This article appeared in the March 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
What, where, scale and quality - and, of course, risk are the keys to spotting promising stocks.
By Allan Trench, author
Although raising capital for exploration remains difficult, the enthusiasm for mineral exploration has been spurred on by notable successes in recent years such as Sandfire Resources and Sirius Resources. Both were catapulted from the ranks of junior explorers by significant discoveries to become sizeable companies.
Here are the main considerations and 10 questions to ask when looking at exploration companies before investing in small resource companies.
1. What commodities are being explored for?
Exploration drill-hits for the likes of gold, copper, diamonds and nickel sulphides have the ability to move share prices quickly. Conversely, drill hits of the likes of magnetite, bauxite, mineral sands, nickel laterites, rare earths, industrial minerals and alloying metals (tungsten, molybdenum, vanadium among others) generally do not - although there are always exceptions.
The first group are examples of "convex" minerals - meaning that higher value, hence a higher share price, occurs early in the mining cycle to a large part upon first discovery. This is because making the discovery itself overcomes the principal risk in exploiting these minerals.
The second group of minerals are examples of "concave" minerals, meaning that value should not come immediately upon discovery, as discovery by itself does not overcome the principal risk in exploiting these minerals. That step comes later, once successful mineral processing and/or marketing is achieved.
2. Where are the projects?
Everyone has a slightly different level of tolerance to risk, and that applies to minerals companies as well as individuals. Some companies choose only to operate "in places where the board would take their families on holiday". Others are willing to explore and mine in the more risky mining and political jurisdictions of the world, such as Africa.
The market mood for risk - and the premium or discount that applies to the location of mineral assets - varies over time. When the market is risk-inclined, assets in riskier jurisdictions do well, with asset transactions demonstrably higher in value per unit of metal/mineral in such locations.
Conversely when the market is averse to risk, assets located in safe jurisdictions, which is roughly synonymous with the developed world, attract premium value.
At present, the market is leaning towards risk-aversion, so expect to pay more for metal in the developed world until that changes. Those investors willing to wait for a shift in appetite back to riskier geographies can consider a contrarian approach and get set now.
3. Are the projects of significant scale?
Understanding this aspect of a screening process for explorers requires some geological knowledge. Scale in this context does not simply relate to the area covered by a company's exploration projects - although, everything else being equal, larger areas (100s to 1000s of square kilometres) are better than smaller areas (1 to 10 square kilometres).
Scale in this context relates to the "size of the prize" if exploration is successful. In gold, for example, does the company see potential for a 20,000-ounces per annum mine or 100,000 ounces? The latter is better.
In copper, that could be 20,000 tonnes per annum production or else closer to 100,000 tonnes. Again the latter is better. The geology of different deposit styles tends to drive what is possible in terms of potential production levels. Everything else being equal, bigger is better.
4. Is there potential for high-grade mineralisation?
"Grade is king" is an old saying in the mining game that still holds true. However, it is actually a combination of grade and material scale (the potential to produce large volumes) that is more appropriate in ranking exploration opportunities than just grade alone.
"Grade with accompanying material scale is king" does not quite roll of the tongue so easily. In gold in particular, a premium value applies to deposits of high grade - or the potential for their discovery - meaning anything approaching 3 grams per tonne for open-pit mines and double-digit grades such as 10-15g/t for underground.
In copper, grade is also important, but scale is relatively more important than for gold. Good grade in copper is 2.5 per cent and above for underground mines (ideally with accompanying other metals such as zinc, gold and silver) whereas good grade for open-pit copper can be as low as 0.6 per cent. If a copper asset has scale, then scale can "beat" grade in copper; few investors have realised this aspect yet.
5. Who is the managing director?
There is much dialogue about the quality of a company's board in assessing listed companies, including junior explorers. While not disagreeing (quality is clearly good), looking most closely at the principal executive in the company is where the sweet spot lies. That may be the managing director, chief executive officer or executive chairman.
Seeing that person up close at investment conferences speaks volumes. One stockbroker advised that he "makes a call" on a managing director in the first five minutes of meeting them. As most investment conference talks are for 20 minutes, that gives you plenty of time to form a view!
6. How much cash does the company have?
Read the quarterly cash flow statement. "Buyer beware" when cash falls below $2 million.
7. When will the company be drilling?
Cash is all good - but exploration companies need to use it. Look for drilling programs over the next half-year. Results usually come four to eight weeks after drilling.
8. Is a re-rating possible?
Is the company drilling out mineral resources - meaning usually "more of the same" - or is there potential for a new discovery? The former gradually builds share price value; the latter can drive a step change in value.
9. What are the relevant risks?
Technical and corporate risks need to be understood. Grassroots (meaning early stage) exploration companies have high technical risk, which is manageable as failure to make a discovery at any one prospect does not impact on the overall viability of the company itself.
Building, commissioning and ramping up operations, on the other hand, places a strain on working capital if costs overrun, with potentially disastrous consequences for corporate-level risk if project milestones are not achieved in timely fashion.
10. Have I taken appropriate advice?
Everyone should take advice. Ask around about the risk profile of a company. Can you tolerate the inherent risk in that company? Junior explorers are risky by the very nature that they have no operating cash flows. The upside for explorers is material - often many times the value of the current share price.
But the downside is material too, with explorers often losing the bulk of their value if they run out of cash before striking exploration encouragement of sufficient order to attract additional equity capital at a healthy share price.
About the author
Allan Trench is a Professor at Curtin Graduate School of Business and Professor (Value & Risk) at the Centre for Exploration Targeting, University of Western Australia. He is a non-executive director of several resource sector companies, and the author of a number of books on resource sector investment.
Watch a range of presentations from junior mining companies at the Australian Resources Conference and Trade show, held in Perth last year.
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