Mining fun in the small caps

Ubiquitous on British and Australian public equity markets, small cap mining stocks can be a lot of fun. If you buy the right ones you can make an absolute fortune. It’s an area where 10-100x returns are completely feasible and not uncommon, while on the flip side in a downturn a la 2008 many will drop 90-95% and a good number will go bust and wipe out the unfortunate souls depending on them.

It goes without saying the challenge is to sort the gold from the crap.

It helps knowing that once a geologist has identified a potential resource there are rounds and rounds of additional surveys and drillings that define the precise scope and geological extent of the ore. Each round will require capital, and each round will dilute existing shareholders. Each round will involve a pitch highlighting the vast wealth to be sucked easily from the ground, in stark contrast to the puddly value of the company holding the key. There are many traps for the unwary.

Usually, the geologist will have spent his life savings early on in the game, amd that of his family and friends soon after. With his license about to expire and his balls against the wall he will have to beg investors to dilute his stake to effectively nothing to take the venture to the next but by no means last level. Every time the nascent venture runs out of cash, the existing equity holders will have to choose between substantial dilution or bankruptcy.

There is a myriad of listed companies at every stage of development, but there are very few sensible times to deploy your own sweet, precious capital.

You have no business investing in the speculative rounds (unless you’re a geologist with particular inside information insight). At no stage should you buy shares of companies that have speculative drilling as their principal business – it is merely a punt on what the drillers find, and more importantly if the resource is much larger than expected, you can be damn well sure the company will need to raise more cash.

The sweet spot is after capital for the actual development of the mine has been raised. Typically this has been dilutive and the stock has sold off substantially and is now, for the first time, cheap. The faded dreams of those-who-went-early will provide an excellent entry point. Equally important, the real risk of such ventures – that development funding will not be forthcoming – has vanished. There are typically huge discounts to value, and more importantly, it actually makes sense to invest.

Further in favour, now that development is about to commence there will be a string of predictable and steady announcements of progress, all providing catalysts to close that gap between value and price. Obviously there are risks of production delays and the like, but instead of speculative companies in the exploratory phase the odds of positive announcements are substantially more in your favor.

Sound easy? The macro picture is just as important, multiplicatively.

Good small caps are like options that never decay: they provide substantial leverage, limited loss and you can hold them forever. They should be traded as such. You should buy stock worth 2-3% of your portfolio, and target 10x movements over the mid term, ie each returning 20-30% to your bottom line. You should be willing and capitally-able to withstand those effectively going to zero.

So what happens when the shit hits the fan? Should you run a stop loss? My preference is to dodge this one, and say you should only buy in bull markets. If everything looks rosy, the shares will be valued on rosy assumptions and the risk is enormous, while in the red-hot depths of market panics if they are trading at all there is probably some prospect of success. Because there is so much in built leverage they are a damn good way to bet on a recovery.

I’ll let you decide which extreme we’re closer to right now.

Obviously there’s more to it (but less than you’d think). I’ll write something up on a small cap miner or two I have positions in and you can judge their performance.

ps did you buy the fucking dip?


3 thoughts on “Mining fun in the small caps”

  1. Pingback: Rust « adamantic

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