By Jonathan Goodman
We at Dundee Goodman Merchant Partners have spent most of our working lives in the resource industry. Collectively we are money managers, geologists, engineers, mining operators, and natural resource/mining bankers. Moreover, all of us are personal investors in gold. To us, there is nothing more exciting than a resource bull market driven by gold, and the ensuing wild ride of speculation and excitement that follows in the equity markets. As of early 2019 gold has broken out of its previous slump, now topping USD $1,550 per oz. Driven by increased political polarization, increased geopolitical tensions, and negative real interest rates, many are now forecasting a potential breakout of precious metals, and an ensuing bull market in the natural resource sector.
The purpose of this article is not to discuss our macro thesis on the coming boom in metals, and gold. We believe this is already happening. This piece will comb through the unlearned lessons of our industry’s past failures, in the hopes of best serving the interests of the investor. The prevailing consensus between mining companies, and resource-focused capital market firms alike, is that the potential of a breakout, and the ensuing bull market run will bring generalist investors back into our sector. The hope is that with a rush of capital, it will be seen as easy money for the deal makers and market movers. With all the excitement, most participants have failed to realize that there are reasons for the decline in company values, that have very little to do with metal prices. In fact, over the last five years, while many mining companies have struggled; the gold price has remained high in local currencies. The price of gold is at, or is near, an all-time high, when measured in Australian dollars, Brazilian Real, British Pounds, Canadian dollars, Indian Rupees, Japanese Yen, Mexican Pesos, Russian Rubles, and the South African Rand. Despite this, gold stocks are still trading at significant discounts to where they were just eight or nine years ago. The elephant in the room is that the devaluation of mining companies cannot be explained by the commodity price, instead it is dictated by the self-inflicted mistakes of a commodity boom, and the irresponsible management of these assets. The elephant in the room is that most of these mining companies believe that the commodity boom will continue to bail out their lackadaisical management and operations. The elephant in the room is that mining companies, in the past, maximized returns for an ever-rising gold price; optimizing project resources for scale rather than payback and returns. The elephant in the room is that the mining industry has made so many mistakes; mistakes in the geological modelling, mistakes in community relations, mistakes in environmental planning, mistakes in capital markets, mistakes in communicating with investors, and mistakes in overpromising and promoting their business. The elephant in the room is that the mining industry has lost the trust of the most serious investors, causing an exodus of capital that will not return quickly.
As an industry, we cannot simply count on greed to shepherd in a new group of investors. We need to figure out how to make our sector investment-grade, while giving potential shareholders the information required to make an intelligent investment decision. While the issues outlined above refer to all mining companies, the junior mining segment has received the brunt of the value destruction, and in our opinion, is where the most prominent opportunity exists. What has really happened is that investors do not need mining companies to get their exposure to metals. You can buy gold and precious metals at the majority of financial institutions, online, and you can buy most commodities on commodity exchanges everywhere. What the market is saying to companies is that if you want access to capital, then you have to run your business properly. Real investors want to make real investments, not just overhyped stock plays.
When it comes to Junior Mining, the quality of the publicly available information that is readily accessible to investors is insufficient to make an intelligent investment decision by institutional standards. When a mining company, debt provider, or an institutional investor makes a significant investment, they engage in due diligence by first signing a confidentiality agreement (CA) and obtaining detailed geological, and engineering data. An individual equity investor [or a fund manager] must rely on only the publicly available information. Research analysts rely on the same publicly available information as the individual investor, significantly mitigating the level of due diligence, and analysis that is in a sell-side research report. This is not a small problem. These reports are the materials that are used by investors to make a quick decision. Industry insiders understand these limitations well, but for more generalist investors, the shortcomings in data quality can leave many feeling hoodwinked. This exacerbates the boom and bust cycle, and consequently harms the mining industry’s ability to attract long-term capital.
The issue is that retail and institutional investors do not have access to enough accurate information to make an intelligent investment decision. This problem is made worse by the quality of the technical reports, the use of the bought deal, and the differential between trading commission rates, and new issue financing rates.
Technical Reports
In Canada, the use of technical reports, specifically the NI 43-101, was implemented in the mid-90s by the Ontario Securities Commission (OSC) in response to the Bre-X fraud. These are standardized technical reports for resources, Preliminary Economic Assessments (PEA), Pre- Feasibility Studies (PFS), and Feasibility Studies (FS). These reports were created to increase oversight, and establish standards to protect investors. While the intent of these reports was wellfounded, what these studies have become is concerning. PEAs are the preliminary study to assess the project viability using conservative assumptions. These reports are based on sparse data, and are supposed to provide an initial viability assessment. Instead, most investors use these reports to ascribe value to assets; this is concerning because these reports are not supposed to be for valuation purposes. Investors use these reports for valuation purposes without realizing they have become marketing tools, as opposed to a judgement on a project’s viability. The mining company is now faced with increased pressure to present impressive project economics. With the competition for capital so intense, management teams put a lot of pressure on their consultants to use more aggressive assumptions, and to include every piece of positive information in each study. With the competition for business fierce among the engineers that produce these project studies (PEA, PFS, FS), they often comply with the demands of the asset owner. As the mining company increases its resource data (drill holes, and geological understanding), they proceed to more advanced studies, PFS (prefeasibility study) and FS (feasibility study). The PFS and the FS are formed on assumptions with more certainty; this includes more specific details on mine design, actual price quotes for equipment, tighter drill spacing for resource delineation, and an intricate plan for any environmental concerns. As they advance, the reports begin to resemble a more objective reality. Understandably, there is a strong trend in increasing capital costs as a project goes from PEA to PFS to FS; operating costs exhibit the same pattern, and project IRR’s have an inverse trend at a given metal price. Differentiating the quality of these reports is no easy task. We have often joked that if you took the highest quality PEA and compared it with the lowest quality PEA report, most knowledgeable investors would be unable to distinguish the difference. The issue is that what separates between high-quality and low-quality is not in the report. It is the assumptions made behind the report that make the difference.
Bought Deals
When a Canadian mining company raises equity capital in Canada, it is often done through a financing method known as a bought deal. Bought deals are considered one of the key components in what makes Canada the go-to place for raising money in resource markets. In simplest terms, a bought deal is when the broker promises to finance a company with a guaranteed price. The broker then reaches out to everyone that might be interested in participating. If the broker cannot sell it, they own the shares. These deals can happen because of the continuous disclosure system. Without going into detail, because all of the material information is available and accessible to the market, they can use a short form prospectus to execute the deal quickly. This structure is to the benefit of brokers, and the mining company. The broker wins because they can lock in a fee, and the mining company wins because they can raise capital without the market fluctuations of a full roadshow. However, the bought deal does not benefit the investor. Bought deals are sold hard on a firstcome-first-serve basis, and push investors into making quick decisions before they have done due diligence. While smart investors have learned how to game the system, these hardselling structures do a disservice to an industry with a credibility problem. If you look at any Canadian Investment Bank and look at their mining bought deals, and then look at today’s prices of the underlying securities, the results would be shocking.
Brokerage Commissions
Versus Financing Fees As the financial services industry has evolved, commission rates for trading securities have declined dramatically. With online trading, commissions on share purchases have come down to negligible levels. At the same time, fees on financings are still around 5%. Institutional and retail financial advisors make, in many cases, 10-20 times more on a deal versus just buying shares in the market. Considering that they can only do limited due diligence, they are hugely conflicted in that they need the deals to make a living. Even though all the investment banks work hard to maintain internal walls and independence of their research, their businesses only work if they do many deals. This creates a massive conflict for almost all investment banks.
Conclusion
The focus of this industry is to find, build, and develop mining properties for the benefit of our investors. Investment banking institutions want to help companies raise capital and create wealth for investors. Investors are looking for quality projects that can generate significant returns. From my experience, this industry wants to get it right. While everyone wants to get it right, desire is not enough; we need to make changes as an industry. We need to find a better way of doing things. We need to eliminate the conflicts that plague our industry, and align the interests of everyone involved so that investors feel that they have a fair chance.
How Can Things Change?
We need to start discussing the elephant in the room. Firstly, we need to put more detail into the technical reports, which will lead to better technical information. Secondly, peer reviews need to be completed. The studies should include more details on the assumptions made, as well as further information on the geological interpretation, and the wireframes used in the resource reports. If the sum of the work is already disclosed, then why do you have to sign a CA to get the data that went into it? Putting out more data will give the public better information, which will also give research analysts a breadth of information to pull from to do higher quality work. This will allow the market a better opportunity to distinguish between quality work, and inflated-promotion. In medium, and large companies, internal engineering reports are subject to a peer review. This is where other qualified engineers review and critique the work. This process is sorely missing for junior mining companies. Hiring a second firm to conduct a peer review will greatly enhance the quality of the technical reports.
Deals should be fully marketed. The bought deal should be abandoned. Brokers should be forced to work with companies raising capital on a fully marketed basis. This means that a full investor roadshow should be completed, which will allow many investors to do more work, and it will also force the brokers to be more selective with who they want to finance. A marketed deal typically involves greater planning, more effort and additional diligence to get a deal done. It will also level the playing field between the big banks, and the independent brokers, as the banks can no longer use their financial muscle to squeeze out the smaller brokers and win all the business.
Brokers should hold back a piece of their commissions for one year, and dedicate that capital to help provide liquidity towards the company’s share price. While commissions on financings are very high, liquidity for the smaller companies is very low. If the brokers were forced to hold back a third of their commissions, and use it to provide liquidity in the name, that would go a long way towards solving the liquidity problem. It would also force the brokers into doing more work prior to financing a company, and better align their interests with their clients.
The Dundee Goodman Way
At DGMP, we are very excited about the opportunity to invest in this dislocated market. With junior stocks trading at pennies on the dollar of where they were eight or nine years ago, we see a generational opportunity to make money. We have assembled a team of investment professionals with over 200 years of combined experience in Geology, Mining, Metallurgy, Environment, Finance, Project Management and ESG. We view the publicly available information as a screening tool but like to sign a CA, and do deep-dive technical due diligence. We work very closely with investee companies to help them de-risk their projects, and advance them towards ultimately realizing the potential value that we see. When we do a deal, it is because we are buying the deal and eventually when we make money, so do all our partners. We strongly believe that an alignment of interests is paramount to succeeding in this industry. While we cannot change the industry, we can insist that every deal that we invest in has all interests aligned.
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