Roundup Takeaway 1: Outsmart Tough Odds
It's a common stat in the sector: only 1 in 1,000 discoveries becomes a mine. But David Harquail, president and CEO of Franco-Nevada, takes that sobering fact one step farther.
Harquail started in the business as a child, following his father around as the elder Harquail assessed projects for famed mine-finder Thayer Lindsley. Harquail later took on a similar role with similarly famous resource titans Pierre Lassonde and Seymour Schulich.
That team became curious: how many mines actually produce economic returns? They assessed mines in western Canada and determined a full half were either disappointments (did not return the cost of capital) or failures (did not even return invested capital). Another 40% did not give a good rate of return.
That produced the sobering conclusion that only 1 in 20 mines generates a good rate of return – which means only one in 20,000 exploration projects becomes a good mine!
That's bad, but not terrible from an investment perspective.
For one, those numbers were crunched in the 1980s. Hopefully mine developers have improved their success rate since.
Even if they have not, junior exploration investing is not always – or even often – about identifying projects that will become mines. It's about identifying companies with good potential for a strong share price run.
In the best cases, those goals align. Investors who jumped onto Diamond Fields Resources in the early 1990s got to live that dream: the Voisey's Bay nickel discovery pushed DFR shares sky high and in fairly short order the discovery became a very significant mine.
In many other cases, a great share price run moves a project through parts of the exploration-development process until something changes its course. Perhaps a major takes out the company or buys the project; maybe metal prices collapse; possibly the country in question changes its taxation structure or starts expropriating assets.
In these situations investors can still get great bang for their buck, even if the project later stalls completely.
Of course, there are many companies that fail to produce any of these positive results and instead act only as investment black holes. The worst are scams and promotions; the rest are just failures.
Harquail figures if you plot this on a chart, showing number of resource companies versus their return of capital, you get a normal distribution – a classic bell curve. Half of companies generate negative capital returns, half positive. The majority of companies cluster near the zero capital returns line. Only about 1 in 20 is a true scam; similarly only about 1 in 20 is a world-class investment.
Investments make it onto the positive-capital side of the chart courtesy of several characteristics, primary of which are the people, the project, and timing. And Harquail had some interesting ideas about the intersection of people and timing.
Timing is market conditions: metal prices, investor interest in resources, availability of capital, and similar macro forces.
The people running a company have to manage all those macro factors – but there are better and worse ways to do so. One of the worst ways is to pander to what investors want.
"Mining has been around for millennia, so a lot of wisdom has built up around mining," he said. "That wisdom says, if you have one of those 1 in 20 deposits, a Hemlo, you develop it as fast as you can. If you have an average deposit – if you decide to build a mine, make it a low cost, long life mine so you get a half decent return over a long enough time that you catch a couple of cycles."
That wisdom works well. Unfortunately, the bull run of the 2000s made us forget those lessons in favour of investor desires – which are necessarily fickle, because investors have short-term financial goals.
Poor quality projects get financed with debt
Push to maximize NPV
Oversize big capital projects, higher execution risk
Top of market acquisitions, building of high risk projects
Maximize free cash flow
High grading, deferred capital, shorter mine lives, accelerated closure liabilities à liquidation mode
The first three demands all had their day during the bull market run – and we saw all those outcomes clear as day.
Today the push is to maximize free cash flow. That too has its downside.
"Now investors think they've found the Holy Grail," said Harquail. "After a good long downturn they want to maximize cash flow and pay dividends – they want miners to be run as real businesses. That means limiting exploration, deferring new developments, high-grading mines. What's going to happen? In a few years, when companies can no longer defer new capital and mine reserves are down and all those closure liabilities that were discounted into the future are all of a sudden accelerated – I can just hear investors saying, 'Why weren't you keeping development options open? What happened to the growth?'"
It is a great way to explain what happened: why major miners took on excessive debt, built huge risky projects, and bought assets at the top of the market. It also perfectly captures the flavor of today – and the problems it will create.
What's the solution? To me, it's people.
The resource sector will always have its traps. Sometimes the trap is an area play, sometimes it's a commodity craze, often it's a flawed thesis around growth and money management.
The greatest portfolio of projects cannot answer these questions. That comes from people.
Management make decisions about how much money to spend, on what, why, along what timelines. Management track costs and make tough decisions about how to control them. Management need to foster a long-term plan for success.
Management have to learn from the mistakes of each sector trap and avoid repeating history. And they have to do so within the shifting sands of the present.
The shifts underway right now concern commodities. Gold, silver, coal, copper, zinc – these prices used to stem primarily from supply and demand, but not anymore.
Now paper markets and hedge funds have as much or more control than actual buyers. The gold fix used to ground gold prices in supply and demand; now the derivative market is taking over. Metallurgical and thermal coal prices used to flow from long-term contracts between producers and consumers; now coal is traded on the spot market, which gives speculators room to play. In the last year we've seen a copper-for-debt-collateral scandal in China and a series of huge hedge fund bets in China and London push copper prices around significantly. And on it goes.
As Harquail put it: "You are going to see even more volatility going forward, even more decoupling from the physical markets. This casino of trading will make for harder and faster commodity price swings than ever before."
It will take serious smarts to steer any resource company, whether a major miner or a junior explorer, out of the current quagmire of investor disinterest, limited capital availability, and sociopolitical opposition, especially in the context of this new world of commodity pricing.
It will take people with the ability to see new opportunities. It will take management teams able to stick to their guns amidst sector shifts, leaders able to acknowledge mistakes and find new direction, companies able to navigate a social terrain littered with obstacles, fiscally prudent directors with sustainable long-term visions.
It will take smart people, which is why the 'who' of a company is even more important than the 'what'.
Harquail's Franco Nevada is highly successful because its founders came up with a new business model. Wary of the risks of exploration and mine development, they came up with a way to participate in the gold process that sidesteps those risks. The streaming and royalties model has since been replicated by some and lauded by many.
There will be other such success stories. At Roundup every keynote speaker predicted that some new technology or way of operating would bring renewed interest to the mining sector, and so we should all be on the lookout for such developments.
It is impossible to watch what every individual in mining is doing. It is possible, however, to follow the leaders. Leaders earn such a title and deserve to keep it only if they continue to recognize and foster new successes.
And most leaders agree: the most important component in a success story is people.
So follow the smarts. Increase your odds of avoiding the traps. Take advantage of other people's expertise. Gain exposure to innovation.
That's how you win against tough odds.
(To that, I just have to mention: Maven subscribers are now in on TWO companies supported by investing legend Ross Beaty…and we are below his cost on both!)
Your "Maven Letter" has totally blown me away! I was thinking one of your letters would be a 2 or maybe 3 page letter about one or two mining companies. Instead, each one is a detailed report. Bravo to you for such great detail.
I think Peter Krauth's analysis articles are second to none. It would be impossible to conduct a fuller report than those which I have read.