January 20, 2006
We looked at how to value mining companies
last week. Since these companies have real assets (mines), cash flow,
and even perhaps earnings (if we're lucky), putting a value on them is
fairly straightforward. Exploration companies are a completely different
Exploration companies don't have assets,
cash flow or earnings. They typically only have a management team, sometimes
a bit of cash, and one to several properties.
The cash will get spent, usually a lot
quicker than anticipated. Their projects aren't assets: they are liabilities
where the cash is going to get spent. That leaves us with management,
and management is absolutely an exploration company's biggest asset --
if not its only asset. Promoters of these stocks will tell you their company's
management has a superb track record, but the reality is that there aren't
even enough mediocre management teams to run the thousands of exploration
companies resident in Vancouver alone.
If an exploration company's only asset
is management, how do we put a value on it?
Unfortunately the answer is "with difficulty".
There is no easy way to put a value on exploration companies. It is easy
to spot a really good deal when it stares you in the face, and it is equally
simple to see when a stock is overvalued, but the nature of the business
does not readily allow for valuations that one can use for short-term
trading or "value investing".
Exploration is risky business. Buying
exploration stocks is tantamount to gambling, and there are two safe bets
when it comes to any exploration company. One: it will spend the money
it has and two: it is highly unlikely that it will make a discovery. Yet
I personally invest essentially all of my net worth in exploration stocks
because I believe that there are ways to mitigate the risks and to shift
the odds of success in my favor. Fortunately this part is straightforward.
The Nineties were rough for mining and
there are now very few new exploration geologists graduating from school.
To make things worse, most of the graduates of the past decade want desk
jobs making their odds of discovering anything very slim.
When the major mining companies downsized
their exploration efforts during the Nineties they not only curtailed
exploration expenditures, they fired most of their geologists, closed
regional offices and let many of their projects go. This caused a shift
in exploration demographics -- the more innovative and experienced exploration
professionals got together and formed new junior exploration companies,
and picked up many of the projects the majors dropped. As a result, major
mining companies now lack the human resources needed to explore for new
Still, mining is a depleting business
-- the more you mine, the less you have left to mine and without exploration,
mining will cease very rapidly. The mining companies know they need access
to good exploration projects and, more importantly, good exploration teams.
We know it too.
We need to look for companies whose managements
have the ability to generate new exploration projects and the business
acumen to joint venture those projects to major mining companies. A joint
venture partnership allows the junior exploration company to use its intellectual
capital to generate exploration ideas but the mining company's financial
capital to test them. It is absurd to think that the average exploration
company has but the remotest chance of making a discovery given how much
money and time it takes. The only rational way to approach exploration
is to marry the innovative skills of quirky, and often unsocial, exploration
geologists with the balance sheets of mining companies in a win-win partnership.
In a typical deal the exploration company
will generate an exploration idea, acquire the ground and perhaps spend
a little bit of money to confirm that the geologic model it is proposing
has merit by looking at soil geochemistry, geophysics and good old-fashioned
geological mapping. Thereafter it will attempt to get a mining company
to commit exploration funds to test its ideas in return for earning a
percentage interest in the project. Typically the mining company can earn
up to 70% to 80% by completing a bankable feasibility study or even financing
the project to production.
This means that if our company is successful,
we will end up owning 20% to 30% of a mine, whereas if it is unsuccessful
it would have lost some time and a little bit of money because the mining
company footed the heavy bills. This way an exploration company can use
its limited cash resources to generate numerous projects, all funded by
joint venture partners. It increases the life expectancy of the exploration
company and by enabling it to generate and test more projects it also
increases the probability that it will eventually be successful. I would
much rather own 30% of a successful project than 100% of a dud.
There is something else that happens
here. With this model the exploration company has to convince the geologists
working for the mining company that its projects have merit. Not only
do they need to have merit, they need to have sufficient merit to compete
with the exploration projects generated internally by the mining company
and all the other exploration projects being presented to the major by
other juniors. This is a lot more difficult for a junior to do than to
convince doctors, lawyers, dentists and taxi drivers that its projects
are one drill hole away from changing the world (with all due respect
to doctors, lawyers, dentists and taxi drivers).
I therefore avoid exploration companies
that tell me they are going to spend millions of dollars drilling on their
wholly owned projects, unless there are very, very, very compelling reasons.
We also have to look at what kind of
projects the exploration company is looking for. You will be surprised
how many times I have sat through presentations only to learn at the end
that the geological target is unlikely to ever be economic or, if it might
be, that it is likely to be so small that no major mining company will
have any interest in it. The only thing we are interested in is making
This brings us to the next part: you
should have access to a critical and well-seasoned exploration geologist.
I am not a geologist yet I have to sift through geological evidence every
day and decide whether to accept or reject the risk of exploration. I
work very closely with a consulting geologist, and without access to a
consultant I can trust it would be almost impossible to succeed in this
If an exploration company consistently
comes up with new projects and continues to get exploration funding from
major mining companies then this is a business I am interested in owning.
I view stocks as fractional ownership in a company, not as trading cards.
So if I find a business I would like to own I often watch it for several
years, waiting for an opportune time to buy.
Now comes the question of how much we
are prepared to pay for these things. While I cannot give you a formula
with which you can put a dollar value on an exploration company, like
we could with a mining company, the best I can do is tell you what I do
with my own money, and why. My paid newsletter is essentially a weekly
commentary of my personal investments, where I discuss the stocks I buy
and sell, my reasoning and any updates on the stocks I own. I do not do
An archive of past issues is on my web
site, and you can subscribe on a month-to-month basis and cancel at any
time. See the Newsletter Section on www.paulvaneeden.com.
There will not be a commentary next week
- I will be in Vancouver at the Cambridge House Resource Investment Conference
and then at the Mineral Exploration Roundup.
Paul van Eeden
P.S. I may in future stop publishing
these commentaries on Kitco so if you enjoy reading them I suggest you
go to my website at http://www.paulvaneeden.com/commentary.php
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