It’s often the case that investors looking to pile into small cap mining stocks are doing so after watching the run of some of the best successes over the past few years — such as ASX-listed Pilbara Minerals. Of course, not every explorer has been so fortunate; and the rise from a few cents a share to north of five Australian Dollars has come with masses of volatility.
It’s comparable to the rise of Bitcoin and Ethereum – early investors might bemoan selling too soon, but very few have the psychological temerity to wait through dips and spikes amounting to thousands, and often, tens of thousands in potential profits.
To start with, it’s important to clarify the distinction between hard and soft commodities. Soft commodities are usually grown — and include orange juice, lean hogs, wheat, corn et al. Hard commodities, such as oil, gas, gold, or iron are extracted from the Earth. Mining companies are going after the hard commodities, and there are greater inherent risks.
As the saying goes, ‘if it isn’t grown, it’s mined.’ Every product you own, or use is made out of wood from trees, plastic from oil, or metals dug up from the ground. But the mining sector is split into two distinct divisions: the majors and the juniors.
Junior mining shares are riskier than majors
Juniors are typically much riskier companies with little capital, while the majors are less volatile with a large portfolio of global projects and a chunky cash pile to fund exploration for future assets. Both classes are subject to several unique risks not found in other sectors, including fluctuating commodity prices, geopolitical factors, and also the difficulty of finding large-sized quality deposits.
For example, a junior exploring for lithium in a semi-stable African state is contending with volatility on at least three fronts.
Majors are relatively easy to value due to their size, capitalised position, global operations, and steady cash flow. In fact, miners like Rio Tinto or Glencore aren’t much different from FTSE 100 oil majors BP and Shell in some regards, with most fundamental valuation metrics the same. While the industry is cyclical, it’s unlikely you will ever see a double-digit rise or fall in a single day of trading.
Juniors are the opposite. They usually operate on a shoe-string budget (especially in the exploratory stage), have short histories, and are hoping to deliver exceptional returns in short timeframes. And a 10% rise or fall in any given week is simply to be expected.
There are three outcomes for junior resource companies:
- the most common result, by far, is failure. They spend all the investor cash exploring a deposit that is not economically feasible and then close down. This is high-risk stuff.
- the second-most common result is discovering an economically feasible deposit, with a major paying a decent sum of cash for the asset and everybody walking away into the sunset.
- and then there’s that magic moment when a junior discovers a ‘monster’ resource and has the leverage to get a major or funding house to lend it enough cash to retain some, or even keep all, of the economic interest.
This third scenario is becoming more common than in the past — Greatland Gold’s Havieron, Premier African Mineral’s Zulu, Kodal Minerals’ Bougouni et al — partially because it’s becoming easier to acquire mining equipment from OEMs or build a fast-start pilot plant than in the past.
You can see this in PREM’s pilot plant, Marula’s XRF sorters, and Atlantic Lithium’s plans to develop its own pilot. Where once you might have needed years of time and masses of cash to develop an asset, juniors can actually get a very basic operation up and running for less than $5 million funded by share placements — enough to prove the asset’s viability and convince a funding house to lend the $40 million or so needed to build a sizeable producing plant.
Valuation Risks of Major and Junior Miners
Valuing majors and juniors is therefore no longer as straightforward as in the past. However, as a primer, the value of a mining company roughly tracks the value of its reserves, with a premium for blue chip miners given their cash positions and history of successfully bringing assets to production.
These reserves are evaluated through assays and feasibility studies — typically a desktop study, scoping (conceptual) study, pre-feasibility study, and definitive feasibility study. The further along the discovery stages an asset is, the more certain geologists are of the deposit and therefore the higher the premium paid for the asset.
In essence, if an asset is found to be feasible, then it will fetch more money than the costs associated with digging it up. Importantly, it’s often the case that an asset that wasn’t feasible in the past becomes feasible due to new mining technology, rising asset prices, governmental tax incentives or similar.
There is one more stage that junior investors tend not to consider much — the bankable feasibility study — important for a potential JV partner, equity investor, or funding house, to decide what terms to offer for lending. In technical terms, this may not differ much from the DFS, but an asset in the heart of a Tier-1 mining district surrounded by successful projects, infrastructure, and highly qualified personnel is likely going to be looked upon favourably when it comes to financing terms.
Conversely, assets in the middle of virgin bush in a semi-stable country without access to power, water, or personnel are going to be riskier — even if the deposits themselves are close to chemically identical.
There’s also the investor geological understanding to consider. Similar to how it takes a biomedical researcher to understand what’s actually happening in an oncology clinical trial, much of the technical details won’t mean much to the average retail investor. We all do our best to understand the geology, but in reality, there will always be a knowledge gap.
But the key factor to understand is that a junior resource company usually lives or dies on its flagship asset. In the run-up to a feasibility study — like the run-up to a clinical trial — share prices tend to rise alongside volatility. A successful study can send a share price soaring, and a failure is often enough to collapse the company entirely.
A major has no such problems — if one promising deposit leads to a dead end, it’s simply written off as the cost of doing business. Of course, the majors prefer to let the juniors take all the risk of exploration — only swooping in once feasibility is established.
The exception to this is near-mine exploration; in lucky cases, a junior can strike deals with a major to explore prospective tenure close to already proven assets (and especially where that major has an interest in the already proven asset).
Overall, it’s much cheaper for the majors to let the juniors take on all the risk and then just pay a premium for the successful operators. This creates a solid exploration pipeline.
Thereafter, it’s a question of choosing a pathway — a sale, a JV, or going down the self-development route. Self-development is of course riskier, but the rewards are far higher, and investors can enjoy further rollercoaster moments, such as offtake partner signings, first sales, first profitability etc.
More and more, a junior will start simple operations to improve the understanding of a deposit, prove profitability IN PRACTICE, and de-risk it further in order to secure a higher sale price.
How to get started
We have covered all the basics to get started in investing in exploratory mining shares here, but from a risk perspective, there are some important further points to consider:
- these are smaller companies, and you can lose all of your investment. This is for risk capital, and definitely not the pension or Junior ISA
- the AIM market has fallen by a third over the past five years. Your chances of success are slimmer with monetary policy tight and lenders less prepared to fund riskier ventures
Whether by luck or skill, it’s almost always the same names in exploration that see the successes. These people often sell an asset, go spend all the cash, and come back a couple of years later to sell something else.
It takes a specific kind of person to choose to trek into some of the snake-filled, spider-infested areas where the best deposits of gold, lithium or similar are often found. Of course, these areas also often boast outstanding natural beauty, but the generic point is that explorers have actively chosen not to sit behind a desk in a comfy office with high speed wi-fi, hot coffee, and generic chit-chat.
Conversely, there are many companies run by ‘lifestyle’ management. These are people who use share placements and the promise of some never-fulfilled hope of profits to kick back and live life on investor cash. Failing to find a viable asset is one thing; bloated management salaries is another.
As a caveat, it’s important to understand that demanding management to be paid in shares only and not cash is unrealistic — unless management already has large amounts of personal finance at the ready.
Companies are paying for specific expertise, and it is not the fault of a management team if an asset is found to be unfeasible (and they still need to meet day-to-day living costs). Most of these people are not multimillionaires and cannot wait to be allowed to cash out shares which are usually subject to lock-up periods.
There is a fine balance here.
The bottom line
The junior resource sector is a high-risk, high-reward arena, filled with colourful characters, where most companies will lose money. While we cannot give advice, you should only invest risk capital — what you can afford to lose — and you must do copious research to be happy with your investments.
Worse, you must be prepared to hold through the spikes and the dips to take advantage of the serious profits.
However, one decent success can often outweigh ten losers.
And then there’s leveraged trading — but that’s really only for the HNW investors.
This article has been prepared for information purposes only by Charles Archer. It does not constitute advice, and no party accepts any liability for either accuracy or for investing decisions made using the information provided.
Further, it is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.