Why Resource Stocks . . . and Why Now?
For investors who haven’t been paying much attention to what has been happening in the metals
and commodities markets over the past couple of years, this may be an important wake-up call.
While most U.S. investors have likely
been focused on the typical stocks found on U.S. exchanges and NASDAQ, there is a whole other investment world out there which has
been moving along in its own orbit at an even faster rate of speed. And now, many investors are discovering that the rising prices
of metals, energy and related commodities present some very attractive opportunities in the stocks of companies involved in exploring
for, developing and producing these basic building blocks upon which most industrial production relies. These are the metals and minerals
which build, power and provide financial backing for the world economy.
The Growing Demand for Commodities
After nearly a quarter
century of floundering in the doldrums, the prices of metals and other commodities began a strong upsurge some two years ago and still
appear to be generally headed higher in the foreseeable future. Those who were around in the late 70's and early 80's probably remember
what happened at that time in the precious metals markets, culminating in huge price spikes based upon fears of rampant inflation,
a weakening US dollar, Cold War concerns, political turmoil in the Middle East and $40 oil. Well, here we are again a generation later.
Except now, on top of those factors we have a rapidly growing international demand for everything that comes from the earth because
a much larger and more prosperous world population needs and wants more of everything.
A generation ago China, as a whole, was just
beginning its transition from effectively being stuck in the first half of the 20th century, and India was still largely a Third World
country. Today, the U.S. is so dependent upon China for most consumer goods that our stores would be largely empty if it weren’t for
products “Made in China.” And where would we get our “Tech Support”and “Customer Care” from if there were no call centers in India?
All that growth and prosperity overseas has resulted in a huge increase in the demand for metals, minerals, energy, food commodities
and building materials. So how can investors profit from all of this? Certainly, trading in commodity futures is one avenue - but
not for the timid and certainly not for the average investor. Buying and holding physical metals can make sense for gold and silver
due to their relatively high value to size ratio, but not for a few tons of copper or zinc sitting in the garage. On the other hand,
a half ton of molybdenum (worth around $20,000), would fit in an airline carry-on bag - if you could move it.
A Reasonable Alternative
So,
just as was the case a generation ago, a reasonable alternative, and one which can make sense for many investors who are farsighted
and willing to take some risk, in return for the possibility of potentially large gains, we have the world of resource stocks. These,
of course, are the stocks of companies which explore for, develop and mine gold, silver, platinum, copper, lead, zinc, molybdenum,
tungsten, uranium and other less common but often equally important minerals extracted from the earth.
Unlike most companies in the
manufacturing, technology or services industries, the resource business has its own set of somewhat unique characteristics. Other
than the relatively small number of “Majors”, as they are typically called in the industry, most of the companies is this field are
called “Juniors” and are quite small by most investment standards. We’re talking about market caps of generally less than $100 million
and often less than $20 million. Those numbers may sound “scarey” to the average U.S. investor but therein also lies the opportunity.
The other “scarey” factor is that the vast majority of these companies consume cash rather than produce it - at least initially. So
in many respects, they are like the R & D operations typically funded by venture capitalists, except these companies have markets
for their stocks and the investing public often act as the venture capitalists.
Time and Patience
It’s important to understand that
this is a business which is measured in terms of years and not quarters. The process of finding, developing and placing a cash flow
producing mining operation into production is time-consuming, expensive and complicated. It’s like a big land development or skyscraper
building project, with added complications. But once a mine is placed into production, the payback can be very quick - often less
than three or four years. However, it can easily take three to five, and often more years to get into production from the time the
first drill hole goes down. Some properties are explored by a series of companies over many years before economic reserves are defined;
and metals prices usually make the difference between when a project is considered economic and when it’s not.
With no earnings reports
to look forward to on a quarterly basis, before production, investors and the markets obviously need something to maintain their interest.
In the resource development business the news can often come fast and furious. Sometimes it’s positive and exciting and other times
it’s disappointing. For companies with adequate financing which are actively engaged in ongoing exploration programs or acquiring
new properties, the flow of news releases can often be a source of continuing market excitement - certainly much more so than waiting
around for the next quarterly earnings report.
The thing that makes this such an exciting business is that a small company can spend
a few million dollars and come up with an asset literally worth billions of dollars (in the ground). There’s a big step, however,
from “in the ground” to “in the bank.” And that’s where most small companies end up with either a much larger joint venture partner
or, quite often, being acquired by a mid-tier or major company in the industry. So, just as a cash-out for a venture capital backed
R&D company may come through either an IPO or a buyout from a larger company, successful smaller resource companies are often
acquired. On the other hand, some remain independent and eventually grow into mid-tier operations themselves, which then often acquire
smaller Juniors.
Big Moves in a Short Time
If waiting for years isn’t your bag, there are still great opportunities in the shorter
term for investors to make many times their capital back if they are able to score big on a winner. It’s not that uncommon to see
gains of 300% to 500% in a year, and sometimes as much as 1000%. It’s just the nature of the business. One or two good drill holes
can produce results which can attract lots of attention and sometimes make a stock double or triple in a day or two. Where else can
you find that sort of action? For example, MAG Silver Corp. (MVG - AMEX, MAG - TSX) saw the price of its stock go from around
C$2.75 in early October of 2006 to a high of $16.40 in July 2007. That’s nearly a 500% increase in just over 9 months. Between July
10, the day the stock was listed on the AMEX and July 23, 2007 it ran from a low of US$11.35 to $15.80 - a 39% move in two weeks.
Fronteer Development Group (FRG - AMEX) ran from about US$5.50 to $14.50 in less than six months between October 2006 and mid April
of 2007 - a 160% move.
With lower priced stocks, the moves can be even more dramatic. It is certainly not unheard of to
see a 1000% rise (ten times) in a period of only a couple of months. A good example is VMS Ventures, a stock we watched run from less
than C$0.15 in early September 2007 to over $1.70 less than 6 weeks later on news of a significant discovery. But,
to be perfectly objective, we also need to be aware that the prices of many of these stocks can drop like a rock on disappointing
news, weakness in metals prices or a general market downturn. Usually, when the excitement subsides, the news flow slows and the profit
takers cash in, prices retreat back to more reasonable levels. So, while it can be an exciting ride up on the rollercoaster,
it can also be a wild and scarey slide on the downside. Even so, there are few investment arenas where this sort of potential is available
without taking on the risks of something like currency or commodities trading.
The Magic of Leverage
One of the reasons that resource
stocks can be a very interesting and potentially rewarding investment medium is that they offer substantial leverage on earnings based
upon price increases in the products mined. Unlike companies in the manufacturing or service industries, where competition keeps price
increases in check, operating mining companies can profit handsomely when metals prices rise. As an example, if a gold mining company
produces gold at an operating cost of $600 an ounce and sells it for $750, it grosses $150 per ounce. When the gold price rises $50, just
6.7% to $800, the operating profit goes up 33.3% to $200, (assuming no major production cost increases). That’s a 5:1 leverage factor
of earnings to revenue growth based upon the gold price increase. About the only other place you can get that sort of leverage is
in oil production, which is also a resource business.
The Importance of Canada
One important thing that investors will notice about
the resource development business is that most of the companies involved in it are based in Canada. The reason for this is that, unlike
the United States, there has been a continuously active mining industry in Canada for over 150 years. And perhaps more importantly,
there have been active financial markets there to support and finance the exploration business for over a century. As a result, Canadian
based mining companies are in the forefront of mineral exploration on a global basis. An old joke used to be that no matter where
in the world you went to look for gold, whenever you turned over a rock, there was already a Canadian under it. So now Canadian companies
are active throughout North, Central and South America, Europe, Asia, Africa and Australia. According to statistics published by the
Government of Canada: (1) Canada attracts more investment in mineral exploration than any other country in the world, and; (2) The
offices of more than 850 mining development and exploration companies are located in Vancouver, BC, alone.
In the U.S., on the
other hand, with the exception of a few large companies, most smaller scale metals mining operations died out with the start of World
War II and never really came back. except for the uranium boom of the 1950's and the precious metals boom in the late 1970's to mid-80's.
Most of the action in the U.S. is now taking place in Nevada for gold and silver production and in Arizona for copper and gold production.
The recent uranium boom is also bringing Utah back into the picture. In most places in the U.S. as in the rest of the world, it’s
still Canadian exploration companies that are leading the search for new sources of production.
Procedures and Regulations
Some investors
have heard and still believe the quote from Mark Twain to the effect that “A gold mine is nothing more than a hole in the ground with
a liar on top.” While that may have often been the case in the past, in recent years, regulatory authorities in Canada have pretty
much set the international standards for defining how the mineral exploration and development business is to be operated by publicly
held companies. Unlike the U.S., where the public reporting standards for the mining business are not as well defined, Canadian Securities
Administrators have imposed strict definitions, operating procedures and reporting standards for public companies. These are embodied
in what is called “National Instrument 43-101".
Consequently, investors who follow the resource market in Canada are used to seeing
news releases reviewed by “qualified persons”, which are geologists or mining engineers with properly vetted credentials to talk about
technical data disclosed by public companies. “43-101 reports” are prepared or reviewed by qualified persons talking about “resources”
and “reserves” and other technical matters related to the exploration and development work performed on mineral properties; and must
comply with the requirements of N.I. 43-101.
So, why now?
Everything runs in cycles and we are now in the growth phase of a global
commodities boom, which is predicted by many experts, to run for many more years. Based upon the type of market performance which
resource stocks have had in past up-cycles, there is good reason to believe that investors, now, can expect similar, and maybe even
more exciting action than anything we’ve witnessed in the past. Only time will tell, but as they say in the gaming business, “You
can’t win if you don’t play.”
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