The New Landscape in the Resource Sector

By James West

http://www.resourceinvestor.com/2012/11/15/the-new-landscape-in-the-resource-sector?ref=hp&t=mining-investments&page=2

November 15, 2012 • Reprints

As a speaker and panelist at the upcoming San Francisco Hard Assets Conference, subscribers have been asking me, “Why bother? Why even look at companies when the performance of the whole sector has been so dismal?”

What they are invariably referring to is the horrible performance of resource exploration and production companies over the last two years, which suggests junior mining investment especially is a non-starter. But that’s exactly why, more than ever, I think attendance at a conference such as this is something every serious investor should make time for.

Instead of scrutinizing one’s portfolio for some flaw in investment style or strategy, time is better spent acquainting one’s self, in my opinion, with the fundamental changes that have asserted themselves in the global marketplace, and how they have changed the game entirely for the junior resource sector.

It’s Over

And the game has definitely changed. In a conversation with a prominent investment banker in Toronto earlier this year, he told me, “It’s over.”

What he meant by that dire conclusion, is that the Canadian investment banking formula of running a volume-oriented business of financing companies at a discount to market prices with a warrant and blowing out shares in a continuous monetization of those investments regardless of those companies’ success or failures, is over.

That model has been a major contributor to the state of the market. These companies that sell financings to funds depend on a steady turnover of fee and warrant-based private placements to pay for the overhead of running a network of regional retail advisors, an institutional sales department, a research department, compliance, back office, front office, etc.

They are not investors like you or I who selectively evaluate companies on their merits with an expectation to hold an investment for three to five years. They look at companies simply from the standpoint of, “can I sell this to the funds and our retail clients?”

The amount of effort required to adopt a real investor business model is too much work for these shops. It’s all about turnover for them. So the demise of that model, which is weighing down the market along with the macro factors of economic weakness, debt and currency debasement, is here.

My friend is right – Its over.

Which really, is good news for resource investors. Because what that means is the landscape now cluttered with companies of bloated structure and marginal project quality is gradually going to clear, and the one thing that the predatory and rapacious investment banks need in order to run an indiscriminate volume shop will be absent – thousands of hungry small corporate mouths needing capital.

We’re at a point now, where after two years of horrible markets, companies who delayed financings because conditions were so bad, and who have now had to recapitalize at any price because conditions are worse, are going to start falling off the game board.

The market is in the process of contraction. The time to be identifying and participating in companies is now, when everybody else is selling or abstaining. But, and it’s a huge but, the winners are going to be few and far between. Why? Because of the structural changes of the market place thanks to never-ending debt crises, central bank shenanigans, government folly and fiscal recklessness.

Here are the key items that have changed:

1. There are fewer investors

The last two years of bad performance have vaporized more than a few individual investors and plenty of investment funds. Even a few investment banks are history. Therefore, the lift one used to be able to expect from successes – a great drill hole, for example – is significantly diminished.

2. Average paid-in capital per share is way down

In other words, a company that used to arrive at 100 million shares outstanding did so with a much higher average price paid for share than is the case now, because so many companies have had to undertake financings on onerous and dilutive terms. So that means buyouts are going to occur at a much lower average premium to the average price paid per share.

3. There are an increasing ratio of companies that can’t raise money

Lots of companies out there are quickly running out of money and going on life-support, which is a condition you won’t glean from press releases. Read the financials.

4. Share structure is more important than ever

Starting with the founders round, make sure you know where every share has been sold or bought on the price curve. Take note of warrants, their strike prices and expiry dates. Too many financings at low prices are resulting in massive market overhangs. Exploration success has a much harder time driving a share price upward through cheap shares and warrants.

5. Takeovers aren’t necessarily big wins anymore

Because of all the cheap financings of the last couple of years, we have gone from an era where, from discovery to buyout by a major, a resource project would typically see valuation increases measure in the thousands of percent.

Recently, takeovers of companies – especially in the mining sector – while occurring at a premium of anywhere from 15%-40% over current market prices, are nonetheless at steep discounts to market highs prior to 2011.

The bottom line here is that there are going to continue to be big winners throughout the small cap resource sector, but they’re number as a ratio to the companies that fail is going to go way down. That’s why conferences like the San Francisco Hard Assets conference are now, more than ever, an important part of the landscape for investors seeking insight into current investment trends.

Outlook Bleak

The dire warnings about the US “fiscal cliff” are rather laughable stacked against the outcomes of previous fiscal cliff rendez-vous of years past. By now, we know that its just another opportunity for bipartisan brinkmanship. There is no cliff. The tax cuts will get rolled back and/or replaced with other ones, the debt ceiling will be raised, rinse and repeat. The next unit of measurement for government spending is “quadrillions”. We went over the real cliff decades ago when Nixon closed the window on US dollar redemptions for gold.

The ongoing reprehensible destruction of value inherent in the capital fabrication process we call quantitative easing is the real crisis issue, though being a crisis of unprecedented magnitude, its temporal lifecycle is long, and therefore, not easily understood in the context of “crisis”.

But crisis it is indeed. As the investment industry grapples with the direct outcome of such fiduciary delinquency i.e. lots of cash around but no capital investment, viable projects and companies run out of money, the unemployment lines are bolstered, and incrementally fewer exploration projects move forward.

Not that this is such a bad thing. By most accounts, the boom years of the early 2000s created an excess inventory of junior exploration companies chasing too few projects. Thus, ultra-low grade deposits that are only marginally viable even with high metals prices consumed vast amounts of exploration capital, only to find themselves shelved again, now that metals prices have pretty much uniformly stabilized a lower levels.

Value Destruction on an Unprecedented Scale

The impending fiscal cliff and debt ceiling raises are not crises in andx of themselves. Rather they are symptomatic of a much larger and real crisis looming – that of complete economic collapse.

What should be evident by now to governments locked in a cycle of stimulus, zero interest rates, and debt extension-revision, is that the more these “tools” as the Fed likes to call them, are deployed, a) the more they exacerbate the magnitude of the growing debt, economic stagnation, risk and investment aversion, unemployment, and diminished corporate earnings, and b) the less effective these tools become as they are deployed again and again.

I mean, lets face it. “Quantitative Easing” is exactly the issuance of more debt, but where the lender is the Fed itself, exercising its Congressionally protected right to create money out of thin air.

Zero interest rates are merely the mechanism whereby the US and its economic allies are able to extend the illusion that more debt is manageable.

So the “tools” are really the mechanism that not only ensures a continuation and worsening of the problems the world faces financially, but they guarantee that we have no choice but to carry on down this path, absent the leadership with sufficient credibility and gumption to say, “Enough!”

When the government embarks on a policy of fraud and market manipulation just to be able to continue servicing its debt and funneling wealth to the top 5% of the electorate who support them, the endgame is close at hand.

Which means we’re entering an investment cycle, in the junior resource sector, where there is a lot of cash, diminishing opportunities, and diminishing returns.

So by all means, come down to the Hard Assets show and attend my presentation, and I’ll show you a few companies that are performing well, and some that will, and why they are going to be successful in a fragile and weak market.

James West will participate in a keynote panel on “Up and Comers”on Friday and give a newsletter editor presentation on Saturday during the San Francisco Hard Assets Investment Conference.