It’s Time To Get ‘Greedy’ With These ‘Hated’ Stocks
What can a 90 year-old woman from Nebraska teach us about finding profit opportunities in today’s downtrodden mining sector?
Let me tell you a story.
In 1983, Mrs. Rose Blumkin — nonagenarian proprietor of Nebraska Furniture Mart — was approached by a local investment fund manager who was interested in putting money into her family’s business. After talking with “Mrs. B” and observing her Herculean managerial style about the store, the buyer handed her a check for $55 million. No audit of the books, check of inventory, or verification of property titles. He saw all the qualities he liked in Mrs. B — and was willing to pay a lot based on a few key observations and a handshake.
That man was Warren Buffett. I’ve learned a lot by studying his examples, like the one above, and applying them to natural resources investing.
This “be like Warren” message is an important one for my Junior Resource Advisor readers. That’s because investing in mining — and particularly its highest-potential-return sub-sector, exploration and development — is radically different from conventional investing.
#-ad_banner-#Unlike banks or manufacturers, mineral exploration and development companies have no revenue or cash flow. I’ve sat in meetings with Wall Street bankers and been asked about the price-to-earnings (P/E) ratios for these firms — and had to point out that the number is technically infinity, the inevitable result when you divide any P by an E that is zero.
So why should we care about these serial spillers of red ink? Because, when done correctly, exploration can yield profit multiples nearly unmatched across the investment universe. In the mineral business it’s possible to spend millions of dollars identifying an in-ground asset through sampling, drilling and compilation of results, and come up with a single, massive product that commands a one-time sale price in the billions.
Many observers believe that the exploration market is dead today. With commodity prices slumping and the valuations of major miners down, who cares about finding new ore deposits?
But my analysis shows something completely different. The market for exploration properties is as active as it’s ever been — if not more frenetic.
Look at the chart below. I’ve plotted acquisitions of exploration properties during the second quarter of this year. These are deals where one company pays another to purchase the rights to a mineral project.
In total, there were 66 property deals completed in the quarter. Hardly a dead market. (And this analysis only covers companies listed on the mining-heavy Toronto stock exchange (TSX). Undoubtedly there were more deals done in places like London and Australia.)
The most interesting metric is the purchase price. Acquiring companies generally pay for properties through a combination of cash and shares. They also usually commit to spending a certain amount in exploration on the project — adding value to the retained interest that the project generator often maintains in the property.
Adding up cash, shares and work commitments, the average price paid for an exploration property in the second quarter — pro-rata to ownership — was $4.85 million. The maximum value was $26.3 million, with the minimum standing at $67,500. These numbers tell me the market for exploration is as active as ever.
I’m also hearing about this anecdotally. Majors and mid-tier producers are still under pressure to replace their depleting reserves. Most of them have looked at advanced assets for sale globally, and been underwhelmed.
Simply put, there aren’t a lot of good deposits out there in inventory. The world’s biggest miners recognize that new discoveries must be made.
That means the thesis for buying shares in exploration and development companies still holds water. The question is which ones to buy?
The challenge of selecting exploration companies for investment is compounded by a hard truth about the industry: few companies succeed.
That’s because success in this business requires a management team with two important elements: it knows what it’s looking for and has the ability to go into the wilderness and find it.
That sounds simple enough. But the majority of companies fail even on the first count, having no clue what needs to be discovered in order to constitute an economically viable mineral deposit. They have violated Sun Tzu’s cardinal rule: “Win, and then go to war.”
And even if the team has an idea what a valuable deposit looks like, it often fails on the second count. Field work is a tricky business. The mineral fields of the world are laced with poor infrastructure, inclement weather conditions, inhospitable locals… the list of potential pitfalls goes on and on.
Having established why most exploration firms fail, it’s instructive to look at why a handful of companies succeed in creating outsized profits in this business. This is where Warren Buffett’s wisdom proves useful.
The story above about Buffett’s handshake deal with the furniture store owner tells us that investing success doesn’t necessarily come down to number-crunching and esoteric models. Instead, you can make millions following a few basic principles — more common sense than complex — that cut through the noise of endless possible analytical variables and instill a Zen-like clarity in good times and bad.
These principles are so basic that you can apply them to all investments, whether you’re talking about Goldman Sachs (NYSE: GS) or Goldcorp (NYSE: GG). And they frame some of the most important things we need to remember to take a steady hand and profit from the current mini-collapse in the mining sector.
The numbers show that current times are definitely fearful. I highlighted above how the average exploration property commands a value of just under $5 million. And yet many good exploration companies — holding an inventory of many such projects — are selling for less than their cash value, implying that investors are valuing at zero a product for which the market is willing to pay much more.
This is a situation Buffett would approve of. After all, it was Buffett who famously quipped: “Be fearful when others are greedy and greedy only when others are fearful.”
This may be the cardinal rule for buying good exploration companies. As such, I’m looking to add new exploration companies to my Junior Resource Advisor portfolio while the rest of the market is fearful — ones with a proven management team, projects of obvious and significant value, and strong cash positions. All of which can be had today for a fraction of the price that the “greedy” crowd was paying for it less than a year ago.
If you’re interested in finding out more about the kinds of resource companies I’m looking at in Junior Resource Advisor — the kinds that can have the power to deliver massive returns unlike any other sector, I encourage you to check out my latest report here.