Can the TSX Venture Be Saved? - John Kaiser
Published in on February 15, 2013
Source: JT Long of The Gold Report (2/15/13)
Is the end near for the TSX Venture Exchange, the victim of "algo traders," low volume and lack of institutional investors? If newsletter writer John Kaiser is right, as many as 500 of the 1,484 resource companies listed on the Venture Exchange will go under this year due to lack of money in the bank. In this Gold Report interview, Kaiser suggests that a crowd sourced valuation system may give the investors the information they need to invest with confidence and fend off the proprietary traders.
The Gold Report: John, at the Cambridge Conference in Vancouver, you spoke about visualizing an alternative to "zombie land," the zombies being the 1,000+ companies in the resource sector trading at less than $0.20/share, which include a good number of the more than 600 companies with less than $200,000 in the bank. You predicted at least 500 would go out of business in the next year. Is this a more dire scenario than before or are there just more companies?
John Kaiser: In the junior sector, 1998–2002 was a very difficult period. Metal prices, especially gold, were weak. The Bre-X Minerals betrayal in 1997 had shattered investor confidence in the exploration acumen of the resource juniors. New and interesting exploration plays were few and far between. Area plays were dead on arrival. And the siren song of the dot-com bubble sucked away whatever risk capital remained in the hands of retail investors. That five-year bear market was a very dark time for the industry, but it survived to experience a phenomenal bull market during which TSX Venture (TSX.V) juniors raised $57 billion ($57B) and over 200 Canadian resource juniors disappeared in takeover bids worth $115B.
TGR: So with only two years into the current bear market, why the fuss?
JK: Something is disturbingly different this time. In 2008, the resource sector was blindsided by the financial crisis, followed by a sharp rebound in 2009 and 2010. A lot of companies with projects in midstream revived themselves, helped by the unexpected recovery in base metal prices and the fully expected rise in precious metals prices. Some 98 juniors were taken over in 2009–2012 through bids worth $51B. But we have been in a resource equities sector bear market since Q2/11 despite persistently high copper, gold and silver prices. Unlike 1998–2002 when the resource juniors were indeed a wasteland, today I see numerous juniors with advanced projects that should have much higher valuations if we assume today's metal prices as the new minimum reality. I also see many interesting exploration plays in whose substantial upside potential I can place bets almost for free.
"I see numerous juniors with advanced projects that should have much higher valuations."
So when you ask about 500 juniors disappearing, it strikes me as the wrong question. I believe a purge of 500 juniors would be a very healthy culling. What worries me about this second dip is that it could unleash systemic destruction of the remaining juniors, in effect the entire junior resource sector.
TGR: Before you explain your bigger concern, can you elaborate on why you seem eager to see 500 distressed juniors disappear?
JK: The TSX.V has a culture where resource juniors recycle themselves through reverse splits when their projects fail, their issued stock becomes unwieldy, and they run out of money. These rolled-back juniors refinance themselves and get a new project to start the exploration cycle all over again. Sometimes it is with the same management team; other times a new group takes over. I like this because it gives existing shareholders a shot at getting their money back and sometimes more. Over time there have been more surviving juniors than delisted defunct juniors.
These juniors used to start as an initial public offering (IPO) with a so-called project of merit. But over the last decade the Canadian brokerage industry shifted its focus to a different type of IPO called a capital pool. Since January 2000, the TSX.V listed 1,135 new capital pool companies. Many of them acquired advanced resource projects during the super-cycle boom of the last decade. Many of these companies disappeared through takeover bids. But many also acquired mediocre resource projects that had almost no chance of yielding a new discovery or were so marginal not even super-cycle metal prices could help them. Now the funding for the resource sector has dried up. Between the old group of recycled juniors and this newer crop of former capital pools, we have a glut of resource juniors.
Each one of these companies uses up about $200,000 a year in overhead just to exist as a public company. While I am fairly adept at distinguishing the pretend juniors from the serious ones, I've spent 30 years focused on this sector to acquire this skill. To quote the statistician Nate Silver, the noise is drowning out the signal for less specialized audiences. The disappearance of 500 companies would be good for the sector. It would allow investors to focus on the serious companies.
TGR: But there have always been coattail companies that owned little more than sagebrush. What is different now that has you worried about the others?
JK: During the 1980s, 1990s and even before, the story was about exploration. Juniors raised money, generated a target and drilled it. Usually, it was a dud. When it looked interesting, there would be a flurry in the stock; early investors would sell at a profit, others would have their hopes dashed, and the price would fall. The earlier investors would reinvest some of their proceeds in another junior, reseeding the exploration cycle for a new story. Those who bought late and did not sell bore the losses. Some leave in disgust, others come back smarter. Every once in a while, a stock discovery was so big that the price just kept going until a major bought out the company and developed the discovery into a mine. Metal price trends played little role in the resource junior's market cycles, which tracked macroeconomic cycles that determined risk appetite, and discovery booms, which focused risk appetite.
TGR: You frequently make the point that during the last decade the dynamic of the Canadian resource juniors underwent a big change, which you believe has turned into a trap of sorts. What was that change?
JK: During the last decade, the Canadian juniors grew up. The junior space became all about demonstrating resource feasibility for existing deposits. These were past exploration cycle failures dragged out of the woodwork and rethought in the context of prices driven higher by the China super-cycle. This required a new level of experience among resource juniors and substantially raised the bar for what counts as a serious company. The NI 43-101 disclosure regime imposed in the wake of the Bre-X scandal had an exquisite timeliness. The number-crunching aspect of feasibility demonstration in the context of rising metal prices attracted institutional capital the resource juniors had never seen. The pure exploration sector was neglected to some degree, because the new game was all about demonstrating the feasibility of existing deposits so they could be bought out by majors looking to replenish their supplies.
"The big gains in metals over the past decade have been gobbled up by substantial cost escalation—both capital and operating—in the mining sector."
This new game seems to be over. The institutional money has vacated the sector because of pessimism that the super-cycle remains intact and concern that gold may have nowhere to go but down. I am concerned that we may see structural collapse in the junior resource sector due to a vacuum created by the departure of the feasibility-oriented institutional money and the continued absence of the more exploration discovery-oriented retail investor. Juniors still working on advanced projects cannot get the funding to continue work except at horrific dilution due to low stock prices. Juniors with good exploration ideas have a hard time raising any money because the market perceives the exploration glass as worse than half empty. This situation threatens the viability of the 1,000 companies on the TSX Venture Exchange that are real, functioning companies. We may see an entire institution disappear.
TGR: Are the zombies just companies getting back into the exploration sector, doomed to fail?
JK: Some of the zombies are companies that tried very hard, but ended up short in the profitability department. The big gains in metals over the past decade have been gobbled up by substantial cost escalation—both capital and operating—in the mining sector; the profitability implied by higher metal prices has disappeared. I have seen estimates of 10% inflation compounding over the past five years. Contrast that with the 2% CPI inflation for the same period.
As an illustration, consider a gold deposit that was barely economic at $900/ounce ($90/oz) gold in 2008. Gold is currently trading nearly 80% higher at $1,610/oz. So you would think it is party time for the junior whose gold deposit was marginal at $900/oz gold. But it is not the case because if operating costs escalated 10% annually during the past five years, that $900/oz operating cost is 60% higher today or about $1,450/oz. Apply the same 10% escalation to the capital cost, which has to be incurred upfront, and you get a nasty capital expenditure explosion. Throw in tougher royalty and tax regimes imposed by financially stressed governments fixated on the phenomenal gain in the price of gold, and the economics decline further. So despite the gold price nearly doubling, many deposits are worse off today than a decade ago.
For many companies that got hold of a project, established a resource and perhaps even did a preliminary economic assessment (PEA), the projects are not viable even at current metal prices. Add into the mix the latent fear that precious metal prices are in a bubble, and it is no wonder the junior resource sector has been abandoned. Some of these projects may be recyclable a decade or so from now, but today these companies have an asset without any real value with current metal prices. A similar situation applies to the base metal sector.
TGR: What options do these companies with advanced projects have?
JK: Some of these companies are still trying to explore in the hope of finding a higher-grade core within their project that changes the economics. A good example from the 1998–2002 bear market is the Veladero gold-silver project in Argentina that looked like a bust in the wake of Bre-X because of low grades, but ongoing drilling found the sweet spot in 1998, which led to a $500 million ($500M) takeover bid by Homestake Mining Co. Today Veladero is owned by Barrick Gold Corp. (ABX:NYSE).
"What we really need is to add a fourth pillar to the existing pillars of the market."
Many juniors still have an exploration team in place, but have no money left. Unless they can come up with an extraordinary story, they cannot raise money right now. This market is not interested in incremental progress and no longer believes higher metal prices that make everything better are on the horizon. In fact, while this market will respond to a hot discovery hole, it is reluctant to place the bet on the basis of the target alone. A surprise move on the upside for gold or a big discovery by a junior in a place like Nevada that opens up potential for similar discoveries would help break the sector out of this trap.
TGR: You say that many juniors are sitting on extensive mineral systems whose apparent profitability with higher metal prices has disappeared thanks to mining cost escalation. At the same time, you appear optimistic about new discovery potential within these mineral systems. Given the adage that the best place to look for more gold is near existing gold, doesn't it seem that juniors sitting on these advanced projects that "no longer" quite make the grade should have no trouble raising capital for additional exploration?
JK: Over the last few years the gateways by which capital flows into company treasuries have been compromised. The regulators, in their zeal to protect investors, changed the rules. To do a private placement that puts money into the treasury rather than into the pockets of existing shareholders, investors must today have a net worth of $1M, excluding net equity in primary residential real estate; be somehow related to management; or willing to risk a rather formidable minimum $150,000.
Regulators are also restricting the flow of money into corporate treasuries by trying to funnel it through the brokerage industry on the premise that brokers know how to assess a client's risk profile and the risk-reward nature of a resource junior. What the regulators are really doing is setting a liability trap for the brokerage industry, which is avoiding it by shunning all but the more lucrative advanced resource juniors. Rules are being introduced that would prohibit a finder's fee being paid to third parties who are not part of the brokerage establishment. The regulators are even thinking about reducing the exemptions that allow non-brokered private placements to be done. The regulators seem focused on stopping abuses whereby stock in private companies is sold to retail investors on false premises using the private placement exemptions. Public companies that are subject to rigorous disclosure rules and enforcement are unintended roadkill in efforts to deal with a serious problem.
The brokerage industry is shifting to an asset management model where brokers stuff their client portfolios with structured products such as mutual and index funds or exotic securities like Real Estate Investment Trusts. Individual trade-based commissions are too low to justify the level of client interaction required for investments in individual resource juniors. Except for a few boutiques, the brokerage industry has become irrelevant to the resource juniors as a gateway for risk capital, especially juniors pursuing discovery-oriented exploration rather than resource feasibility demonstration.
TGR: So regulatory changes designed to protect the investor and structural changes within the brokerage industry are creating a choke point that prevents money from flowing into corporate treasuries?
JK: We have this paradox where an individual can draw down every line of credit, and impoverish him or herself by loading up on lottery tickets, put it all on red at the roulette wheel or even deposit it into a day-trading account designated as 100% high risk, but he or she is prohibited from putting it directly into the treasury of a highly regulated public company. I don't think we can change how brokerage firms operate nor should we argue that regulators worry less about protecting investors. Everybody needs to understand that the junior resource sector does involve a high level of uncertainty and investors who enter this arena must do so with eyes wide open.
TGR: This growing difficulty of putting money directly into a corporate treasury where it can be put to work to create new wealth seems at odds with what you call an unholy celebration of a trading culture divorced from fundamentals. Trading profits are understood as the reward for imposing discipline on inefficient markets, which is generally acknowledged as a positive contribution. Why are you hostile toward this trading culture in the arena of resource juniors?
JK: In principle I am not against arbitrage trading when inefficient markets offer such opportunities. After all, I style myself as a bottom-fisher and spec value hunter, which would not be a productive pursuit if the junior resource sector were efficient. One has to distinguish between structural and incidental inefficiencies. In a truly competitive environment inefficiencies erupt as brief windows of opportunity that close rapidly. I'm not talking about inside information, just the inefficient or incorrect processing of public information. Whoever spots and exploits the inefficiency first makes a profit. The ability to milk an incidental inefficiency is limited by the speed with which others notice your good fortune and edge in on it. That is a transparent market at work.
In contrast, a structural inefficiency is one that does not disappear through competition generated by its identification. It is the collaborative fleecing of a victim where the spoils are systemically shared by the so-called arbitragers who are not competing with each other, but rather collectively against the victim.
The Canadian junior resource sector has been invaded by such a structural inefficiency. The trading culture that has turned 40% of the U.S. market into algorithmic-type trading has now wandered into the Canadian junior arena. Computerized programs and human proprietary traders armed with computers are stalking the system. When money flows in, they scuffle over to it and harvest it by selling stock they do not even own, flattening the position by the end of the day. The regulators allow these "directionally neutral" accounts that have the privilege of not tagging short sales as such because the intent is to cover short positions by the end of the day.
In a traditional short account the investor places a bet based on a perceived disconnect between the market's valuation of a company and the value of the company based on fundamentals alone. Such a short seller must maintain the short position for more than a single day, and to do that he or she must borrow stock, which is not always easy to do. This type of short seller plays a valuable role in the stock market because such short positions represent useful information for the market, which is why the regulators insist that they be tagged as short sales.
TGR: Historically short selling has been restricted by the uptick rule, which stated that you cannot sell short at a price that is lower than the last different price. But American regulators eliminated the uptick rule in 2007 and the Canadian regulators have followed suit. Why do you think this is bad news for the resource juniors?
JK: The uptick rule was eliminated to facilitate high frequency trading where the goal is to arbitrage price differences between equities and various structured products such as index funds, exchange traded funds, options and futures. This requires computer assisted simultaneous buying and selling of related securities in different markets. This is impossible to do legally on a meaningful scale if the uptick rule applies to short sales in equity markets.
In the case of the resource juniors, there are few arbitrage opportunities because options only get written on a handful of stocks, only a few stocks are inter-listed on NYSE MKT and none are components of publicly traded structured products. However, in the name of competition the Canadian regulators forced the TMX Group, the parent of the TSX and TSX.V exchanges on which the resource juniors trade, to allow trading through alternative trading systems operated by third parties. Instead of just one electronic order book where the principle of first-come-first-serve rules, and transparency in market depth and trading activity is absolute, now we have a market fragmented by parallel order books. Each brokerage has its own system for routing client orders through this mess of order books. Furthermore, clients can specify into which alternative trading system their orders get placed. Both algorithmic and proprietary human traders can arbitrage these parallel order books.
The uptick rule only works when there is strict sequentiality in order execution, which continuously defines the last price traded. In such a system a sell order tagged as a short sale cannot be executed if it would be at a lower price than the last different traded price. But if orders can be executed in parallel trading systems, you cannot establish a definitive sequence of different prices so that the uptick rule can be enforced. The Canadians eliminated the uptick rule for short selling so that orders involving the same security can be transacted on competing trading platforms.
TGR: How does this create a structural inefficiency in the junior resource market?
JK: The current setup makes it possible for traders to strip out money flowing into the system without contributing any offsetting value. The rationale for accommodating algo and human prop trading is that this creates liquidity. Perversely, some of these trading systems even pay for these day trading orders while penalizing real investors putting on longer-term positions based on fundamentals. The trouble for the resource juniors is that the day traders are not interested in project fundamentals; they are focused only on volatility and capital flows. By being able to sell short stock without tagging it as such they can intercept money moving into the stock from fundamental investors. Obviously to profit they need to unwind the short position. This is just a matter of waiting for the inflow of new money to end, and then pounding the bid side of the order books with further short sale orders until the failed rally triggers a cascade of selling by despairing long shareholders, which allows the day trader's short positions to be covered the same day.
When fundamental speculators, that is, people who are betting on the fundamental outcome of whatever the company is trying to do, have to compete against such traders, the fundamental speculators disappear. This makes it difficult for the resource juniors to establish a higher trading price in response to positive fundamental developments and fund further work at those higher prices. Include the regulatory efforts to curtail the flow of private placement funding in the name of protecting investors, and you end up with the junior stuck on a dilution treadmill, issuing more stock to a shrinking pool of "accredited investors" at the same or lower prices despite making fundamental progress. Because ongoing equity financing is the key to delivering a definitive fundamental success in the form of a deposit that can be turned into a profitable mine, this "structural inefficiency" further skews the playing field in favor of traders. Allowing these supposed liquidity creators into the system has actually caused liquidity to evaporate.
The end game for this situation is that eventually fundamentals-oriented investors will withdraw entirely from the junior resource sector, leaving only the algo and human prop traders to battle each other. That may create the appearance of a thriving market for a while, but none of the capital in play flows into corporate treasuries. If the companies cannot produce fundamental successes, there is no reason for investors seeking winning bets on fundamental outcomes to pay attention to the junior resource sector. Furthermore, these day traders have become pretty good at recognizing when they are battling each other. Once it becomes apparent that they are cannibalizing each other rather than preying on real investors, they flee. Then there will be only very large spreads with little stock on either the bid or offer side, in effect a dead market. This is the institutional failure of the Canadian junior resource market that I fear.
TGR: You mentioned earlier that a higher gold price or a major discovery with "me too" implications could turn around the bearish sentiment clouding the resource juniors. But during your conference keynote you indicated that this time you believe a simple change in market mood is not enough to save the sector. Why should we not just dismiss this as the usual grumbling during a bear market bottom?
JK: There has been much discussion about computer-driven high-frequency trading on the TSX and TSX.V, but the reality is that the liquidity is too low to support algo trading on a widespread scale. The problem I described today mainly involves human traders who may be using computers to sniff out capital harvesting opportunities and design trading strategies. If we get a bull market these human day traders would get blown away. However, the technology infrastructure is now in place to allow massively scaled up pure algo trading to kick in if and when a bull market tries to come to life. The Canadian resource juniors have never experienced a trading storm of this magnitude, which I fear would suffocate future bull markets in this sector.
TGR: At the conference, you called the TSX Venture Exchange "an online video game populated by algowarriors battling with fundamentals-based traders left as roadkill in the volatile swings." What can change the Venture Exchange into a transparent, functioning vehicle for funding companies that can reward investors?
JK: The biggest problem with the resource juniors is that, as Rick Rule likes to say, they have no intrinsic value, they have neither revenue nor cash flow. They are venture capital companies trying to demonstrate that they have an asset that, someday, will generate cash flow. Until a mine is in production, it has no intrinsic value; it has only potential value.
The larger markets can handle algorithmic trading because the volatility swings around an externalized valuation created by analysts who extrapolate from financial information such as revenues and cash flow. But for these fragile creatures called exploration juniors, the potential outcome sits in the imaginations of the company's management and of the speculators who are buying the stock in the hope of something like a 5-million-ounce (5 Moz) gold deposit discovery with a good grade. There is no externalized valuation available except at discrete, widely spaced intervals when NI 43-101 resource estimates and economic studies are published. The absence of a continuous publicly available valuation that serves as a reference point for the market makes these resource juniors so vulnerable to the destructive predations of algo and human prop traders.
The regulators are not going to return the uptick rule for short selling. Algorithmic trading will not be eliminated. It may be possible to introduce some friction by charging algorithmic traders a fee when they place an order; that might prevent trading from deteriorating into battles between algo traders.
What we really need is to add a fourth pillar to the existing pillars of the market (the TSX Venture Exchange), the regulatory system (IIROC and NI 43-101) and the companies. This fourth pillar would visualize the potential outcome for exploration and development projects on a real-time basis that bridges the time gaps between exploration results, NI 43-101 resource estimates and economic studies. We need a floating externalized valuation point that responds to new information and changing perceptions about the future fundamental outcome of these resource projects. We need to see the deposit and its likely mine as imagined by the market.
Then when the proprietary traders arrive, the fundamental investors will have an externalized value of the company's potential, which they can contrast with the valuation assigned by the market. When the proprietary traders try to strip capital by manufacturing volatility, the fundamental investors can sell when the proprietary traders push the price too high, and buy when they push it too low. In such a world the algo/prop traders can co-exist with the fundamentals oriented investors. In fact, I would expect the algo traders to incorporate this value visualization universe into their trading strategies. Instead of smashing around like bulls in a china shop, the algos would be trading the swings within a narrower band around an equilibrium valuation.
TGR: What would this fourth pillar look like?
JK: I imagine an online system with registered members, similar to all these online gaming systems, that enables its members to construct an imaginary deposit, attach the likely costs for that deposit's most plausible mining scenario and run it through the discounted cash-flow model to come up with two numbers. The first is a net present value (NPV), which defines what a project would be worth if it was going into production tomorrow, and the second is the internal rate of return (IRR), which indicates whether anybody would fund that project into production. I'm interested in simple back of the napkin versions, especially for projects that are still awaiting their first economic study produced by independent qualified professionals.
When only one person does this type of economic visualization it is not very meaningful, because the uncertainty margin is very high. But if a number of people do it for the same project, there will be a distribution of perceptions whose range is constrained by the fundamental information generated by the company under NI 43-101 disclosure rules. Within that range there will be a clustering effect as various members bring their experience to bear in extrapolating the geological information. If these visualizations are posted to an online system open to the public, and then aggregated to create a wisdom of crowds type of consensus for a particular project, then we will have an externalized potential outcome that captures the perceptions and expectations of the fundamentals-oriented audience.
This knowledge structure becomes the basis for thinking about the project fundamentals while simultaneously linking it to the market's valuation of the project. Today we have a situation where the market's valuation does not seem to be linked to anything fundamental; the fourth pillar would restore this relationship without needing to roll back the clock on trading technology. Each project would become a node for a vast social network focused on speculating on resource sector projects.
TGR: Of what use is an outcome visualization that cranks out a $1B NPV with a 20% IRR for your imaginary 5 Moz gold deposit? How do you relate that to a junior whose potential 5 Moz gold discovery has a single drill hole into an anomaly?
JK: The $1B outcome visualization would not make any sense unless there was a way to make it reflect the uncertainty of delivering that outcome. My rational speculation model applies an uncertainty ladder to nine stages of the exploration-development cycle. For example, at the grassroots stage the chance that a property will deliver what you think it ought to host is 0.5–1%. That chance has jumped to 2.5–5% by the time there is a discovery hole. Upon delivery of a preliminary economic study, the chance has jumped to a range of 10–25%. The exploration cycle is an information gathering/uncertainty reduction process that gradually restricts one's imagination until there is an operating mine.
The price one should be willing to pay at the current exploration stage should discount the reward you expect if the project makes it through all the stages intact as visualized. That discount is the uncertainty. So if you visualize a $1B outcome for a project with a discovery hole, the fair value would be $25–50M, or 2.5–5% of $1B. If you accept the uncertainty ladder as a valuation framework, you can use it to determine if the value implied by the market is above, below or within the discounted fair value range for your visualized outcome.
TGR: What would keep the visualized outcomes from being manipulated?
JK: The beauty of an open system like this is its transparency about the builders' assumptions for a particular project, as well as their construction history. A system like this, with a back-end that can compute and generate statistics about how the aggregate visualization is constructed, and which lets you drill down into details as well as a participant's history, will let you see where the builder sits in the spectrum between pumper and basher. You would even be able to discern builder alliances within this information-rich online world. Members can tag specific assumptions with notes. Newsletter writers could create content describing the trends and drama. The whole system would have a self-correcting nature where every basher build attracts a pumper build in the middle of which will emerge thoughtful builds done by an army of retired geologists and mine engineers.
It could turn into an online game, where the shorts and the longs attack each other and create positive and negative scenarios for a potential outcome. The larger audience of people who do not care to imagine the details of a project will be able to see the consensus view. That consensus, of course, will change over time. Whenever there is new information, the visualization, and the market valuation, will change.
This would give a structure to the junior resource sector it now lacks in the absence of any real analytical coverage. The brokerage industry provides so-so coverage of companies it has financed. The newsletter community, myself included, is very sparse and dispersed. A central system harnessing the wisdom of crowds would create a solid structure and offset the trading culture that now haunts the whole market.
TGR: It sounds a little like Yelp with numbers. People would contribute their opinions, investors would read it all and come to their own conclusions.
JK: It would be similar to Yelp, except that criticism or praise would not be referring to something no one else witnessed. It would refer to the decisions the builders have made in crafting their outcome visualization. I am talking about a major perception capture system that can be studied from many angles. Both building and observing would be very educational about what makes geology and mining tick. This would help overcome the fallout of the Bre-X betrayal in 1997, after which the retail investor lost touch with the resource sector. Although the sector has always had the attention of gold enthusiasts, the narrative over the last decade has been one of pending collapse and higher gold prices.
The retail investor no longer views gold companies as a proxy for gold. The audience has shifted to owning physical gold and maybe a gold exchange-traded fund. If we get a higher real price for gold, that is, not one accompanied by fiat currency collapse and soaring costs, investors will rediscover the gold producers because they know how to think about revenues and cash flow. But the preproduction juniors will remain orphans because few investors know how to think about them, and even if they do, they lack efficient means to do so, and no one to share the fruit of their labor. A crowdsourcing system, which forces people to make best guess choices based on numbers, would haul investors up the learning curve very quickly, and empower them with a productivity whose sharing creates a collective output worth far more than the sum of the inputs.
This system also provides an outlet for the generation of geologists and mining engineers about to retire. They can come up with a pseudonym and be an expert within the system. They could critique others' visualizations, point out where someone has missed the metallurgical problems. It would become a vibrant conversation outside the one the regulators allow the company to have, especially when it comes to quantifying potential.
TGR: A number of the rules you mentioned—who is a qualified investor for private placements and feasibility studies—were intended to increase investor confidence in the TSX Venture Exchange. Would your new system of crowdsourced valuation add another level of confidence and bring people back to the Venture Exchange?
JK: I think it would help enormously. I believe it would draw larger pools of capital interested in speculation, as opposed to investing for cash flow and return. Potential investors are able to see high-quality data produced by the companies under the NI 43-101 regulatory rules. Then, investors could look at this crowd of visualizers quantifying and sharing their perceptions on the project data, the gold price, geopolitical risk and so on.
It would be similar to the sports arena. People bet huge amounts of money on who will win the Super Bowl or the World Series. They use information and statistics to handicap the competition and place their bets. In my view this is a tragic waste.
A conventional gambling system is simply the redistribution of existing wealth minus the leakage of the gambling system operators. My crowdsourcing idea is different, in that some of the money flows into the companies' treasuries, where it can be used to create new wealth.
The junior resource sector would benefit because the data-driven contextualization will funnel capital into the companies with better prospects. It will eliminate the 500 companies we talked about earlier, whose only purpose is to suck up money and waste it on overhead while pretending to explore.
Money will be invested in companies that have done the work to prepare their targets, in companies in which the investor audience trusts management to raise capital and spend it on testing the targets.
TGR: You have been talking about this being "an ideal time for a bottom fisher." If 500 companies are likely to go out of business this year, how do you determine which ones will survive?
JK: One criterion to look for is companies that still have lots of money. Filter on working capital and verify that the company will not have to finance at today's low prices. The search engine at Kaiser Research Online does this and a lot more.
First, look for projects that have interesting potential and experienced management teams. This is a good time to look for companies that are roadkill as a result of the general bear-market conditions. I look for companies with interesting stories that are down and out.
An interesting example is Namibia Rare Earths Inc. (NRE:TSX, NMREF:OTCQX), which is trading at its cash breakup value. Its $18M treasury was raised during the rare earth boom to fund exploration at its Lofdal project in Namibia. Instead of delivering a monster rare earth deposit, Namibia delivered a small, low-grade deposit at Area 4 with a very high 86% enrichment in the heavy rare earths. The property has potential to yield additional similar zones, but the current resource is sufficient as a potential near-term solution to non-Chinese demand for heavy rare earths such as dysprosium, terbium and yttrium.
Although the dominant mineral is xenotime, it is in a fine-grained form interwoven with thorium and zircon. The junior is conducting metallurgical studies to see if the heavy rare earths can be liberated in a cost-effective manner. This bench scale study is not expensive, will be completed in Q2/13 and will dictate if Area 4 proceeds to the PEA stage. Because the rare earth sector is currently in the dumps, speculators get the outcome of this program for free. Either management gets a green light to fast-track Area 4 as a short-term heavy rare earth supply solution, or it gets a red light, which signals it to look for other projects in Namibia where it has established itself. Namibia is operated by the Africa-experienced team of Gerry McConnell and Don Burton, and backed by the mining finance house Endeavour Mining Corp. (EDV:TSX; EVR:ASX).
Second, look for projects that already have PEA-level or higher disclosure. I think we are through the worst of the cost escalation. If perceptions shift to where everybody expects metal prices to do nothing worse than stay flat, with the trend bias to the upside, a lot of advanced projects will rebound as the perspective shifts from glass-half-empty to glass-half-full.
International Enexco Ltd. (IEC:TSX.V; IEXCF:OTCQX; I6E:FSE) is an example of a dual-pronged strategy that offers speculators a macroeconomic bet on the direction of copper prices through the advanced Contact project in Nevada and a bet on the potential for a high-grade uranium discovery at Mann Lake in the Athabasca Basin. During the past year Enexco has focused on expanding its mining model for its Contact copper deposit after acquiring adjacent claims that allow it to deploy a large pit design. Contact is a modest, low-grade deposit with an in situ value of $5B at the current copper price, but a low rock value of $20/tonne. Enexco plans to deliver a feasibility study during 2013 for a solvent extraction and electrowinning mining operation. The NPV will not be high because of the project's scale, but at the current stock price the market is assigning a value of only $20M to the project. The exit strategy will not be a buyout by a big copper producer; if the feasibility study is positive, development funding could come from yield-hungry private equity.
For substantial upside, speculators should keep their eye on the 30%-owned Mann Lake project where Cameco Corp. (CCO:TSX; CCJ:NYSE) has initiated a 21,000 meter drill program to further test a target area where a short high-grade uranium interval helped Enexco to a $4.50/share peak in 2007 during the uranium bubble. Enexco's share of the program has been funded through an equity financing by Denison Mines Corp. (DML:TSX; DNN:NYSE.MKT), which recently struck a buyout deal for part of Fission Energy Corp.'s (FIS:TSX.V; FSSIF:OTCQX) assets.
Finally, with regard to the exploration juniors, discovery exploration will be the game for the next couple of years. Although I hope for it, I doubt we will see significant metal price gains in the near term. If that is the case, money will want to go into discoveries where investors are not certain of the valuation limit, where the sky is the limit until the drill ceases intersecting ore grade mineralization. Of course, a discovery only counts as such if the grade will work very well at current metal prices and can handle a 25% decline.
Orsa Ventures Corp. (ORN:TSX.V) has a 100% option on the Quartz Mountain gold deposit in Oregon from Seabridge Resources Inc. (SEA:TSX; SA:NYSE.MKT), which gathered up the failures of past exploration cycles during the dark years of 1998–2002. Orsa has spent the past couple of years compiling historical data and conducting verification drilling with two goals in mind. The first is to deliver an NI-43-101-compliant resource, which it did in February 2012 when it reported a low-grade inferred oxide resource of 1.3 Moz with a rock value of $33/tonne at spot gold, and a somewhat better grade sulphide resource of 1.5 Moz with a rock value of $55/tonne.
In situ rock values are not the same as recoverable rock values, so Orsa is also conducting metallurgical studies as a prelude to completing a PEA for the existing resource. The value assigned to the outcome of the first goal will ultimately depend on where gold prices are headed and what the costs are for developing the existing resource. The second goal is to rethink and test the exploration potential of Quartz Mountain for additional, ideally higher-grade mineralization, either near surface elsewhere on the project, or deeper underneath the existing resource. Success on this front would shift the development focus for Orsa and expand the upside valuation limit.
TGR: Could one big discovery make a big difference in the stock prices of a lot of these junior companies?
JK: Yes. It would be ideal if the windfall came in one of these companies with a lot of people owning the stock, one that starts off from near dead, only to rise into a monster success story for all the right reasons. The companies I mentioned are all examples of juniors that I regard as having the potential to deliver a home run that switches the market's glass back to half full.
TGR: John, thank you for your time and your insights.
Readers can hear John Kaiser speak at the California Resource Investment Conference at Palm Springs, Calif., Feb. 23-24, 2013. Click here for more information and to register.
John Kaiser, a mining analyst with 25+ years of experience, produces Kaiser Research Online. After graduating from the University of British Columbia in 1982, he joined Continental Carlisle Douglas as a research assistant. Six years later, he moved to Pacific International Securities as research director, and also became a registered investment adviser. He moved to the U.S. with his family in 1994.
Want to read more Gold Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Interviews page.
DISCLOSURE:
1) JT Long of The Gold Report conducted this interview. She personally and/or her family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Namibia Rare Earths Inc., International Enexco Ltd. and Orsa Ventures Corp. Fission Energy Inc. is a sponsor of The Energy Report. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) John Kaiser: I personally and/or my family own shares of the following companies mentioned in this interview: International Enexco Ltd. and Orsa Ventures Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
Is the end near for the TSX Venture Exchange, the victim of "algo traders," low volume and lack of institutional investors? If newsletter writer John Kaiser is right, as many as 500 of the 1,484 resource companies listed on the Venture Exchange will go under this year due to lack of money in the bank. In this Gold Report interview, Kaiser suggests that a crowd sourced valuation system may give the investors the information they need to invest with confidence and fend off the proprietary traders.
The Gold Report: John, at the Cambridge Conference in Vancouver, you spoke about visualizing an alternative to "zombie land," the zombies being the 1,000+ companies in the resource sector trading at less than $0.20/share, which include a good number of the more than 600 companies with less than $200,000 in the bank. You predicted at least 500 would go out of business in the next year. Is this a more dire scenario than before or are there just more companies?
John Kaiser: In the junior sector, 1998–2002 was a very difficult period. Metal prices, especially gold, were weak. The Bre-X Minerals betrayal in 1997 had shattered investor confidence in the exploration acumen of the resource juniors. New and interesting exploration plays were few and far between. Area plays were dead on arrival. And the siren song of the dot-com bubble sucked away whatever risk capital remained in the hands of retail investors. That five-year bear market was a very dark time for the industry, but it survived to experience a phenomenal bull market during which TSX Venture (TSX.V) juniors raised $57 billion ($57B) and over 200 Canadian resource juniors disappeared in takeover bids worth $115B.
TGR: So with only two years into the current bear market, why the fuss?
JK: Something is disturbingly different this time. In 2008, the resource sector was blindsided by the financial crisis, followed by a sharp rebound in 2009 and 2010. A lot of companies with projects in midstream revived themselves, helped by the unexpected recovery in base metal prices and the fully expected rise in precious metals prices. Some 98 juniors were taken over in 2009–2012 through bids worth $51B. But we have been in a resource equities sector bear market since Q2/11 despite persistently high copper, gold and silver prices. Unlike 1998–2002 when the resource juniors were indeed a wasteland, today I see numerous juniors with advanced projects that should have much higher valuations if we assume today's metal prices as the new minimum reality. I also see many interesting exploration plays in whose substantial upside potential I can place bets almost for free.
"I see numerous juniors with advanced projects that should have much higher valuations."
So when you ask about 500 juniors disappearing, it strikes me as the wrong question. I believe a purge of 500 juniors would be a very healthy culling. What worries me about this second dip is that it could unleash systemic destruction of the remaining juniors, in effect the entire junior resource sector.
TGR: Before you explain your bigger concern, can you elaborate on why you seem eager to see 500 distressed juniors disappear?
JK: The TSX.V has a culture where resource juniors recycle themselves through reverse splits when their projects fail, their issued stock becomes unwieldy, and they run out of money. These rolled-back juniors refinance themselves and get a new project to start the exploration cycle all over again. Sometimes it is with the same management team; other times a new group takes over. I like this because it gives existing shareholders a shot at getting their money back and sometimes more. Over time there have been more surviving juniors than delisted defunct juniors.
These juniors used to start as an initial public offering (IPO) with a so-called project of merit. But over the last decade the Canadian brokerage industry shifted its focus to a different type of IPO called a capital pool. Since January 2000, the TSX.V listed 1,135 new capital pool companies. Many of them acquired advanced resource projects during the super-cycle boom of the last decade. Many of these companies disappeared through takeover bids. But many also acquired mediocre resource projects that had almost no chance of yielding a new discovery or were so marginal not even super-cycle metal prices could help them. Now the funding for the resource sector has dried up. Between the old group of recycled juniors and this newer crop of former capital pools, we have a glut of resource juniors.
Each one of these companies uses up about $200,000 a year in overhead just to exist as a public company. While I am fairly adept at distinguishing the pretend juniors from the serious ones, I've spent 30 years focused on this sector to acquire this skill. To quote the statistician Nate Silver, the noise is drowning out the signal for less specialized audiences. The disappearance of 500 companies would be good for the sector. It would allow investors to focus on the serious companies.
TGR: But there have always been coattail companies that owned little more than sagebrush. What is different now that has you worried about the others?
JK: During the 1980s, 1990s and even before, the story was about exploration. Juniors raised money, generated a target and drilled it. Usually, it was a dud. When it looked interesting, there would be a flurry in the stock; early investors would sell at a profit, others would have their hopes dashed, and the price would fall. The earlier investors would reinvest some of their proceeds in another junior, reseeding the exploration cycle for a new story. Those who bought late and did not sell bore the losses. Some leave in disgust, others come back smarter. Every once in a while, a stock discovery was so big that the price just kept going until a major bought out the company and developed the discovery into a mine. Metal price trends played little role in the resource junior's market cycles, which tracked macroeconomic cycles that determined risk appetite, and discovery booms, which focused risk appetite.
TGR: You frequently make the point that during the last decade the dynamic of the Canadian resource juniors underwent a big change, which you believe has turned into a trap of sorts. What was that change?
JK: During the last decade, the Canadian juniors grew up. The junior space became all about demonstrating resource feasibility for existing deposits. These were past exploration cycle failures dragged out of the woodwork and rethought in the context of prices driven higher by the China super-cycle. This required a new level of experience among resource juniors and substantially raised the bar for what counts as a serious company. The NI 43-101 disclosure regime imposed in the wake of the Bre-X scandal had an exquisite timeliness. The number-crunching aspect of feasibility demonstration in the context of rising metal prices attracted institutional capital the resource juniors had never seen. The pure exploration sector was neglected to some degree, because the new game was all about demonstrating the feasibility of existing deposits so they could be bought out by majors looking to replenish their supplies.
"The big gains in metals over the past decade have been gobbled up by substantial cost escalation—both capital and operating—in the mining sector."
This new game seems to be over. The institutional money has vacated the sector because of pessimism that the super-cycle remains intact and concern that gold may have nowhere to go but down. I am concerned that we may see structural collapse in the junior resource sector due to a vacuum created by the departure of the feasibility-oriented institutional money and the continued absence of the more exploration discovery-oriented retail investor. Juniors still working on advanced projects cannot get the funding to continue work except at horrific dilution due to low stock prices. Juniors with good exploration ideas have a hard time raising any money because the market perceives the exploration glass as worse than half empty. This situation threatens the viability of the 1,000 companies on the TSX Venture Exchange that are real, functioning companies. We may see an entire institution disappear.
TGR: Are the zombies just companies getting back into the exploration sector, doomed to fail?
JK: Some of the zombies are companies that tried very hard, but ended up short in the profitability department. The big gains in metals over the past decade have been gobbled up by substantial cost escalation—both capital and operating—in the mining sector; the profitability implied by higher metal prices has disappeared. I have seen estimates of 10% inflation compounding over the past five years. Contrast that with the 2% CPI inflation for the same period.
As an illustration, consider a gold deposit that was barely economic at $900/ounce ($90/oz) gold in 2008. Gold is currently trading nearly 80% higher at $1,610/oz. So you would think it is party time for the junior whose gold deposit was marginal at $900/oz gold. But it is not the case because if operating costs escalated 10% annually during the past five years, that $900/oz operating cost is 60% higher today or about $1,450/oz. Apply the same 10% escalation to the capital cost, which has to be incurred upfront, and you get a nasty capital expenditure explosion. Throw in tougher royalty and tax regimes imposed by financially stressed governments fixated on the phenomenal gain in the price of gold, and the economics decline further. So despite the gold price nearly doubling, many deposits are worse off today than a decade ago.
For many companies that got hold of a project, established a resource and perhaps even did a preliminary economic assessment (PEA), the projects are not viable even at current metal prices. Add into the mix the latent fear that precious metal prices are in a bubble, and it is no wonder the junior resource sector has been abandoned. Some of these projects may be recyclable a decade or so from now, but today these companies have an asset without any real value with current metal prices. A similar situation applies to the base metal sector.
TGR: What options do these companies with advanced projects have?
JK: Some of these companies are still trying to explore in the hope of finding a higher-grade core within their project that changes the economics. A good example from the 1998–2002 bear market is the Veladero gold-silver project in Argentina that looked like a bust in the wake of Bre-X because of low grades, but ongoing drilling found the sweet spot in 1998, which led to a $500 million ($500M) takeover bid by Homestake Mining Co. Today Veladero is owned by Barrick Gold Corp. (ABX:NYSE).
"What we really need is to add a fourth pillar to the existing pillars of the market."
Many juniors still have an exploration team in place, but have no money left. Unless they can come up with an extraordinary story, they cannot raise money right now. This market is not interested in incremental progress and no longer believes higher metal prices that make everything better are on the horizon. In fact, while this market will respond to a hot discovery hole, it is reluctant to place the bet on the basis of the target alone. A surprise move on the upside for gold or a big discovery by a junior in a place like Nevada that opens up potential for similar discoveries would help break the sector out of this trap.
TGR: You say that many juniors are sitting on extensive mineral systems whose apparent profitability with higher metal prices has disappeared thanks to mining cost escalation. At the same time, you appear optimistic about new discovery potential within these mineral systems. Given the adage that the best place to look for more gold is near existing gold, doesn't it seem that juniors sitting on these advanced projects that "no longer" quite make the grade should have no trouble raising capital for additional exploration?
JK: Over the last few years the gateways by which capital flows into company treasuries have been compromised. The regulators, in their zeal to protect investors, changed the rules. To do a private placement that puts money into the treasury rather than into the pockets of existing shareholders, investors must today have a net worth of $1M, excluding net equity in primary residential real estate; be somehow related to management; or willing to risk a rather formidable minimum $150,000.
Regulators are also restricting the flow of money into corporate treasuries by trying to funnel it through the brokerage industry on the premise that brokers know how to assess a client's risk profile and the risk-reward nature of a resource junior. What the regulators are really doing is setting a liability trap for the brokerage industry, which is avoiding it by shunning all but the more lucrative advanced resource juniors. Rules are being introduced that would prohibit a finder's fee being paid to third parties who are not part of the brokerage establishment. The regulators are even thinking about reducing the exemptions that allow non-brokered private placements to be done. The regulators seem focused on stopping abuses whereby stock in private companies is sold to retail investors on false premises using the private placement exemptions. Public companies that are subject to rigorous disclosure rules and enforcement are unintended roadkill in efforts to deal with a serious problem.
The brokerage industry is shifting to an asset management model where brokers stuff their client portfolios with structured products such as mutual and index funds or exotic securities like Real Estate Investment Trusts. Individual trade-based commissions are too low to justify the level of client interaction required for investments in individual resource juniors. Except for a few boutiques, the brokerage industry has become irrelevant to the resource juniors as a gateway for risk capital, especially juniors pursuing discovery-oriented exploration rather than resource feasibility demonstration.
TGR: So regulatory changes designed to protect the investor and structural changes within the brokerage industry are creating a choke point that prevents money from flowing into corporate treasuries?
JK: We have this paradox where an individual can draw down every line of credit, and impoverish him or herself by loading up on lottery tickets, put it all on red at the roulette wheel or even deposit it into a day-trading account designated as 100% high risk, but he or she is prohibited from putting it directly into the treasury of a highly regulated public company. I don't think we can change how brokerage firms operate nor should we argue that regulators worry less about protecting investors. Everybody needs to understand that the junior resource sector does involve a high level of uncertainty and investors who enter this arena must do so with eyes wide open.
TGR: This growing difficulty of putting money directly into a corporate treasury where it can be put to work to create new wealth seems at odds with what you call an unholy celebration of a trading culture divorced from fundamentals. Trading profits are understood as the reward for imposing discipline on inefficient markets, which is generally acknowledged as a positive contribution. Why are you hostile toward this trading culture in the arena of resource juniors?
JK: In principle I am not against arbitrage trading when inefficient markets offer such opportunities. After all, I style myself as a bottom-fisher and spec value hunter, which would not be a productive pursuit if the junior resource sector were efficient. One has to distinguish between structural and incidental inefficiencies. In a truly competitive environment inefficiencies erupt as brief windows of opportunity that close rapidly. I'm not talking about inside information, just the inefficient or incorrect processing of public information. Whoever spots and exploits the inefficiency first makes a profit. The ability to milk an incidental inefficiency is limited by the speed with which others notice your good fortune and edge in on it. That is a transparent market at work.
In contrast, a structural inefficiency is one that does not disappear through competition generated by its identification. It is the collaborative fleecing of a victim where the spoils are systemically shared by the so-called arbitragers who are not competing with each other, but rather collectively against the victim.
The Canadian junior resource sector has been invaded by such a structural inefficiency. The trading culture that has turned 40% of the U.S. market into algorithmic-type trading has now wandered into the Canadian junior arena. Computerized programs and human proprietary traders armed with computers are stalking the system. When money flows in, they scuffle over to it and harvest it by selling stock they do not even own, flattening the position by the end of the day. The regulators allow these "directionally neutral" accounts that have the privilege of not tagging short sales as such because the intent is to cover short positions by the end of the day.
In a traditional short account the investor places a bet based on a perceived disconnect between the market's valuation of a company and the value of the company based on fundamentals alone. Such a short seller must maintain the short position for more than a single day, and to do that he or she must borrow stock, which is not always easy to do. This type of short seller plays a valuable role in the stock market because such short positions represent useful information for the market, which is why the regulators insist that they be tagged as short sales.
TGR: Historically short selling has been restricted by the uptick rule, which stated that you cannot sell short at a price that is lower than the last different price. But American regulators eliminated the uptick rule in 2007 and the Canadian regulators have followed suit. Why do you think this is bad news for the resource juniors?
JK: The uptick rule was eliminated to facilitate high frequency trading where the goal is to arbitrage price differences between equities and various structured products such as index funds, exchange traded funds, options and futures. This requires computer assisted simultaneous buying and selling of related securities in different markets. This is impossible to do legally on a meaningful scale if the uptick rule applies to short sales in equity markets.
In the case of the resource juniors, there are few arbitrage opportunities because options only get written on a handful of stocks, only a few stocks are inter-listed on NYSE MKT and none are components of publicly traded structured products. However, in the name of competition the Canadian regulators forced the TMX Group, the parent of the TSX and TSX.V exchanges on which the resource juniors trade, to allow trading through alternative trading systems operated by third parties. Instead of just one electronic order book where the principle of first-come-first-serve rules, and transparency in market depth and trading activity is absolute, now we have a market fragmented by parallel order books. Each brokerage has its own system for routing client orders through this mess of order books. Furthermore, clients can specify into which alternative trading system their orders get placed. Both algorithmic and proprietary human traders can arbitrage these parallel order books.
The uptick rule only works when there is strict sequentiality in order execution, which continuously defines the last price traded. In such a system a sell order tagged as a short sale cannot be executed if it would be at a lower price than the last different traded price. But if orders can be executed in parallel trading systems, you cannot establish a definitive sequence of different prices so that the uptick rule can be enforced. The Canadians eliminated the uptick rule for short selling so that orders involving the same security can be transacted on competing trading platforms.
TGR: How does this create a structural inefficiency in the junior resource market?
JK: The current setup makes it possible for traders to strip out money flowing into the system without contributing any offsetting value. The rationale for accommodating algo and human prop trading is that this creates liquidity. Perversely, some of these trading systems even pay for these day trading orders while penalizing real investors putting on longer-term positions based on fundamentals. The trouble for the resource juniors is that the day traders are not interested in project fundamentals; they are focused only on volatility and capital flows. By being able to sell short stock without tagging it as such they can intercept money moving into the stock from fundamental investors. Obviously to profit they need to unwind the short position. This is just a matter of waiting for the inflow of new money to end, and then pounding the bid side of the order books with further short sale orders until the failed rally triggers a cascade of selling by despairing long shareholders, which allows the day trader's short positions to be covered the same day.
When fundamental speculators, that is, people who are betting on the fundamental outcome of whatever the company is trying to do, have to compete against such traders, the fundamental speculators disappear. This makes it difficult for the resource juniors to establish a higher trading price in response to positive fundamental developments and fund further work at those higher prices. Include the regulatory efforts to curtail the flow of private placement funding in the name of protecting investors, and you end up with the junior stuck on a dilution treadmill, issuing more stock to a shrinking pool of "accredited investors" at the same or lower prices despite making fundamental progress. Because ongoing equity financing is the key to delivering a definitive fundamental success in the form of a deposit that can be turned into a profitable mine, this "structural inefficiency" further skews the playing field in favor of traders. Allowing these supposed liquidity creators into the system has actually caused liquidity to evaporate.
The end game for this situation is that eventually fundamentals-oriented investors will withdraw entirely from the junior resource sector, leaving only the algo and human prop traders to battle each other. That may create the appearance of a thriving market for a while, but none of the capital in play flows into corporate treasuries. If the companies cannot produce fundamental successes, there is no reason for investors seeking winning bets on fundamental outcomes to pay attention to the junior resource sector. Furthermore, these day traders have become pretty good at recognizing when they are battling each other. Once it becomes apparent that they are cannibalizing each other rather than preying on real investors, they flee. Then there will be only very large spreads with little stock on either the bid or offer side, in effect a dead market. This is the institutional failure of the Canadian junior resource market that I fear.
TGR: You mentioned earlier that a higher gold price or a major discovery with "me too" implications could turn around the bearish sentiment clouding the resource juniors. But during your conference keynote you indicated that this time you believe a simple change in market mood is not enough to save the sector. Why should we not just dismiss this as the usual grumbling during a bear market bottom?
JK: There has been much discussion about computer-driven high-frequency trading on the TSX and TSX.V, but the reality is that the liquidity is too low to support algo trading on a widespread scale. The problem I described today mainly involves human traders who may be using computers to sniff out capital harvesting opportunities and design trading strategies. If we get a bull market these human day traders would get blown away. However, the technology infrastructure is now in place to allow massively scaled up pure algo trading to kick in if and when a bull market tries to come to life. The Canadian resource juniors have never experienced a trading storm of this magnitude, which I fear would suffocate future bull markets in this sector.
TGR: At the conference, you called the TSX Venture Exchange "an online video game populated by algowarriors battling with fundamentals-based traders left as roadkill in the volatile swings." What can change the Venture Exchange into a transparent, functioning vehicle for funding companies that can reward investors?
JK: The biggest problem with the resource juniors is that, as Rick Rule likes to say, they have no intrinsic value, they have neither revenue nor cash flow. They are venture capital companies trying to demonstrate that they have an asset that, someday, will generate cash flow. Until a mine is in production, it has no intrinsic value; it has only potential value.
The larger markets can handle algorithmic trading because the volatility swings around an externalized valuation created by analysts who extrapolate from financial information such as revenues and cash flow. But for these fragile creatures called exploration juniors, the potential outcome sits in the imaginations of the company's management and of the speculators who are buying the stock in the hope of something like a 5-million-ounce (5 Moz) gold deposit discovery with a good grade. There is no externalized valuation available except at discrete, widely spaced intervals when NI 43-101 resource estimates and economic studies are published. The absence of a continuous publicly available valuation that serves as a reference point for the market makes these resource juniors so vulnerable to the destructive predations of algo and human prop traders.
The regulators are not going to return the uptick rule for short selling. Algorithmic trading will not be eliminated. It may be possible to introduce some friction by charging algorithmic traders a fee when they place an order; that might prevent trading from deteriorating into battles between algo traders.
What we really need is to add a fourth pillar to the existing pillars of the market (the TSX Venture Exchange), the regulatory system (IIROC and NI 43-101) and the companies. This fourth pillar would visualize the potential outcome for exploration and development projects on a real-time basis that bridges the time gaps between exploration results, NI 43-101 resource estimates and economic studies. We need a floating externalized valuation point that responds to new information and changing perceptions about the future fundamental outcome of these resource projects. We need to see the deposit and its likely mine as imagined by the market.
Then when the proprietary traders arrive, the fundamental investors will have an externalized value of the company's potential, which they can contrast with the valuation assigned by the market. When the proprietary traders try to strip capital by manufacturing volatility, the fundamental investors can sell when the proprietary traders push the price too high, and buy when they push it too low. In such a world the algo/prop traders can co-exist with the fundamentals oriented investors. In fact, I would expect the algo traders to incorporate this value visualization universe into their trading strategies. Instead of smashing around like bulls in a china shop, the algos would be trading the swings within a narrower band around an equilibrium valuation.
TGR: What would this fourth pillar look like?
JK: I imagine an online system with registered members, similar to all these online gaming systems, that enables its members to construct an imaginary deposit, attach the likely costs for that deposit's most plausible mining scenario and run it through the discounted cash-flow model to come up with two numbers. The first is a net present value (NPV), which defines what a project would be worth if it was going into production tomorrow, and the second is the internal rate of return (IRR), which indicates whether anybody would fund that project into production. I'm interested in simple back of the napkin versions, especially for projects that are still awaiting their first economic study produced by independent qualified professionals.
When only one person does this type of economic visualization it is not very meaningful, because the uncertainty margin is very high. But if a number of people do it for the same project, there will be a distribution of perceptions whose range is constrained by the fundamental information generated by the company under NI 43-101 disclosure rules. Within that range there will be a clustering effect as various members bring their experience to bear in extrapolating the geological information. If these visualizations are posted to an online system open to the public, and then aggregated to create a wisdom of crowds type of consensus for a particular project, then we will have an externalized potential outcome that captures the perceptions and expectations of the fundamentals-oriented audience.
This knowledge structure becomes the basis for thinking about the project fundamentals while simultaneously linking it to the market's valuation of the project. Today we have a situation where the market's valuation does not seem to be linked to anything fundamental; the fourth pillar would restore this relationship without needing to roll back the clock on trading technology. Each project would become a node for a vast social network focused on speculating on resource sector projects.
TGR: Of what use is an outcome visualization that cranks out a $1B NPV with a 20% IRR for your imaginary 5 Moz gold deposit? How do you relate that to a junior whose potential 5 Moz gold discovery has a single drill hole into an anomaly?
JK: The $1B outcome visualization would not make any sense unless there was a way to make it reflect the uncertainty of delivering that outcome. My rational speculation model applies an uncertainty ladder to nine stages of the exploration-development cycle. For example, at the grassroots stage the chance that a property will deliver what you think it ought to host is 0.5–1%. That chance has jumped to 2.5–5% by the time there is a discovery hole. Upon delivery of a preliminary economic study, the chance has jumped to a range of 10–25%. The exploration cycle is an information gathering/uncertainty reduction process that gradually restricts one's imagination until there is an operating mine.
The price one should be willing to pay at the current exploration stage should discount the reward you expect if the project makes it through all the stages intact as visualized. That discount is the uncertainty. So if you visualize a $1B outcome for a project with a discovery hole, the fair value would be $25–50M, or 2.5–5% of $1B. If you accept the uncertainty ladder as a valuation framework, you can use it to determine if the value implied by the market is above, below or within the discounted fair value range for your visualized outcome.
TGR: What would keep the visualized outcomes from being manipulated?
JK: The beauty of an open system like this is its transparency about the builders' assumptions for a particular project, as well as their construction history. A system like this, with a back-end that can compute and generate statistics about how the aggregate visualization is constructed, and which lets you drill down into details as well as a participant's history, will let you see where the builder sits in the spectrum between pumper and basher. You would even be able to discern builder alliances within this information-rich online world. Members can tag specific assumptions with notes. Newsletter writers could create content describing the trends and drama. The whole system would have a self-correcting nature where every basher build attracts a pumper build in the middle of which will emerge thoughtful builds done by an army of retired geologists and mine engineers.
It could turn into an online game, where the shorts and the longs attack each other and create positive and negative scenarios for a potential outcome. The larger audience of people who do not care to imagine the details of a project will be able to see the consensus view. That consensus, of course, will change over time. Whenever there is new information, the visualization, and the market valuation, will change.
This would give a structure to the junior resource sector it now lacks in the absence of any real analytical coverage. The brokerage industry provides so-so coverage of companies it has financed. The newsletter community, myself included, is very sparse and dispersed. A central system harnessing the wisdom of crowds would create a solid structure and offset the trading culture that now haunts the whole market.
TGR: It sounds a little like Yelp with numbers. People would contribute their opinions, investors would read it all and come to their own conclusions.
JK: It would be similar to Yelp, except that criticism or praise would not be referring to something no one else witnessed. It would refer to the decisions the builders have made in crafting their outcome visualization. I am talking about a major perception capture system that can be studied from many angles. Both building and observing would be very educational about what makes geology and mining tick. This would help overcome the fallout of the Bre-X betrayal in 1997, after which the retail investor lost touch with the resource sector. Although the sector has always had the attention of gold enthusiasts, the narrative over the last decade has been one of pending collapse and higher gold prices.
The retail investor no longer views gold companies as a proxy for gold. The audience has shifted to owning physical gold and maybe a gold exchange-traded fund. If we get a higher real price for gold, that is, not one accompanied by fiat currency collapse and soaring costs, investors will rediscover the gold producers because they know how to think about revenues and cash flow. But the preproduction juniors will remain orphans because few investors know how to think about them, and even if they do, they lack efficient means to do so, and no one to share the fruit of their labor. A crowdsourcing system, which forces people to make best guess choices based on numbers, would haul investors up the learning curve very quickly, and empower them with a productivity whose sharing creates a collective output worth far more than the sum of the inputs.
This system also provides an outlet for the generation of geologists and mining engineers about to retire. They can come up with a pseudonym and be an expert within the system. They could critique others' visualizations, point out where someone has missed the metallurgical problems. It would become a vibrant conversation outside the one the regulators allow the company to have, especially when it comes to quantifying potential.
TGR: A number of the rules you mentioned—who is a qualified investor for private placements and feasibility studies—were intended to increase investor confidence in the TSX Venture Exchange. Would your new system of crowdsourced valuation add another level of confidence and bring people back to the Venture Exchange?
JK: I think it would help enormously. I believe it would draw larger pools of capital interested in speculation, as opposed to investing for cash flow and return. Potential investors are able to see high-quality data produced by the companies under the NI 43-101 regulatory rules. Then, investors could look at this crowd of visualizers quantifying and sharing their perceptions on the project data, the gold price, geopolitical risk and so on.
It would be similar to the sports arena. People bet huge amounts of money on who will win the Super Bowl or the World Series. They use information and statistics to handicap the competition and place their bets. In my view this is a tragic waste.
A conventional gambling system is simply the redistribution of existing wealth minus the leakage of the gambling system operators. My crowdsourcing idea is different, in that some of the money flows into the companies' treasuries, where it can be used to create new wealth.
The junior resource sector would benefit because the data-driven contextualization will funnel capital into the companies with better prospects. It will eliminate the 500 companies we talked about earlier, whose only purpose is to suck up money and waste it on overhead while pretending to explore.
Money will be invested in companies that have done the work to prepare their targets, in companies in which the investor audience trusts management to raise capital and spend it on testing the targets.
TGR: You have been talking about this being "an ideal time for a bottom fisher." If 500 companies are likely to go out of business this year, how do you determine which ones will survive?
JK: One criterion to look for is companies that still have lots of money. Filter on working capital and verify that the company will not have to finance at today's low prices. The search engine at Kaiser Research Online does this and a lot more.
First, look for projects that have interesting potential and experienced management teams. This is a good time to look for companies that are roadkill as a result of the general bear-market conditions. I look for companies with interesting stories that are down and out.
An interesting example is Namibia Rare Earths Inc. (NRE:TSX, NMREF:OTCQX), which is trading at its cash breakup value. Its $18M treasury was raised during the rare earth boom to fund exploration at its Lofdal project in Namibia. Instead of delivering a monster rare earth deposit, Namibia delivered a small, low-grade deposit at Area 4 with a very high 86% enrichment in the heavy rare earths. The property has potential to yield additional similar zones, but the current resource is sufficient as a potential near-term solution to non-Chinese demand for heavy rare earths such as dysprosium, terbium and yttrium.
Although the dominant mineral is xenotime, it is in a fine-grained form interwoven with thorium and zircon. The junior is conducting metallurgical studies to see if the heavy rare earths can be liberated in a cost-effective manner. This bench scale study is not expensive, will be completed in Q2/13 and will dictate if Area 4 proceeds to the PEA stage. Because the rare earth sector is currently in the dumps, speculators get the outcome of this program for free. Either management gets a green light to fast-track Area 4 as a short-term heavy rare earth supply solution, or it gets a red light, which signals it to look for other projects in Namibia where it has established itself. Namibia is operated by the Africa-experienced team of Gerry McConnell and Don Burton, and backed by the mining finance house Endeavour Mining Corp. (EDV:TSX; EVR:ASX).
Second, look for projects that already have PEA-level or higher disclosure. I think we are through the worst of the cost escalation. If perceptions shift to where everybody expects metal prices to do nothing worse than stay flat, with the trend bias to the upside, a lot of advanced projects will rebound as the perspective shifts from glass-half-empty to glass-half-full.
International Enexco Ltd. (IEC:TSX.V; IEXCF:OTCQX; I6E:FSE) is an example of a dual-pronged strategy that offers speculators a macroeconomic bet on the direction of copper prices through the advanced Contact project in Nevada and a bet on the potential for a high-grade uranium discovery at Mann Lake in the Athabasca Basin. During the past year Enexco has focused on expanding its mining model for its Contact copper deposit after acquiring adjacent claims that allow it to deploy a large pit design. Contact is a modest, low-grade deposit with an in situ value of $5B at the current copper price, but a low rock value of $20/tonne. Enexco plans to deliver a feasibility study during 2013 for a solvent extraction and electrowinning mining operation. The NPV will not be high because of the project's scale, but at the current stock price the market is assigning a value of only $20M to the project. The exit strategy will not be a buyout by a big copper producer; if the feasibility study is positive, development funding could come from yield-hungry private equity.
For substantial upside, speculators should keep their eye on the 30%-owned Mann Lake project where Cameco Corp. (CCO:TSX; CCJ:NYSE) has initiated a 21,000 meter drill program to further test a target area where a short high-grade uranium interval helped Enexco to a $4.50/share peak in 2007 during the uranium bubble. Enexco's share of the program has been funded through an equity financing by Denison Mines Corp. (DML:TSX; DNN:NYSE.MKT), which recently struck a buyout deal for part of Fission Energy Corp.'s (FIS:TSX.V; FSSIF:OTCQX) assets.
Finally, with regard to the exploration juniors, discovery exploration will be the game for the next couple of years. Although I hope for it, I doubt we will see significant metal price gains in the near term. If that is the case, money will want to go into discoveries where investors are not certain of the valuation limit, where the sky is the limit until the drill ceases intersecting ore grade mineralization. Of course, a discovery only counts as such if the grade will work very well at current metal prices and can handle a 25% decline.
Orsa Ventures Corp. (ORN:TSX.V) has a 100% option on the Quartz Mountain gold deposit in Oregon from Seabridge Resources Inc. (SEA:TSX; SA:NYSE.MKT), which gathered up the failures of past exploration cycles during the dark years of 1998–2002. Orsa has spent the past couple of years compiling historical data and conducting verification drilling with two goals in mind. The first is to deliver an NI-43-101-compliant resource, which it did in February 2012 when it reported a low-grade inferred oxide resource of 1.3 Moz with a rock value of $33/tonne at spot gold, and a somewhat better grade sulphide resource of 1.5 Moz with a rock value of $55/tonne.
In situ rock values are not the same as recoverable rock values, so Orsa is also conducting metallurgical studies as a prelude to completing a PEA for the existing resource. The value assigned to the outcome of the first goal will ultimately depend on where gold prices are headed and what the costs are for developing the existing resource. The second goal is to rethink and test the exploration potential of Quartz Mountain for additional, ideally higher-grade mineralization, either near surface elsewhere on the project, or deeper underneath the existing resource. Success on this front would shift the development focus for Orsa and expand the upside valuation limit.
TGR: Could one big discovery make a big difference in the stock prices of a lot of these junior companies?
JK: Yes. It would be ideal if the windfall came in one of these companies with a lot of people owning the stock, one that starts off from near dead, only to rise into a monster success story for all the right reasons. The companies I mentioned are all examples of juniors that I regard as having the potential to deliver a home run that switches the market's glass back to half full.
TGR: John, thank you for your time and your insights.
Readers can hear John Kaiser speak at the California Resource Investment Conference at Palm Springs, Calif., Feb. 23-24, 2013. Click here for more information and to register.
John Kaiser, a mining analyst with 25+ years of experience, produces Kaiser Research Online. After graduating from the University of British Columbia in 1982, he joined Continental Carlisle Douglas as a research assistant. Six years later, he moved to Pacific International Securities as research director, and also became a registered investment adviser. He moved to the U.S. with his family in 1994.
Want to read more Gold Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Interviews page.
DISCLOSURE:
1) JT Long of The Gold Report conducted this interview. She personally and/or her family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Namibia Rare Earths Inc., International Enexco Ltd. and Orsa Ventures Corp. Fission Energy Inc. is a sponsor of The Energy Report. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) John Kaiser: I personally and/or my family own shares of the following companies mentioned in this interview: International Enexco Ltd. and Orsa Ventures Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
Comments