Exploration is a high-risk/high-reward venture where understanding the value proposition is key
It almost goes without saying that the junior exploration and mining companies are currently doing it ‘tough’. But it is also equally fair to say that these companies are made of even ‘tougher’ stuff. Putting aside the current difficulties associated with the business cycle, exploration is an inherently high risk/high reward activity. The following article quantifies all three of these characteristics for the Australian junior sector over the last decade.
Challenges facing the industry
Evidence of the immense challenges facing the industry can be found in the dramatic drop in exploration expenditures in Australia over the last three years. Current expenditures are half that of the A$3656 million spent in 2012. In US dollar terms the fall is even more severe – down by 55 per cent from US$3764 million to around US$1766 million. By comparison, expenditures in Canada fell by 48 per cent (in US dollar terms) over the same period.
Ironically, the riskiest thing that a junior explorer can do is actually find and build a mine!
Given the above, many industry commentators predict that the sector faces widespread carnage. Perhaps the most pessimistic was a news article in January 2013 by Lawrence Williams who suggested that ‘perhaps 50 per cent of [Canadian] juniors won’t be around in a year’s time’. This was based on the observation that, at the time, 632 of the 1400-odd juniors listed on the Toronto Stock Exchange (TSX)-Venture had less than C$200 000 in the bank. A more recent assessment (by the author) of junior mining and exploration companies listed on the Canadian exchanges came up with similar numbers. As at 30 June 2014, 635 out of 1258 (or 50 per cent) of the junior companies on the TSE/TSX/TNX had less than C$200 000 of cash reserves. By comparison, the cash position of the Australian companies was better – with only 19 per cent of the reporting junior companies on the Australian Securities Exchange (ASX) having less than A$200 000 (equal to C$200 000 at the prevailing exchange rate).
It is certainly true that the number of new companies joining the sector has dried up. On the ASX only eight new junior exploration and mining companies were floated in 2014. This is down from 17 in 2013 and 38 in 2012. In terms of junior companies leaving the ASX, the author estimates that in 2014, 33 companies departed versus 22 in 2013 and 28 in 2012. As at the end of December 2014 there were around 650 junior explorers and mining companies listed on the ASX. After netting the two factors out, the total number of junior companies on the ASX fell by only 20 over the last three years. This is surprisingly low.
Resilience of junior explorers
As a cross-check of the apparent resilience of the junior sector, MinEx Consulting took a random sample of 100 junior explorers that were listed on the ASX on 30 June 2004 and tracked their history over the intervening decade. As indicated in Figure 1, 52 of the companies are still listed as explorers as at 30 June 2014. In other words – half of all of the junior explorers are still around a decade later. It should be noted that the average age of the 100 junior explorers in June 2004 was 10.6 years. The average age of the 52 survivors (as at June 2014) is 21.5 years; and the 48 casualties lasted 13.2 years. This gives a weighted average age of at least 17.5 years (and still counting). In other words, Australian junior explorers are remarkably long-lived. This is even more remarkable given that most of these companies had less than two years of cash reserves in place at one time. The junior’s ability to fund exploration critically depends on regular cash injections from its shareholders.
It is insightful to look at what happened to the 48 companies that are no longer active mineral explorers. Ten of these companies were acquired, four switched over to exploring for oil and gas and six went into administration. A further 28 companies built a mine and became producers. In other words, over the last decade around one quarter of the explorers became miners. This is a surprisingly high statistic and may simply be a result of the strong commodity prices of the late 2000s, which made (even small) projects economically viable to develop. It should also be noted that around half of these projects were acquired from other companies – rather than discovered by the junior itself.
With regard to the 28 companies that became producers, only ten of these are still in the business of mining. Five of the companies were subsequently acquired and four closed down their mine and reverted back to being an explorer. The remaining nine companies went into administration. Putting aside those companies that were acquired, 13 of the original 28 companies either closed down their mine and/or went broke. In many cases the company went into administration within one or two years after start up.
The key message from all of the above is that junior explorers are remarkably long-lived and resilient. Ironically, the riskiest thing a junior explorer can do is actually find and build a mine! Half of the companies that became producers failed at this step.
The author’s view is that many of the failures are caused by the company committing to what is often a marginal-economic project (at best), without doing the necessary thorough technical studies and detailed risk assessments beforehand. Often the company’s cash reserves were inadequate to weather any cost over-runs, delays in mine start up and/or adverse changes in commodity prices. Furthermore, management often lacked the necessary experience in building and commissioning mines. Many of these problems can be minimised through good planning, disciplined investment criteria and having the right management team in-place.
A more detailed assessment of the various factors behind why mining projects fail can be found in the work of McCarthy (2003) and Bullock (2011).
Value proposition for exploration
The second part of the author’s analysis was to assess the value proposition for exploration over the last decade. This involved assessing the return on investing in the same (randomly selected) sample of 100 Australian Junior exploration companies. The analysis looked at the value of purchasing $1000 worth of shares in each of the 100 companies as at 4 July 2004 and compared it against the value of these shares as at 4 July 2014. The only variation to this rule was if the company was taken over. In this situation the shares were valued as at the date of compulsory acquisition. To keep the analysis simple, no adjustment was made for any share issues or dividends paid. Also, no allowance was made for capital gains tax due (on any profits or losses).
Figure 2 shows the final value of the shares for each of the 100 companies – as ranked from best to worst performance. Over the ten-year period, the value of the share portfolio grew by 60 per cent from (100 × $1000 =) $100 000 to $160 100. This is equal to a 4.9 per cent compound annual growth rate. After adjusting for inflation, the real rate of return reduces to 2.1 per cent per annum. It should be noted that the actual return will vary depending on the actual time period chosen and/or whether the investor actively managed his/her share portfolio by (hopefully) buying-in during times of weakness and selling-down when prices were strong.
Notwithstanding the above, it appears that passively investing in a random portfolio of Australian junior explorers over the last decade was, on average, a break-even proposition. In practice the returns are very asymmetric – with some companies generating a huge increase in value and other companies destroying almost all of their original value. In detail, of the 100 randomly selected junior companies, 78 of them lost money for their shareholders and 22 increased in value. Of the companies that lost value, 18 of them are now worth less than one per cent of their original value. This includes six companies that went bankrupt – with no return at all. At the other extreme, the shares of the top ten companies are now collectively worth $123 557. This includes four companies which each achieved a ten-fold increase in value.
In spite of best endeavours, most junior explorers lose money for shareholders – but this is counter-balanced by the occasional spectacular success
As a general rule, over the last decade, eight out ten Australian junior companies lost money for shareholders, one out of ten broke even (or made a modest return) and one out of ten made sufficient money to pay for the failures of all of the others.
As noted before, the transition from junior explorer to junior miner is fraught with risk. With regard to the hypothetical portfolio of 100 junior companies, if the investor had sold his/her shares in the 28 companies that built mines on the date they went into production, the total value of the portfolio would be $253 743. It is recognised that some of this gain may simply be a consequence of the cyclical nature of the stock market itself (for example, over the study period the S&P/ASX 300 Metals and Mining index increased from 1900 in July 2004 to a high of 5819 in May 2008 before falling back to 3296 on 4 July 2014). Selling shares mid-way through the study period would invariably result in a higher price than holding on to them to the very end. Resolving whether or not building mines is a value-creating or a destroying step for junior companies is beyond the scope of the current study.
In spite of best endeavours, most junior explorers lose money for shareholders – but this is counter-balanced by the occasional spectacular success. This confirms the high risk/high reward nature of the exploration industry. Given the low success rate, and the inherent difficulties in predicting which company is going to perform best, it suggests that a sensible investment strategy for the public is to hold shares in a broad portfolio of companies. Rather than randomly select which companies to invest in, it is recommended that the shareholder choose those that have quality projects and quality management. Finally, the portfolio needs to be actively managed over the business cycle.
Getting back to the question of how many of the junior companies will survive the current difficult conditions: a good metric to consider is the market cap of the company. The current cash position, while obviously important, is not critical because the company can use its market cap as collateral to raise fresh funds for exploration. The only downside is that in the current depressed market, the new shares will be issued at a low price, thereby diluting the value held by the existing shareholders.
As a general rule, to meet its listing and other statuary obligations, a junior company will need to spend at least $200 000 p/a. The figure will be larger if one adds in rent, directors’ fees and employee salaries. To meet its work commitments and generate a news-flow, the company will need to spend at least $1-2 M p/a, if not more. Raising $1 million of cash through a share issue is a relatively straight-forward process if the company’s market cap is (say) $20 million. However, it is almost impossible if the current market cap is only $1 million.
Figure 3 shows the cumulative number of junior exploration companies versus their market cap as at 14 September 2014. It is significant to note that only five per cent of the Australian junior companies had a market cap of less than A$1 million, versus 26 per cent in Canada and 30 per cent elsewhere. Without the continued financial support from their key shareholders, these companies are at real risk of going under. Given this, the author’s view is that if the current adverse market conditions persist for another year, there is a real risk that five per cent of Australian juniors and a quarter of the Canadian juniors could go out of business. In other words, at least 95 per cent of the Australian juniors and three-quarters of the juniors companies elsewhere will still exist in a year’s time.
Figure 1. History of 100 randomly selected ASX-listed junior companies (June 2004 versus June 2014).
Note: The analysis is based on a random sample of 100 junior mineral exploration companies (out of ~300) listed on the ASX on 30th June 2004.
Figure 2. Value of a portfolio of $100 000 worth of shares in 100 randomly selected ASX-listed junior exploration companies (4th July 2004 versus 4th July 2014).
Note: The analysis is based on a random sample of 100 junior mineral exploration companies (out of ~300) listed on the ASX on 30th June 2004. Final value is based on share price prevailing on 4th July 2014, or on the date it was delisted from the ASX (through takeover or liquidation).
Figure 3. Cumulative number of junior explorers by market capitalisation as at 14 September 2014).
Note: Based on an analysis for 1980 publicly listed Junior Explorers – 1258 on the TSE/TSX, 589 on the ASX and 133 on other exchanges (such as the CSE, NYSE, AIM, NEC, NZE, OTC and NEC and Pink Sheets). Based on ExRate of A$1 = C$1.00 = US$0.90.
In summary, the key learning is that junior explorers are made of ‘tough stuff’ and in the author’s opinion, most of the Australian companies will weather the current ‘tough’ conditions. However, their shareholders may not be so lucky – and only a handful of companies will deliver the returns that investors’ desire.
This article was derived from a presentation titled ‘Uncovering exploration trends and the future: Where’s exploration going?’ given by the author at the International Mining and Resources (IMARC) Conference in Melbourne in September 2014. A copy of the IMARC presentation can be downloaded from www.minexconsulting.com/publications/sep2014.html
Bullock, R L, 2011. Accuracy of feasibility study evaluations would improve accountability, Mining Engineering Magazine, April 2011, pp 78-85.
McCarthy, P, 2003. Managing technical risk for mine feasibility studies, in Proceedings Mining Risk Management Conference, pp 21-28 (The Australasian Institute of Mining and Metallurgy: Melbourne).
Williams, L, 2013. Mining juniors in crisis – gold explorers particularly badly hurt, as published on MineWeb.com, 25 January 2013.