Equity investing is squarely in a risk-off phase and few sectors have been hit harder than junior mining. Rare earth elements equities are no exception, but most of the materials themselves have not dropped nearly as much. The Critical Metals Report sat down with Siddharth Rajeev, vice president and head of research at Fundamental Research Corp., for a good hard look at small caps in this space. Where have these equities been, and where are their valuations heading? Read on for more.
The Critical Metals Report: Siddharth, despite the poor price performance of critical metals equities since the fall of 2011, most of the prices for the underlying commodities have indicated relatively stable demand. What's your view?
Siddharth Rajeev: It's tough to generalize on the mining sector because each critical element has its own supply and demand drivers. We have a positive outlook on a few elements; this is not so with others. However, it's true that commodity prices have not dropped as much as equities. If you look at industry data, you can see that mining companies are in a much better position now compared to four or five years ago. For example, the margins, return on equity and balance sheets of gold and copper producers have improved significantly over the past five years. Despite that, why is the TSX Venture, 50% of which is comprised of mining companies, down by 60%? I believe that the market is overreacting, just as it did in 2008. Therefore, we believe there is a good opportunity to buy quality assets at this time at cheap valuations.
TCMR: Does it help to look at these equities over a two-, three- or even four-year timeline? Most companies would show stock appreciation within that timeframe, whereas very few, if any, show positive year-over-year movement.
SR: It's much easier to analyze and predict an outcome if you have a longer-term outlook. It's extremely difficult to predict an outcome for, say, three to six months, as short-term prices depend heavily on speculation, market sentiment and liquidity. Long-term prices depend only on fundamentals, which is much easier to analyze. That's the most important message investors should take away—consider long-term outlooks when considering small-cap resource equities.
TCMR: Siddharth, you're vice president and head of research at Fundamental Research Corp., the largest independent equity research firm in Canada, and you produce research reports on publicly traded small-cap companies. How do you decide which companies Fundamental covers?
SR: Our goal at Fundamental is to bring more transparency and provide high-quality independent analysis on small- to mid-cap companies to enable investors to make an informed decision. Large-cap companies are more transparent and there are thousands or even millions of people following those companies. The large-cap sector is more efficient in the sense that stock mispricing is rare. Small- and mid-cap sectors are not as efficient because stock mispricing is common in these spaces. Therefore, risk-tolerant investors have an opportunity to gain higher returns in this space. Our goal is to enable investors to differentiate the good small caps from the bad.
TCMR: If a stock consistently underperforms the broader market, does it remain under coverage?
SR: Yes. The junior mining space is very dynamic, so things can turn around in months or even days. Large-cap companies cannot do that; for example, Microsoft cannot change its "fundamentals" in such short periods. Juniors can—through JV partnerships, property acquisitions and changing their management teams. There have been a lot of cases where we have changed our outlook from negative to positive due to positive developments. We don't easily write off underperforming companies in our coverage universe.
TCMR: Do you have any evidence that would suggest that your research increases the liquidity of these companies?
SR: According to the Journal of Applied Corporate Finance, analyst coverage combined with an effective investor relations program increases liquidity and decreases trading costs by 85%. In general, as per the efficient market hypothesis, anything that improves information flow to the market will create a more efficient market. Analyst coverage, with its broad reach and influence over investors, is probably the most effective way to increase information flow. Internally, we know this is the case.
We see that, on average, companies under coverage experience an increase in daily average trading volumes. They also experience an increase in the number of days their stocks trade—in some cases, the number of days doubles.
TCMR: What are some critical minerals equities that have performed well since your firm initiated coverage?
SR: We produced reports on three critical metals companies. I am pleased to say that stock prices of all three companies have performed well since that time. Focus Graphite Inc. (FMS:TSX.V) is up 8%, Commerce Resources Corp. (CCE:TSX.V; D7H:FSE; CMRZF:OTCQX) is up 11% and Lomiko Metals Inc. (LMR:TSX.V) is up 14%.
TCMR: The investment thesis for rare earth elements (REEs) was that the "greening" of America and the rest of the world would call for massive amounts of these metals and no one outside of China produced them. Then the bottom fell out the market. How has that thesis changed? Or does it remain basically intact?
SR: REEs are a very broad sector—it's not possible to give a general comment with any accuracy. But we believe this thesis only remains for heavy rare earth elements (HREEs) that are scarcely available, and this is shown by the fact that prices of light rare earth elements (LREEs) dropped much more than the scarcely available HREEs.
TCMR: How critical is it that some of these plays soon reach production and start generating cash flow?
SR:Most REE juniors are far from production. Only very few companies intend to be in production in the near term—names like Molycorp Inc. (MCP:NYSE), Great Western Minerals Group Ltd. (GWG:TSX.V; GWMGF:OTCQX) in South Africa and Australia's Lynas Corp. (LYC:ASX). We believe investors can generate good returns in this space by identifying companies with solid early-stage projects.
TCMR: What are some REEs companies under coverage?
SR: Quantum Rare Earth Developments Corp. (QRE:TSX.V; BR3:FSE; QREDF:OTCBB) is focused on exploring and developing the Elk Creek carbonatite complex. The company recently came up with a promising new resource, which stated 19.3 million tons (Mt) grading 0.67% Nb2O5 and an increase in Inferred resources to 83.3 Mt grading 0.63% Nb2O5. The U.S. produces very little niobium. That's been the case for a long time. Brazil is the number-one producer of niobium, accounting for about 92% of global production. Therefore, we believe Quantum Rare Earth Developments, if it is able to continue to advance the project, will play a key role in the U.S. domestic niobium supply.
TCMR: There are now enough graphite equities in play to create an entire index, perhaps two. A year ago, there were only a handful of names. How did graphite become the hottest critical mineral of them all?
SR: Just like REEs, it is important to understand the different types of graphite. We are bullish on large-flake graphite. This is because the key demand drivers (lithium-ion batteries, fuel cells, nuclear reactors) currently use small-flake and synthetic graphite, which is more abundant but much more expensive to use because of the processing they must undergo to enable them to be used in these applications. Therefore, we believe large-flake graphite will be in more demand due to their highly superior economics.
A lot of junior graphite companies have popped up in the last 12 months; most of them have yet to do any metallurgical studies to determine if the deposit is large, medium or small. A lot of companies might not survive after the metallurgical studies are completed.
TCMR: What are some graphite equities under your coverage?
SR: Focus Graphite Inc.'s flagship project is the 100%-owned Lac Knife graphite property in Quebec. At 15.7% Cg (carbon as graphite), it is the highest-known graphite deposit grade in the world. Metallurgical testing shows the deposit contains 46.1% large-flake graphite and 39% medium-flake graphite. An initial preliminary economic assessment is expected shortly, which we believe will be a catalyst. In addition to advancing its project, Focus recently signed a license agreement with Hydro-Quebec to develop a graphite purification facility and a graphite anode production facility for lithium-ion batteries.
Another story we like is Flinders Resources Ltd. (FDR:TSX.V). A lot of historic work has been done on its Kringel project. It has a historical resource of 7 Mt at 9% graphite, which is high-grade material. It has a fully permitted mine that can be put into production in the next 18–24 months. It recently announced good drilling results—Flinders has extended beyond the historical zone and is continuing to gather information for its resource estimate sometime before the fall. We think these results are continuing to prove up the historical resource.
Lomiko Metals is a very early-stage project. It just acquired a project in Quebec. Some historic work has been done on the property, and it is going to commence an exploration program. Lomiko recently received a drilling permit.
Standard Graphite Corp. (SGH:TSX.V) is a company we track. The company recently acquired the Mousseau East deposit, which hosts a non-NI 43-101 historical resource of 800,000 tons at 8% Cg down to 40 meters and a 3% cutoff. It also has a few other properties, Sandy Lake and Sandy Lake NE, which are next to the Lac Knife deposit hosted by Focus Graphite.
TCMR: Thanks for sharing your knowledge with us.
Siddharth Rajeev has been vice president and head of research at Fundamental Research Corp., an institutional research firm in Vancouver, since 2006. He holds a bachelor of technology in electronics engineering from the Cochin University of Science & Technology and Master of Business Administration in finance from the University of British Columbia. He is ranked as a four-star analyst in the energy and mining sectors by Deutsche Asset Management.
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1) The following companies mentioned in the interview are sponsors of The Critical Metals Report: Commerce Resources Corp., Quantum Rare Earth Developments Corp. and Standard Graphite Corp. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Siddharth Rajeev: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: Fundamental Research Corp. provides fee-based coverage on the companies mentioned in this interview. I was not paid by Streetwise Reports for participating in this interview.
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