Surviving death by paper cut in today's mining equity market
An investment executive at Sprott Global Resource Investments Ltd., Michael Kosowan is working by three sayings these days: "Well bought is half sold," "Small is beautiful" and "Necessity is the mother of invention." In this Gold Report interview, Kosowan talks about the challenges mining companies face and shares some jurisdictions that offer outsized returns.
The Gold Report: Are you mostly involved in mining investments, or are you also involved in oil and gas?
Michael Kosowan: If it comes out of the ground and has value in a commodity sense, we're looking at it for investment ideas. My background is as a mining engineer, so what I'm often looking at are mineral-style investments along the precious metals space, because a lot of my clients are speculators. They're looking for the high-return, high-potential rewards that we can get from a discovery. We're coming into a market where there's been a lot of work that's gone into the ground and a lot of dollars spent, some misspent. Either way it sets the table for a strong exploration market.
TGR: A lot of these junior mining companies are struggling because they're running out of money for exploration. Yet you say it's a strong exploration market—could you explain that?
MK: Strong because there have been a lot of dollars put in the ground over the last decade that are going to prove up some real buyable deposits. Also, the economic metrics that we're working under are much stiffer than in the past.
We're in a marketplace that has very tight financial constraints. It's also not particularly forgiving—the markets have been lousy over the last 18 months and we are seeing low stock prices. But it's important to make the distinction between the market and the businesses. From a business perspective, I see quite a bit of good work going on.
TGR: Over the past 12 to 18 months, many senior mining companies are spending a lot of time justifying to their shareholders reasons to stay in the stock even though their share prices have not performed, costs have increased and senior management has been fired and replaced. Do you see a pathway for the seniors to retain investor confidence, and do you see them being successful in drawing money away from the exchange-traded funds (ETFs) and back into the equities over the next three to six months?
MK: The senior mining companies are starting from a very low base relative to the prevailing gold price. I'm a big proponent of the slogan "well bought is half sold." From that perspective I see good valuations among the seniors for investors with a bullish view toward the gold price.
The senior gold stocks have to compete with three new elements in the marketplace with which they're not entirely familiar:
"There have been a lot of dollars put in the ground over the last decade that are going to prove up some real buyable deposits."
First, precious metal proxies or ETFs have had a significant impact on the investment flows into the sector, which didn't really exist before the advent of the ETFs. Aside from the direct relativity to the gold price, the metal proxies have had the added benefit of removing the investor from the equity arena.Second, skepticism has grown toward corporate governance. There are some management changes at the top of some of these companies, and investors are starting to ask if management groups are making the best investment choices for shareholders and economically growing the mining enterprise. When the price of gold was moving up strongly, the message seemed to be to grow at all costs. Now that inflation, taxes, regulatory hurdles and labor costs are seen as cutting into the profit margins of the seniors, the seniors are acutely aware of fine-tuning their operations and becoming more economically efficient.
Third, there had been a lack of leverage to the gold price. The price of gold has increased more than fourfold over the last 10 years. Meanwhile the major gold producers have enjoyed a mere 8% annualized return. The low return can be accounted for in part by the attempts made to develop marginal assets. The market was rewarding the industry for ounces in the ground irrespective of what that meant to the bottom line. The concept of leverage to gold got confused in the context of a greatly increasing gold price. Now that reality has set in, in the form of tighter financial markets, inflation playing catch-up with costs, higher taxes and operational constraints, the earning outlook does not seem as pretty as was originally hoped, and the end result is the weak share prices.
TGR: Do you think it's true that extremely high capital expenditure (capex) projects aren't viable anymore?
MK: High capex and low grade have been the death knell of many a project and will continue to be real. The market has changed and is becoming more focused on the economic viability of projects. The market has developed a sweet spot for the "small is beautiful" idea. Smaller gold producers may be in a real window of opportunity where the higher gold prices that we're experiencing go directly to their bottom lines or their margins and are allowing them to be quite profitable because they never really had an aggressive growth strategy to begin with. If you're a 2 million ounce gold producer, you've got a real problem. Your problem is finding more economic reserves to rely on, and that's become a challenge now that we've removed a lot of the low-grade opportunities that were once apparent in the marketplace and financeable in better economic times.
"The market has changed and is becoming more focused on the economic viability of projects."
We've seen the senior names diversifying their asset portfolios to include metals that they hadn't focused on before—for instance with the Barrick Gold Corp. (ABX:TSX; ABX:NYSE)–Equinox Resources Ltd. (EQN:TSX; EQN:ASX) deal that we saw earlier last year. The huge companies are trying to find ways to replace ounces through other metals or acquisition. Going back to my illustration about the gold price going up fourfold, or even fivefold, in a relatively short period, the supply response from gold production has been pretty muted. If you think about the margin that would expand under that scenario for any other commodity, then you would start to see real supply coming onstream, and we just haven't seen it. That speaks to the challenges of finding these good, high-grade, economically viable deposits. They haven't been found at the rate that the industry requires, which is why what we are looking at could develop into a strong exploration cycle.
TGR: Given the backdrop of resource nationalism, increasing cost inputs, exploration risk and the other factors that go into exploration, how do you decide what projects you're going to investigate for your clients? Let's talk about some of your favorite jurisdictions right now.
MK: I like to find jurisdictions that are generally misunderstood, especially if that misconception is further emphasized by the media. I'm a contrarian and find investments at a discount. It's, of course, critical to back up that with concrete, objective facts; however, finding well-valued or cheap speculations involves building up the intestinal fortitude to go against the crowd. I hearken back to what my friend Rick Rule has often said, which is there are many who call themselves contrarians so long as it's fashionable.
"I like to find jurisdictions that are generally misunderstood."
I have looked at areas such as the Yukon, about eight years ago, when it was a frontier market that really lacked infrastructure. I then moved on to West Africa in the wake of the Red Back Mining Inc. (RBI:TSX) acquisition, with the idea that the senior mining companies would see this as a very attractive area because the types of deposit matched their style. They were large, low-grade projects that required high capital and in a sense created a moat around their investment thesis. You couldn't be a little junior company who hopped in there with a rake and a shovel and started going to work and producing gold. It was much more capital intensive and that created the moat, the barrier of entry. With the market developing the way that it has lately, the high-capex projects are nonstarters. I've been looking at heap-leach oxide, near-surface projects. That's where your capex is nicely controlled and infrastructure is readily available.
I think Mexico is a great place. I visited the Guerrero Gold Belt this year with a team of geologists, and I concluded that it was very appealing to the sociopolitical contrarian in me. The drug wars were quite heated, and there was the idea that Mexico is just a terrible place to go, which I didn't see as true. There are certain places in Mexico that are certainly dangerous, but you shouldn't use a broad brush and wipe out the potential or the stability of the entire country based upon what is in the news media. The Guerrero Gold Belt is an old new gold belt. Even though it is an area that has been mined for decades, there is still much to learn from the prospectivity of the geological controls.
This concept of a renaissance is exciting because it gives an air of familiarity with the region, enough to make you comfortable with the geology while opening the door to modeling and interpreting these new gold-bearing structures.
TGR: Do you see Mexico continuing with its support of the mining industry? Could the Mexican government do anything similar to what we've seen in Argentina or Peru, where there is increased resource nationalism, or a more difficult permitting environment?
MK: In Peru, which is a country I worked in with a junior exploration company, the community where the mining activity occurs doesn't share in the social take that is generated in the region. Lima is gaining most of the benefit. Argentina is going down the route of currency controls. But let's face it: the idea that countries worldwide are going to increase their social take is very much on the rise. Part of that problem stems from the mining industry itself, which has simply been announcing operating costs and not taking into account the additional costs of sustaining capital or exploration in finding more ounces. As a consequence, the jurisdictional governments have been saying, "Well, if their margin is that thick, 100%, then they can certainly cut us in for twice the kind of taxes that we have historically achieved."
TGR: That is a problem of a mining company not effectively reporting what its true costs are. Maybe that's part of the better transparency that we might see going forward.
MK: I think we will because they have to. The senior mining companies were rewarded for offering leverage to gold; as a consequence the market misrewarded them, in a sense, for finding marginal ounces, and that's what they gave us in spades. It was very easy for them to deliver on that promise, and now they're sitting with a series of assets that they really can't develop due to the economics of hard times.
TGR: Are there other jurisdictions you like besides Mexico?
MK: I like Serbia. I traveled there two years ago. There are a series of companies along the Tethyan Belt, which really offers a lot of potential. Serbia was closed off largely because of Kosovo and the war. Now that they want to get the economy humming again, it's really looking at these other mineral-type developments.
TGR: Do you have any other parting thoughts for investors in terms of how to navigate 2013, when we have a gold price today at $1,700/oz.
MK: A large part of my investment theory is geared toward discovery. My clients hire me to seek out the high-return speculations available in this market. These markets, while challenging, are still rewarding exploration success. The discoveries are starting to come to the forefront because there has been a fair amount of activity that's gone into plays, or dollars spent to develop geological concepts and ideas that are starting to bear fruit. Speculators often like the idea of getting rich quick, but the exploration process realistically takes time, and it takes a mature view to see how these projects are developing.
TGR: Rick Rule has been famous for saying that the chances of success in the discovery business are extremely slim. Are your clients patient with this process, knowing the odds are not great?
MK: Yes, my clients have developed this discipline over time. I've been working as an investment adviser for over 12 years, and a lot of my clients have been with me through thick and thin. We've been through the 2008 market. We've been through this market over the last 18 months, which I've typified as death by paper cut—it's been a long process. I've been able to educate my clients. If you want to be happy with your stock portfolio over the last two months, that's simple: lower your expectations. You've got to expect that there's going to be times in the race where you're at the back of the pack. It's more important to stay with it on a good trend in a good investment and to know when you're positioned to make a move at the appropriate time.
TGR: That's the whole idea of being a contrarian. That's why it takes a lot of moxie and guts.
MK: It does.
TGR: Thanks for your insights.
Michael Kosowan is an investment executive at Sprott Global Resource Investments Ltd. Originally from Canada, Kosowan holds a master's degree in mining engineering and is a licensed professional engineer. He is also a registered representative, having completed the Series 7, Series 24 and Series 63 in the U.S. and the Canadian Securities Commission course. He also holds a diploma in Regulatory Law. Prior to working for Global Resources, Kosowan was a project engineer at Placer Dome (now Barrick Gold) and the exploration manager for Atapa Minerals in Indonesia.
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1) Sally Lowder 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: None. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Michael Kosowan: 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: None. I was not paid by Streetwise Reports for participating in this interview.