built to the property, or a power line? More importantly, how much money do they need and how much do they have? If it’s a lot relative to the market capitalization (and it almost always is), run. The project has low odds of being built at this point. The promoters will tell you it’s a natural target for a bigger producer, but not many properties get bought. Many of them are just recycled from past bull markets, and they’ll be shelved and dusted off again in due time.
Producers are more interesting; some of them are even trading at stiff discounts to their NPV. For some that’s justified, because the price or cost assumptions used are way off. Investors are clearly fretting about commodity pricing, but they’re also coming to realize that costs can be more volatile. The old saying is something like “only pick-ax vendors made any money in the Klondike.” It holds true. When demand is high, workers get paid what they want and the equipment makers set their own prices. The shareholders? They get what’s left. When demand for labour and equipment is high, that’s usually not much.
But companies with relatively low costs – say first or second quartile – can withstand a downturn in prices and cost inflation, and might even benefit a little if falling demand lowers costs.
Be very wary of high-cost producers, because if they start to lose money they won’t stop mining – they never do. They’ll just raise equity to offset the cash burn, and in this environment that’s death by a thousand cuts.
The other opportunities are in promising technology and biotechnology stories (if you think that’s the next area of interest). There are never as many of these as junior energy or mining stocks, and some of them have the same odds of success, but dig around and you can find some with promise. Because investors have been obsessed with resources for years, some of these firms have been quietly proving out their business cases with little attention. Their stock prices, therefore, are low. These stocks can be hard to value, compared with resource firms (on paper anyway). But you see the odd insider buying, which is always an encouraging sign.
More importantly, the financial industry always needs to sell something. If, indeed, the next flavours are tech/biotech, these names should soon be getting a lot of attention. Being early won’t hurt.