The New Landscape in the Resource Sector

San Francisco Hard Assets Investment Conference 2012 Online Preview

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. 

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