AUSTRALIAN RESOURCE STOCK SELECTION
In the 2002 RESOURCE STOCKS/AIG investment risk survey Australia for the second consecutive year topped the tables in terms of being the least risky country in the world to invest in. Following Australia in order were, Canada, United States, Chile (Chile was runner-up to Australia in 2001, and was number one in 2000), South Africa, Ghana, Tanzania, Brazil, Mexico, Malaysia, Vietnam, Argentina (Argentina was ranked at number five in 2001), China, Peru, Philippines, Russia, India, Indonesia, PNG, and Zimbabwe.
The investment scenario in Australia can be daunting based on the wide selection of commodities, precious metals and importantly for retail investors the companies that produce and/or explore for them.
Money Management
The percentage of funds allocated towards resource investment will differ greatly between each investor. Our resource and in particular gold sector has been perceived as being "casino" like in nature, however with the improvements in gold, silver and copper in particular sentiment appears to be turning towards resources after industrial and technology companies attracted the bulk of attention and funds.
The price movement and media attention of the gold price, has served as a recruitment drive for the sector and those that developed a higher tolerance towards specific and market risk would be moving into a number of situations that had been previously ignored by the Dotcom brigade.
Producer or Explorer?
There could well be a number of misconceptions based on the risk profile of an exploration company. During difficult times, exploration companies can either cease operations to conserve capital, or jump on the latest investment craze. Many companies that took the capital preservation route and maintained the minimum expenditure levels on tenements are now being rewarded for their persistence as capital is more easily accessed. Producers, whilst providing an income stream through dividends are also prone to currency, operational, and commodity based risk. A number of companies have suffered as a result of hedging policies that backfired, despite possessing excellent producing assets. Those with a more conservative investment outlook will stick to the major producers that have developed a brand name, before they venture into the mid-caps or precious metals arena.
Not many exploration companies simply roll over and pack it in. Small placements can cover the rent, coffee/cream biscuits, 2-ply toilet paper and tickets to mining seminars.
Whilst large producers tend to be a leading indicator due to the institutional money flow, it is often the emerging miners and explorers that accelerate quickly once an upward trend is in place. This is where the small retail investors (Mums and Dads) have an advantage in terms of targeting stocks that are yet to attain market capitalisations that will attract the larger investors that will hopefully take the ball up in the next phase.
Whilst owning a zinc explorer can be like pulling teeth in the current environment, it should remembered that continued low prices will send a number of producers out of business, and as we are witnessing with copper, large mining houses are cutting production to assist in price stabilisation and eventual appreciation. During both quiet and boom times, it could well be argued, "grade is king"
Share Structure
The number of shares on issue for a company when multiplied by their share price provides a market capitalisation and whilst being a basic form of valuation is critical in resource stock selection. Some may feel that a company with a 10c share price is cheap, compared to one that is trading around 80c. The 10c stock may have 500m shares on issue, whilst the other has been far more conservative with capital raisings/dilution and only has 40m on issue. Speculators will be far more attracted to the leverage potential of the 10c stock, with a move to 15c providing a handy 50% profit. During boom periods the 10c stock will attract a significant number of investors and traders and rising volumes will normally assist in the share price rising. It is when times become tough that those with large share issues can become stuck in quicksand and in order to raise further capital they are forced to either reconstruct their share capital, and/or viciously dilute their shareholder base through a rights issue. The company priced around 80c, has numerous avenues of capital raisings available to it, and a comparative move from 80c to $1.20 is not impossible.
A small company I covered in 1998, Aquarius Platinum (AQP) was trading at 45c, and managed to peak of $10.95 on Friday without any share reconstructions or severe dilution. Whilst the company benefited greatly from rising PGM prices, the underlying asset and financial base was sound and facilitated the stunning re-rating.
Situations like AQP are rare, however the process involved in identifying companies with similar potential can be rewarding both financially and in terms of an investor's ongoing education.
I tend to stick to researching companies with under 70m shares on issue, however when I venture outside this criteria the aim is to have resource bases and/or exploration potential that justifies the companies market capitalisation. A company with 200m shares on issue, trading at 20c could well be ripe for a re-rating if the shares issued have been utilised in assisting the company's asset base, and not to simply fund pot shots at exploration targets.
Summary
- A cheap share price does not imply a company is fairly priced. A company with a share price of $1.20 may represent far better value than a company trading under 1c.
- Despite being listed for a considerable period, some companies have policies of maintaining tight share structures and have developed a loyal shareholder base. If the potential of the company's projects complements the structure the risk is reduced whilst the leverage potential remains.
- Share reconstructions can seriously dilute shareholder wealth, but can also provide a company with much needed access to fresh capital and the short-term pain can benefit the company over the long run.
- Reconstructions carried out during a speculative boom that is showing signs of maturing can be outright dangerous, and investors should be mindful of this aspect when buying a 1c share that has moved strongly to 5c or 6c with a considerable number of shares on issue.
- Companies can have a number of different securities on issue, including options (listed and unlisted), contributing shares (similar to options but normally have staggered payment conditions), converting preference shares, and convertible notes issued to investors which can be exercised readily.
- Whilst having a working knowledge of the company's share structure is beneficial the fact remains a considerable number of traders and investors will purchase the stock without any diligent research, which will normally result in a share price becoming overvalued. Investors should be mindful of this factor in all market conditions.
- A number of company's market capitalisations are not fully diluted when reported so comparisons undertaken should account for any discrepancies.
Management
Ascertaining the value of a company's management team can be a daunting experience based on the vast array of Directors involved in the resource sector. A company may have professional and hardworking management but may lack the expertise in promoting the company and attaining a share price that more accurately reflects their potential. On the other hand some companies may have management that are excellent promoters and have the ability to move the share price during boom periods, but lack the technical expertise to see a company through from an explorer to a cash flow positive producer.
Some may argue that value is eventually recognised, however without a profile in the investment community many shareholders whilst realising the potential will sell out in search of other opportunities. Others may become unsettled with a company that constantly issues cheap stock that is out of the reach of the small investor as the promotional aspect comes to the fore. In some cases the issuing of cheap stock can have a positive affect, and often the issued stock is payment for acquiring a project and can be crucial to a company's more medium-term outlook.
A company that has the ability to attract press attention with a strong management team and project profile is often one that will trade between reasonable value and during periods of speculative excess is prone to becoming overvalued. The challenge for investors is to find a company that has one element missing or needing improvement, then to sit patiently until the market picks up the story. Throughout my involvement in the stock market I have located such companies, however the ride was not always smooth as expected with a number of critical issues arising from both a management and project perspective.
Those with some experience in the speculative market will no doubt be aware of the power of certain Directors to attract a high level of interest with the capital to follow.
I make it my business to speak with Directors on a regular basis to assist with updating my clients on important issues. A number of companies have investor relations departments and in most cases the company secretary is happy to provide an overview of the company's projects to an interested investor. If contact cannot be made investors should request what I refer to as a "propaganda pack" which will include reports, ASX announcements and where applicable broker analysis. Another avenue is to ask for the company's website which will often feature a section on management and will provide some valuable background information on the people running the company.
Summary
- Management's ability to promote their story is not to be underestimated. Some company's will be excellent promoters but lacking the expertise to follow a project through to production.
- In periods of speculative booms, the stock promoters are often very successful in creating strong share price surges through their ability to attract media attention, and in some cases the Directors themselves may have a strong media presence.
- Diligent management that continues to develop a company, with shareholder value in mind will often have share price movements far less volatile than stocks that are heavily promoted, however they may have the foundation for sustainable growth.
- Look for companies that do not have a high burn rate of Directors, and also check their remuneration relative to their performance (contained within the company's annual report).
- Do not be afraid to phone a company and ask to speak to a Director, remembering they are not legally entitled to tell you the sensational drilling results they are releasing to the market tomorrow.
Resource Company Growth Stages
The majority of resource companies begin their lives with a package of tenements, an enthusiastic management team, and the dream of finding the next "elephant" or "Lasseters Reef". In order to highlight the potential patterns that could emerge in a company's development, I have provided an example of a company that moves from explorer to producer, looking at how each stage could impact on their share price, which is the prime concern of the retail investor.
Stage 1: IPO (Elephant Mines NL Lists on the ASX)
The majority of Australian junior resource companies elect to issue stock at 20c, with a ratio of free attaching options or low cost loyalty options at a future date. EPM manages to time their listing well and interest in junior explorers has improved, and an immediate premium is applied to the 20c IPO price, due to having a high-profile chairman and prospective tenements. Share Price 30c
Stage 2: Initial Exploration
EPM launches into a RAB program. (Rotary Air Blast), and the results are well received. Share Price 45c
Stage 3: Follow Up Drilling
Due to the success of the RAB program, EPM decides to go for an extensive RC (reverse circulation) drilling campaign and the results indicate the potential for a high-grade resource to be delineated. At this stage volumes in the junior gold sector have increased significantly and the market reacts with a degree of "irrational exuberance" to the results. Share Price 90c
Stage 4: Resource Definition
EPM is determined to come up with a resource, and carries out further infill drilling and begins modeling a future production scenario. The excitement from the RC results has subsided and a broader correction in gold stocks has taken place. Those that bought at the peak are looking to exit, or place their holder statements in the bottom drawer. Share Price 50c and falling
Stage 5: Feasibility Studies
The resource base has been established, and the company conducts a capital rising at 30c to fund feasibility studies. The share structure has increased from 40m shares to 80m after vendor stock was gradually released from escrow and private placements were conducted. Share Price 28c
Stage 6: Joint Venture Partner and Large Capital Raising Planned
At this stage EPM has progressed to the stage, where they are planning to construct a plant and move towards gold production. A major gold company with a regional interest approaches EPM and offers to inject significant capital into it through a placement and convertible note issue. The market reacts positively to the news, and EPM's share price steadily increases. Share Price 35c (EPM now has 130m shares on a fully diluted basis on issue and has a 60% interest in the project)
Stage 7: Change Of Company Name and Further Raisings
Elephant Mines NL at the time of the major gold spike had a novel name that tended to attract speculators. The major gold company that took an interest in it, along with an institution has indicated that they would prefer a more conservative name, and a tidier share structure to facilitate further development. The share register starts to attract a host of small resource funds, and commissioning of the mine is getting closer. Share Price $1.50 (50c based on the previous share structure, for every 3 shares held EPM issued one new share with a bonus attaching option)
Stage 8: Production and Acquisition
EPM (now known as Enterprise Gold and Minerals), has poured its first gold bar, and has acquired a suite of exploration tenements through corporate moves and joint ventures. The gold price gradually increases, and EPM is now a 100,000oz pa producer with a vision of rewarding shareholders with a regular dividend stream. Share Price $4.80 ($1.60 on former share structure)
EPM for many would have been a profitable investment, however those that got caught during the market frenzies would have held for a considerable period to see a return on their investment or simply given up in disgust just prior to the share price turning.
The aim for experienced investors is to lighten into any artificial strength and accumulate during periods of weakness and a lack of visible activity.
Boom Periods and Danger Signals
During boom periods many new investors are attracted to the market like insects to car windscreens on country roads, and often fail to make it through to the next market phase. Instead of learning the mechanics of the market, they dive straight in based on market gossip and often find they are holding stocks near their yearly highs on the journey south. Whilst bull markets are exciting and create considerable wealth, they can do severe damage to an investor's confidence and bank balance. It is often the less experienced that buys companies with hideous structures and end up selling their investment in June for a fraction of the price they paid. (Often not enough to even cover brokerage).
Successful investors will use boom periods to gradually increase their holdings of quality companies, through profiting from some short-term movements in explorers and more speculative stocks. Whilst their core holdings of emerging and small producers may not outperform a number of micro caps, they are not tempted to cash in their holdings and throw the lot at a kennel of potential dogs.
I have spent the last nine years making mistakes and trying to learn from them in terms of stock selection. Whilst the process will continue indefinitely, if the current trend continues in precious metals and develops in a number of commodities, 2004 could well be the year where it finally comes together.
Tony Locantro
locantro@iinet.net.au
11 June 2002
Sources
Resource Stocks Magazine May/June 2002, published by Aspermont. (World Investment Risk Survey 2002)
The Green Room "A Guide To Speculating On The Australian Stock Market" by Tony Locantro 2001.
Tony Locantro is a client advisor in Perth, Australia, and the author of "The Green Room", A Guide To Speculating on the Australian Stock Market. Tony was previously a major contributor to Australian Internet forums under the nick "Budfox" from 1998-2001.
Stocks mentioned in this article are for illustration purposes only and do not represent investment advice. The author has both direct and indirect interests in stocks mentioned in the article and these may change without notice.
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