Recently we were asked to provide a presentation at the Botswana Resource Cap conference. Botswana has vast national resources, though many projects are starting up and in early phases of development. As such investment is critical if these projects are to come to fruition. We consider what investors look for when choosing to commit to funding these projects.
With respect to junior mining projects in particular, it is important to realise that around 5% of junior mining projects are responsible for delivering over 90% of the returns to investors. Therefore whilst the returns may be spectacular, which is what drives the investment demand in the first place, we need to be sensitive to the fact that the risks to investors for junior mining projects in particular are vast. Therefore investors generally look at a number of key criteria or red flags before making their investment decisions. We consider these factors in order of importance:
1. Management
The quality and experience of a mining firm is a critical decision in the investor’s due diligence process and is often the determining factor.
The people running the company must be professionally competent and should have an established track record of past successes. They also must be committed in terms of having a significant stake in the firm’s equity. A company funded by 100% debt without the management taking a stake is often a red flag to investors. Performance based salaries is also critical. Convertible share options held by management which stand to significantly dilute shareholder value is another aspect that investors consider. Above all else management must know what they are looking for – a simple concept to state and a clear vision. The problem with junior miners, especially those which may have a multi-resource deposit is that they lack clear vision about the type of deposit and its true potential profitability. I can’t tell you how often I am asked whether a company should regard themselves as a rare earth prospector with some phosphate or a phosphate prospect which can potentially produce rare earths. And often the reason for the question comes down to “but which is more attractive and in vogue for an investor?”
Management also must be ruthless when it comes to bailing out of a project that is not proving. Many junior mining companies that investors come across are ones where the management team is simply holding on in the hope of a buyout offer. In this case they are trying to play the greater fool theory i.e. they know that there isn’t much chance that the next drill hole will produce much but they are unwilling to cut their losses and are therefore waiting for some greater fool to buy them out. So what investors look for is consistent, increasing positive news. I.e. an initial resource statement, followed by a revision of resources showing higher resource potential. Or initial cost estimates in the prefeasibility study, followed by similar cost estimates in the feasibility study.
Finally an investor would like to see other successful mining ventures brought to market by this specific management team. Suffice to say that it is easier for a junior mining project to get financed if the management team have in their time brought other projects to market which are successful entities today.
2. Country and Political Risks
As commodity prices rise, two things happen. Firstly producers and prospectors become willing to seek out more risky projects and host countries of these resources become more greedy and possessive over their fortunes. Commodities are seen as a meal ticket and a way in which countries can raise additional funds. Therefore country risks have increased considerably over the last five years driven higher by the global financial crisis as governments see commodities as a way to make money. This trend we expect will continue.
Already several countries have written into their laws language that gives them the authority to nationalize or partially nationalize mining projects. For example, Russia’s mining code states that it could nationalize every mine of strategic importance, but does not define what constitutes a strategically important mine or commodity. In South Africa the subject of mine nationalization has been brought up countless times, but the government has never formally dismissed or denounced the notion.
There are however some emerging economies where country risk is actually relatively low such as Serbia and Bulgaria. The war ended in Serbia around 17 years ago and since the country has become open for foreign investment and has a favorable tax rate. It is also a potential candidate to join the EU and as such political risk has declined dramatically.
In other instances the perceived country risks are higher than they actually are one example is Eritrea. Despite the fact that government takes a relatively large stake in projects (10% stake with the option of raising this to 30% if NPV is high enough- Botswana incidentally has a similar system), there has not been issues of mine nationalization or loss of licenses as is the case in the DRC.
In Argentina, owing the nationalization of an oil company by President Cristina Kirchner, a lot of investors believed that mine nationalization would follow and so the country risk premium is perceived to be higher. However this was 15 months ago and the risk of nationalization and federal government involvement is limited as mining licences are distributed by the states. Still the perception is that Argentina is riskier that it actually is.
With respect to South Africa, the perceived investment risk has increased dramatically since 2008, following strikes and wage hikes. On top of that, the BEE regulation stipulates that 24% of every project be given to a Black Economic Empowerment Movement. This legislation was supposed to be phased out by 2010, but to date it remains. In the minds of the foreign investor, they believe it will increase to over 50% as is the case in Zimbabwe. While this is outside of the mining industry, I would mention that BMW is decreasing its manufacturing capabilities in South Africa by 50% owing to high labour costs and unrest pertaining to labour. So stability, both political and social is vital to attract and retain foreign investment.
3. Location
The next important factor investors consider is location. And this cartoon illustrates the point quite well:
The project’s location must be considered from several vantages when investing in junior or start-up mining companies:
1. The mining district and the project’s proximity to other producing mines
2. The availability of infrastructure (roads, electricity, water and labour force)
3. The regional as well as the intra-claim geology and geochemistry
The geology of the junior mining project can be evaluated in several ways. One of the most helpful tools when investing in junior mining companies is the Canadian National Instrument (“CNI”) 43-101 Report. The 43-101 report is a mineral resource classification standard used for the public disclosure of information relating to mineral properties, and it is widely used throughout North America and in other regions. The report complies with strict guidelines on how mining companies can disclose scientific and technical information about mineral projects. Reports which comply with the Australian JORC standards or the South African SAMREC codes are also ways which provide investors with assurance.
Another way to evaluate the geology of the mining project when investing in junior mining companies is by its proximity to other proven or operating mines. There are mining locales or geologic trends where multiple mines are located. Finding a junior copper mine operation in the middle of Zambian’s copper belt helps validate the possibility of a successful junior mine and large potential investor returns.
In 2006 there were suddenly an increased number of junior platinum or coal producers being listed on the JSE or Altx market. In addition to the usual metrics of evaluating junior mining companies … mining rights, management, resource quality, one of the considerations was proximity to an established platinum or coal producer who have not yet me their BEE quota and therefore a BEE deal was imminent. The rationale in this instance was that in order to secure the required BEE credential, it would be beneficial if an established miner such as Anglos, Lonmin or Billiton would annex the junior mining company and in that way the risk that the project may not have funding to go all the way was reduced. Furthermore the considerations over power, infrastructure and management ability was also alleviated as the area had already proven that it had the existing infrastructure.
Established infrastructure is another key element when investing in junior mining companies. Access to roads, utilities, water, labour and equipment can make a significant difference in the cost of the ore mined and in the cash generated by the project. If a mining firm has to pioneer all or many of these infrastructural necessities then it will need a higher grade ore to be competitive with a mining project that has all of this in place. In June of last year, The Ring of Fire chromite deposit located in Northern Ontario made the decision to not proceed with it’s EIA report and to halt all work on the project. Despite a large resource deposit and a favourable location in terms of mining law, the fact that it would require large capital investment in order to secure power to the area due to its remote location and delays with land rights issues led to the decision to stop progression of the project.
If we consider the four iron ore projects in Sierra Leone:
- The Kukuna and Marampa projects (Cape Lambert)
- Tonkolili projects (African Minerals)
- Marampa Project (London Mining)
London Mining’s Marampa project is the only project that does not have access to any part of the infrastructure network despite the fact that the rail line from Tonkolili to Pepal runs directly past the Marampa mine site. Cape Lambert has the right to 2m tpa on African Minerals network while African Minerals is ramping up its phase 1 and thereafter the project will have a 5m tpa allocation once African Minera;s phase 2 is commissioned. Access to infrastructure particularly in Africa is key and enables a company to achieve growth and scale. London Mining’s lack of infrastructure access could constrain its growth in the future and could limit Marampa’s ability to ramp up to its desired 17m tpa.
Both these examples of the South African junior platinum and coal companies as well as the iron ore deposits points to another important consideration for investors- that of scalability. Investors want to see growth potential in its projects, companies with the ability to develop large and diversified resources or can expand due to resource size or proximity to transport and so forth generally fair better in attracting investors.
4. Predictability
We’ve alluded to this already, but in the context of mining company evaluation, predictability refers to the stability and regulatory consistency of the political jurisdiction in which the company operates. Junior mining firms are finding it increasingly to their advantage to operate in regions that have predictable regulatory frameworks around mining operations. When investing in junior mining companies, one resource is to look at The Fraser Institute of Canada’s annual rankings of the top ten most mining-friendly jurisdictions in the world. In 2013 the least attractive jurisdictions were as follows with Congo being rated the best out the worst bunch:
Indonesia, Vietnam, Venezuela, DRC (Congo), Kyrgyzstan, Zimbabwe, Bolivia, Guatemala, Philippines, and Greece.
All of these countries were in the bottom ten last year with the exception of DRC, Greece and Zimbabwe. Both the DRC and Zimbabwe dropped significantly in the rankings over the last year, falling from 76th to 93 in the case of the DRC and from 74th to 91 in the case of Zimbabwe. On average Africa’s score as a whole declined, continuing its five year declining trend. Mali dropped the most, followed by Madagascar. Mauritania and Namibia showed improvement, while Botswana remains the highest ranked Jurisdiction (17th) on the continent. And as a result Botswana does realise foreign investment in its mines and outside of diamonds there is presently discussions around investment in a fertilizer industry, various copper and coal prospects and a power line.
The bane of mining firms worldwide has been incurring the substantial cost of finding, developing and initiating production on a rich ore zone in a less than stable political jurisdiction and then just when the project is generating significant cash flow having it either confiscated or made uneconomical because of arbitrary increases by the state in royalty, rent seeking or other mineral related payments.
One recent example cited by the Caeser Gold Report of just this sort arbitrary state action occurred in August of 2011, when Hugo Chavez decided to recall the country’s gold reserves and nationalize the gold mining industry. Speaking on state television via telephone, the leftist leader indicated that he would introduce a new decree in the coming days to put exploration and extraction of gold into the government’s hands.
Closer to home, in August this year, Zimbabwe’s President made a bid to seize control (51%) of foreign-owned mines without paying them as part of a program to accumulate $7bn of assets following the July election victory. Non-compliant mine owners risk losing their licenses.
KPMG also assesses the political risks and operating environments of African Mining jurisdictions, on this graph we note that Algeria, Ethiopia, Swaziland and Zimbabwe rank the worst from both an operating environment perspective as well as in terms of political risk. While Botswana and Zambia are regarded as the best countries to operate in from both a political risk perspective as well as the operating environment.
Deployment of Capital
Lastly another important consideration to investors when investing in junior mining companies is how the firm has deployed its capital.
Has most of the money gone into General and Administrative expense or into Investor Relations expenses indicating that management is more interested in pumping up the share price than mining. This often goes hand in hand where management is remunerated with share options as opposed to aligning the remuneration package with performance, milestones and earnings. Or has most of the money gone into drilling, assaying and ore body evaluation and the preparation of corresponding reports? If the former, it must be a red flag to investors that management is more focused on promotion than production.
If the firm has completed a NI 43-101, or a Preliminary Economic Assessment or, even better, a Pre-Feasibility Study, that includes a definitive resource calculation and some estimates of a project’s economics, then that is an excellent sign that management has spent its capital wisely and is looking to build shareholder value through development and exploitation of the mineralised material.
The other thing an investor needs to consider when investing in junior mining companies is the level of the firm’s debt. Long term debt in the form of convertible debentures, can be a fast lane to bankruptcy if the firm has no immediate cash flow. Frequently these debenture holders want to drive the share price down so they can convert into greater amounts of equity and this can send the company’s shares into what’s known as a “death spiral.” This set of circumstances is a common outcome among the juniors that are constantly strapped for cash.
Most juniors an investor will encounter are not in a strong cash position, which represents opportunity when investing in junior mining companies. Investors need to determine if the firm has enough cash on hand to sustain minimum levels of operation when investing in junior gold mining companies. This leads us back to our first point that a strong experienced management team is critical to the success of a project. A good management team can often make an average project with respect to ore body or resource work, whilst history is dotted with examples which I won’t mention of bad management teams and high quality deposits which they are unable to make a go of.
