This year's Prospectors and Developers Association of Canada (PDAC) mining conference has been accompanied by desperate new ideas to generate new investment dollars. For investors, this should come as no surprise – the global mining giants and institutional investors that make up the "smart money" have already deserted the field, taking their massive wallets with them.
The two regulatory proposals touted most intensely – crowdfunding and increased use of private equity deals – are seemingly innocuous. Crowdfunding – the solicitation of small investments on the Internet to fund mining development – is already legal in Saskatchewan and sensibly limited to $1,500 per investor.
Expanding the use of private placement deals led by individual brokers also makes sense on the surface but, based on my own experience, it's a terrible idea for investors.
There is a prime directive investors should always keep in mind when dealing with new stock issues, including private deals: The quality of the new investment is inversely proportional to the commission the broker makes.
The dirty secret of finance is that the investment risk of initial public offerings and secondary offerings is carefully calculated by the underwriters long before investors hear of the deal – it is inherent in the broker commission level.
In cases where investors are desperate to take part in a new stock offering – Facebook Inc. is a good example – the underwriters set the broker commission very low at mere pennies per share. The underwriters know that the stock will sell anyway and they don't have to incentivize retail brokers to find a home for them.
When times are tough in a market sector, as they are now for junior mining companies, the underwriters are often forced to pay exorbitant commissions – around four per cent of the total dollar value of the stock – to motivate brokers to find buyers for the offering.
In most private deals, the commission is even higher. An abomination called "7 and 7" is common for private deals for small mining companies – a seven per cent commission off the top, and then an amount of potentially dilutive broker warrants equal to seven per cent of the entire deal.
Remembering the prime directive – the higher the commission, the less an investor should be interested – you can see why I'm nervous about more private deals in the mining sector.
Investors should also question the sanity of buying into a mining sector where insiders are pulling in their horns. Rio Tinto Group was unable to find a reasonable bid for its Canadian iron ore assets and Cliffs Natural Resources Inc. has slashed investment plans for Ontario's Ring of Fire assets. Rebar prices in China, one of the most sensitive indicators of construction and global commodity demand, are hitting record lows.
Optimists in commodity sectors will point to the 16 per cent increase in the S&P/TSX Materials Index year to date as a sign of an industry resurgence, but the rally has been the result of short-term factors, not an increase in global manufacturing activity.
Natural gas is higher because of the historically cold winter and futures markets predict the price will fall sharply in the coming months. Commodities like iron ore and copper, which would be climbing if the global economy was accelerating, have been weak.
The commodity supercycle is, if not dead, then entering hibernation. A domestic mining sector that has grown used accustomed to mega profits since 2002 is looking for ways to keep the party rolling. Investors should think twice before playing along.
Scott Barlow