What’s Wrong With This Picture?

Throughout my 30 years’ experience in the equity markets, I have seen periods of time when various sectors of the market have exhibited either extremely positive or extremely negative environments. I refer to this as “market psychology” and at times, it can be the most prevailing factor affecting the stocks of a particular sector. In a positive environment negative news is often discounted, while in a negative environment positive news is usually ignored.

The tech stock rally from 1998 through March, 2000 is but one example of an extremely positive environment in which the market’s euphoria for this sector proceeded illogically until the “bubble” burst in 2000. At the other extreme, the banking sector during the 1990-91 recession was so pessimistic that bank stock valuations reached compelling levels well below book value.

Currently, with gold trading near a high above $1200/oz. and silver trading just under $20/oz., it is apparent that the exploration (junior) mining sector is undergoing a similar valuation displacement. Perhaps the most extreme example of this is ECU Silver Mining, Inc. Let’s review some of the significant fundamental developments in the following table exhibiting the progression of ECU from 2005 through 2010.

ECU’s common shares rallied sharply from US$0.40/sh. in late 2005 to US$2.90/sh. by June, 2006. (The stock actually peaked near $3.35 in May, 2006.)

Through the onset of a major exploration program that began in early 2006, ECU was able to confirm an ore body of 98 million silver-equivalent ounces by June, 2006.

Contributing to the stock’s escalation over that period of time were comments from analysts like Eric Hommelberg of The Gold Drivers Report who stated, “Almost every single week (since Jan., 2006), ECU managed to come out with astonishing drill results.” Furthermore, in an interview with Hommelberg in May, 2006, ECU C.E.O. Michel Roy confirmed the following: “The geological environment we are encountering certainly has the potential to contain a large deposit.”

Also contributing to the many sharply-rising exploration stocks like ECU was anticipation within the marketplace that merger and acquisition (M&A) activity would begin heating up in the precious metal mining sector. As the senior producers depleted their inventory, the natural progression along this industry food-chain would be the acquisition of proven exploration companies. In fact, analyst David Chapman speculated that ECU “could become a target of a takeover,” while others were comparing ECU’s potential ore body to that of Gammon Lake Resources, which appreciated from $0.30 in 2001 to over $20 in 2006.

By June, 2006, with a market cap of $516 million, ECU’s (confirmed) resource was valued at $5.26/ silver-eq. ounce. This was high given the fact that silver was only $11.25/oz.; however, investors were anticipating that ECU’s ore body would soon grow much larger since the four major discoveries of 2006 would not be included in the calculation until the next NI 43-101 report (Jan., 2008).

ECU also expanded its sulfide mill operation during this time from 250 tons per day (tpd) to 320 tpd in order to generate additional cash flow to help fund drilling. This mattered little to the market place, however. It was all about the size of the resource! The market psychology for this sector was extremely positive and exploration company stocks were well-rewarded for this resource growth.

With continually significant drilling success, ECU expanded its exploration program in the fall, 2006 by adding three more drills. Over the subsequent months into 2007, as the company reported the discoveries of highly-mineralized skarns and stockwork zones, the market began to anticipate another solid NI 43-101 resource report to be reported in early 2008.

However, some of the enthusiasm surrounding the exploration sector began to wane. Perhaps due to limited takeover activity among the exploration companies, stocks within the sector became extremely volatile as hedge funds began to aggressively short them. ECU remained close to $3/sh. in 1Q 2007 but it suddenly became very volatile and began to pull back along with the price of silver into the fall of 2007.

Analyst Eric Hommelberg felt that the selling pressure was temporary and wrote in his 10/28/07 The Gold Drivers Report, “When taking into account the big discoveries of 2006 to be included in the upcoming NI 43-101 report, it wouldn’t surprise me to see ECU’s proven resources expand by 50%, and possibly up to 100%. It is my strong belief that ECU shares will top the C$3 mark by year end (2007) and challenge its all time high of C$3.65.”

As a matter of fact, in the subsequent NI 43-101 report dated Jan. 24, 2008, ECU increased its resource by over 100% to 217 million silver-eq. ounces, a stunning accomplishment. In addition, the auditor MICON Intl. approved an enormous 465-807 million “potential” ounces that could possibly become proven with additional drilling and confirmation.

This prompted the mining analyst at TD Securities to raise his price target on ECU from C$3.00 to C$3.50, despite the fact that the stock was selling for only C$2.05 at the time. According to the analyst Daniel Earle in his 1/25/08 report, “The higher end of the range provided by MICON suggests that total resources could grow to nearly a billion ounces.”

This report also did little to curb the enthusiasm of mining analyst Richard Gray at Blackmont Capital, who had claimed in his “initiating coverage” report dated Nov. 23, 2007 that, “We believe the (ECU) property has the potential to become one of the largest silver mines in Mexico over the next five to seven years.”

In April, 2008, TD Securities generated an in-depth report entitled, “Precious Metal Outlook: Sector Consolidation – Bigger is Better” in which an analyst raised the question, “When will the majors start using their strong share price currencies to acquire the arguably weakened juniors?” In summary, the analyst felt that a 3-way merger announced the prior month involving three small to mid-tier firms would be the catalyst to greater consolidation activity in this sector. TD Securities anticipated major miners acquiring junior companies as well as junior companies merging to gain critical mass.

ECU, with the size and location (Mexico) of their resource, would seem to be a logical candidate of interest among major producers.

Unfortunately for the precious metal industry at this time, silver began a sharp $4 decline, creating more volatility among the exploration companies as hedge funds continued to short the industry.

On June 15, 2008, I had an hour-long private conversation with precious metals advocate, James Sinclair. He convinced me that collectively, hedge funds had been operating a long/short arbitrage for months, whereby they were buying the major producers and shorting the junior explorers. He also felt that the trades were predominantly “naked short” since they could get away with it in Canada where securities laws are gray and for the most part not enforced. This allowed the perpetrators to operate with minimum exposure, causing the public records of the (junior miner) short positions to be severely understated. This last point prompted my subsequent filing of two separate formal complaints with the Canadian regulators in Nov., 2008 and July, 2009.

On July 9, 2008, ECU announced in a press release, a confirmation that “massive sulfide veins had been intercepted at depth.” This was a significant discovery and confirmed to the market the growing possibility (and management’s expectation) that a very rich massive sulfide zone lay beneath an area currently being drilled.

Had this been announced against the backdrop of a positive environment for exploration companies, the stock probably would have soared! However, this was not the case as the sector psychology remained fairly weak and would weaken even further as silver immediately began a significant 5-month decline from $19/oz. to below $9/oz., thanks to bullion banks like JP Morgan.

By the time ECU issued its next resource report in December, 2008, the market environment for all precious metal mining companies was horrendous. Gold and silver had been slammed by the bullion banks, while the credit market was in total disarray.

Credit lines were severed (including ECU’s) and the exploration sector seized up as the market feared that many of these companies would be unable to access either bank or security market capital.

Nonetheless, ECU announced a stunningly positive resource increase, doubling the prior report and now claiming 431 million silver-eq. ounces. Furthermore, the resource “potential” now ranged from 569-930 million silver-eq. ounces. Speculation that the company may be sitting upon 1 billion silver-eq. ounces was becoming closer to reality.

At the same time however, it was also becoming apparent that the psychology for this sector had shifted so much that the only aspect that mattered in the past -- the size of the resource -- suddenly didn’t matter! Thus, the company, which was once valued at $5.26 per silver-eq. ounce, had fallen to $.54 per ounce.

This decline in valuation is best exemplified in the following TSX Venture Index Graph:

Amidst this psychological shift, with the market now discounting the significance of an explorer’s ore body size, ECU was forced to focus on production and cash flow. As a result, the company quickly acquired a 600 tpd oxide mill from Hecla in March, 2009.

This was critical for the company although it was costly for shareholders. The equity offering to purchase the mill provided additional ammo for the hedge fund shorts, thereby putting more pressure on the stock.

A year after acquiring the mill, ECU turned cash flow positive with reported revenue of $2 million in the month of April, 2010. Monthly revenue should continue to escalate with the recent hiring of two key production managers, and it will ultimately provide funding for the massive sulfide zone drill program. In addition, efforts are underway to negotiate a sale of the large gold pyrite inventory which, if consummated, would provide additional credibility to the economics of the ore body. A Skoping Study is underway to provide documentation of the resource economics.

It is obvious that ECU and its shareholders have been forced to deal with a lot of adversity over the past few years. Although the company’s stock remains under pressure, the fundamentals have improved significantly. In fact, ECU is a much better company today than it was when the stock traded around $3/sh. Unfortunately, the environment has not reverted back to the positive atmosphere that existed a few years ago, but it will,

and when it does the proverbial glass will be “half-full” again and not “half-empty.”

Some catalyst, whether it is continually escalating gold and silver prices or perhaps the long-awaited wave of merger activity, will turn the psychology around for ECU, restoring the appropriate valuation to its huge resource and production accomplishments. At that point, the nuisance hedge funds will turn buyers of the stock.

Those with patience will be rewarded.

Wistar W. Holt
wholt@holtshapard.com
July 6, 2010