Selectivity and Patience

Amongst the blogs and articles making the resource rounds this weekend was a Globe and Mail article titled Big mining companies to take lead on Canadian prospecting.

The idea: with juniors strapped for cash, it is major miners who are planning the most significant exploration programs in Canada this year. Goldcorp’s exploration spending is up 10%. Agnico Eagle is pouring money into the Meliadine gold project in Nunavut; Centerra is pouring even more into the Trans-Canada project in Ontario.

Last year juniors spent $743 million exploring in Canada, while majors spent $1.2 billion. For majors to outspend juniors on exploration is indeed anomalous, as it is usually juniors who explore their way to the discoveries that larger companies then develop.

But this long, deep bear market has created two new realities. First, cash for juniors is very limited and is only really available to advance discoveries towards resource expansion or, better yet, production. That means grassroots exploration has slowed to a crawl.

Second, majors generally prefer to spend their dollars buying advanced assets from juniors rather than exploring themselves. (Majors just aren’t that good at early-stage exploration.) But the list of acquisition-ready projects is actually pretty short. It’s a rock-and-hard-place scenario: juniors have struggled to make discoveries and advance assets during the bear market but majors today are only interested in assets with exploration excitement and development momentum.

There are exceptions, of course. Kaminak Gold is one: the Coffee project in Yukon has made significant progress towards development during the bad years, while continuing to produce exploration interest. There are others – but the list of projects likely to attract takeover bids from major miners in the near term is short.

That’s ok, because there are still good projects out there. They are just earlier stage. It means majors aren’t interested today – but they will be interested down the road, when gold is rising reliably, when the caution majors are exhibiting around acquisitions today subsides slightly in the face of urgency to add production, and when a year or two of better markets has given these interesting assets renewed energy.

It boils down to this: mining equities of interest today fall into three categories. There are major miners. There are juniors with those rare takeout-ready assets. And there are explorers with promising but earlier-stage assets that won’t really perform until the market improves.

Managing your mining portfolio today means building positions in all three kinds, but based on different requirements and expectations.

1. Identify the select group of true takeout candidates and build low-cost positions.

Kaminak is a good example – when KAM shares dip because the price of gold slides, add to your position. When gold goes on a run, like it did in January, sell part of your holding to lower your cost base.

Consistently applying this approach will establish a low cost position in one of the few companies that could actually get taken out in the near term, which would make it one of the few mining stocks to generate sizeable returns before the broader market rallies.

2. Decide which major miners you like best and buy.

Key considerations include all-in sustaining costs of production, production growth profile and the capital requirements involved, debt load, cash on hand (ability to act on acquisition opportunities), dividends, jurisdictional or legal challenges, and management (stagnant or dynamic, business as usual or realistic and reactive). In a few years time we will look back at today wistfully and wish for this kind of buying opportunity.

3. Spend time identifying the best juniors going forward.

That list can include early stage explorers, near-development stories, and small-scale producers – the whole range. What really matters is management, money, a realistic plan, and a solid share structure. Who is steering the ship and do they have the experience, drive, and network to not just survive until the market recovers but to inject new momentum? Does the company have money or access to money in the near term? What is the plan – are there catalysts on the horizon that will draw eyes to the stock? How many shares are outstanding, are any lots of below-market shares set to come free trading soon, what is the warrant count and status, do insiders own, and if institutions are involved who are they, how long have they been with the stock, and what is their outlook? That is a long list of questions but stocks that can produce positive answers to all will outperform the market when resources rise again.

In a grand sense, the future is far from clear. However, during my 7 hours of trail running this weekend (I run a lot) I spent a lot of time thinking about gold. Here are a few things about which I have become pretty certain.

• I would not want to be Janet Yellen. Raising rates in the face of poor wage increases and deflationary pricing pressure from the wickedly strong US dollar does not make sense. However, not raising rates when there is so much expectation would raise credibility issues. I expect tougher language from the Federal Reserve at the mid-week press conference following their monthly meeting and a small rate raise within the next few months.
• The market has mostly priced in a rate raise but when it is announced it will hit gold nonetheless. The yellow metal might fall below its November low, though it might not (we came pretty close last week). Either way, I still see $1,142-per-oz. as a solid yardstick for gold’s broad bottom. Last week showed that gold finds significant support at $1,150.
• The bright side for gold is, ironically, the US dollar. At some point the Fed will have to acknowledge the obvious: that the dollar’s strength is bad for business. US multinationals are struggling to remain competitive and maintain earnings.
• Some combination of higher interest rates and concern over the strength of the dollar could well be the straw that breaks the camel’s back and ends the S&P’s ascent. Once that safe haven disappears, investors will start casting around for undervalued equities, stocks with the potential to produce returns while the rest of the US markets either crash or slide. Mining equities – gold miners in particular – will stand out as opportunities.

Timing is both everything and nothing. I’m not being flippant. What I mean is that the long-awaited mining rebound now depends primarily on large-scale scenarios that are not going to play out tomorrow, but that will show more and more of their cards over the coming months.

It will require patience. And it will be patience of a challenging kind: rather than awaiting a specific event, we have to wait for broad parameters to change.

But as I was reminded in another astute article encountered over the weekend, waiting is better than predicting. Waiting keeps focus on the present: an investor awaiting change focuses on finding assets that are highly undervalued today. A predictive investor, by contrast, is always trying to guess when values might rise.

That difference gives waiters a big advantage over predictors, because we have lots of information about the present and zero information about the future.

So we wait, and while waiting we continue our search for undervalued equities with the right combination of characteristics to outperform either today or tomorrow. Tomorrow will arrive when it arrives and those well positioned will see their waiting rewarded.