5 Points You Need to know before Investing in a small-cap resource company on the ASX?
5 Points you need to know before investing in a small-cap resource company on the ASX? Many would ask, are you trying to sell a How to Blog? My answer is simple. I have been in this industry for nearly 30 years, and I feel that the structural parameters of risk and reward ratio that “entice” investors have not changed after all these years. You would be surprised how often investors ignore these simple basic questions. In the last ten years of “corporate” work, I have heard so many people say that promoters misled them and were all liars. What I know is that in many instances, the fault is in not asking these simple questions. It is not negligence, its that fact that this is a unique and dangerous sector but filled with the excitement of more substantial capital gains.
How many times have you been approached to look at a company that is raising money, doing an RTO, an IPO or merely being asked to buy on the market? We all know that investing in a small-cap resource company on the ASX can be very challenging.
When you look at this industry, many commentators have compared the process much like going to the casino. In many aspects, I agree, but every gambler has a system that uses science to explain the process. It is this science if applied properly that increase your chances of getting a good result from investing in a small-cap resource company on the ASX.
So What Should We Be Looking For?
Investing in a small-cap resource company on the ASX is something of a unique beast as it deals with the blue sky but yet requires a lot of the first principle of investing, DYOR (Do Your Own Research). The issue with the average punter and those that are new to the industry is that many of the research may sound like a foreign language or don’t see the full spectrum of activities behind the scene and don’t realise that what they read and see is not necessarily a result in reality.
In my opinion, there are many factors to put on a checklist. However, let’s discuss those that are probably more relevant, more important or more critical. These points are not a saviour of a decision but give an excellent guide to what you would want to know, before investing in a small-cap resource company on the ASX.
So How Does it Normally Work?
For your average Joe investor, opportunities arise where an “introducer” proposes to you to invest your hard-earned money into a company through one of these five scenarios,
• RTO (Reverse Takeover – probably less likely in time to come as the ASX is slowly making it less attractive to do this method.)
• IPO (Initial Public Offering)
• Rights Issue.
• Buy on Market
Lately, the RTO or Reverse Takeover was a flurry of activities, but I see this as less likely. The ASX is now making it hard for an easy RTO and instead of making participants go down the route of re-compliance and do a new IPO. All pathways to the “easy money” no longer exist.
The traditional IPO is probably the least favoured as there is a perception that it is harder for 20 cents to get to $1 than for a stock to go from 2c to go to 10c. This kind of thinking is purely an act of market psychology and I feel that strongly through my trading activities. The market is all about psychology and very little on fundamentals. One can argue that but what makes a stock price plummet many percentage points overnight, technical or psychological?
Placements are the most commonly used instrument, and they occur very often. When you are dealing with a business that does not make an income and the investors make money from the capital appreciation of the share price (and this is why activities are essential for the company), you would expect cash burn rates to be higher than usual. The downside of placements is that they usually are not placed to the public and all the good ones are for the “boys” club. And when you get a look, you would wonder why am I getting this?
Rights issues are an interesting phenomenon as it is like a double edge sword. Rights Issues are taken to raise more money from existing shareholders and sometimes, it’s a good thing, and sometimes it’s a bad thing. It is also used in many cases to change ownership of the management and the shareholding. Don’t get me wrong, this happens in all the other forms of capital raising, but this is just the most commonly used instrument. It is also the most “legal” way of doing things :-).
Buy On The Market
Buying on the market is the most easily understood. Buying on the market is least used to influence a sinister plot. In saying that, I am assuming that you are not going to buy a controlling stake from a recommendation. The professionals do take controlling stakes from the open market. I have seen this happen more than once, but they are people who have a mandate/agenda to achieve a future yet determined purpose.
So what are the points to look out for?
With over 30 years of experience, it usually only takes a quick 5 minute of reading and investor deck, an Information memorandum or Presentation for me to decide if I need to spend any more of my time. You will be surprised at the numerous name changes that projects can go through with a new concept or a new super idea over and over again. The predominant motive for investors in this sector is to make money and make good capital gains. Otherwise, you would buy BHP (ASX: BHP), Rio Tinto (ASX: RIO), National Australia Bank (ASX: NAB) or Westpac Bank (ASX: WBC). Investors in this sector tend to turn a blind to the “sharks” in return for the share price heading north.
Let’s try and make this simple and discuss some of the critical points that I think one must check before throwing our hard earned money into the hands of these “sharks”. In my normal checklist are these items to be considered,
Market Perception of the Commodity
1 – Technical Merits
All projects have a specific component that will make it happen or not. A good friend of mine once told me that all diamond mines have something unique that will make it viable. If not for that component, the mine will never happen. He said, look at Argyle Diamond mine, it’s the Pink diamonds that make it viable. You could also add the marketing of its browns as Cognac and Champagne diamonds was anything but a spectacular stroke of genius. Take Ellendale diamond mine, the yellow diamonds kept the company going, and as soon as that marketing game finished, the company was in administration.
On the other side is the Letseng Diamond mine in Lesotho. Letseng is characterised by extremely low-grade ore (less than 2 carats (400 mg)/hundred tons) and is known for producing huge diamonds, having the highest percentage of large diamonds (greater than 10 carats (2.0 g)), giving it the highest dollar value per carat of any diamond mine. The world average is roughly US$81 per carat, while Letseng averaged over US$1,894 per carat for the first six months of 2007.
My point is that the technical merits of a project are not the headline numbers. It is about possible production numbers. It is about the intrinsic value that it has which makes it a viable project. Also, depending on your investment strategy, are you looking for capital gain while the story is in high momentum or when it comes to production. Again, these are essential factors to consider.
In many gold projects, investors get excited with big numbers, but they need to realise that an interception of say 5m at 125g/t is markedly different from 150m at 2.5g/t. The example I have given there is almost on two extremes of the spectrum, meaning that the first may not work and the second is practically a discovery.
2 – Corporate News
Corporate activities are the most contentious point for investors and vendors of projects. In reality, most plays are in a public company scenario and where everyone is going to make lots of money from the share price going up. For companies that are in the ASX, it is common for vendors of projects to be paid in part or in full with company shares. The share price going up is what vendors are all hoping that they will have their payday soon. Under present ASX listing rules, in most cases, vendors of projects have their shares escrowed for up to 12 months or at least 12 months (the shares are held and not allowed to sell till a particular time in the future).
This is where the problem starts for everyone. Everyone benefits with a rising share price, and if your drill hole does not come right, that is not going to be good for all shareholders. As companies “make money” through placements, the company wants as high a price as possible before they start issuing shares for new money. As you can see, the ingredients for mining the market begins, and with all schemes, it just gets worse as time goes.
The Old Boys Club, kool to some people. (source:Tailgatecorneroffice)
The term “mining the market” is very well used and the losers are the shareholders, and the smaller you are, the more insignificant your thoughts and feelings are to the company. Sweet deals are very commonly placed to “the boys club” to average their cost down while the smaller shareholders are ignored.
3 – People
The management team/directors need to be compatible with the activities of the company. As the company is a non-income generating spending machine, those paid an income need to be doing it’s best to reduce the expenditure. A mineral resource company with AUD5m in the bank is not going to have a lot of money left if they are paying themselves a high wage and employing everyone under the sun.
I would go further in saying that the directors who are geologist should be the ones sitting on drill rigs. Mark Bennett is one that is a real example of saving money and doing it all and the result was the discovery of the Nova-Bollinger nickel-copper mine with Sirus Resources Limited. Sirus is now absorbed into IGO (ASX: IGO). There are too many examples of directors who are on a high wage and not making any real effort to reduce the spending. For a small company, controlling cash is a significant issue as the cost of operating a public company and making sure you get the stories and maintaining market expectations is very difficult.
4 – Brokers
The broking industry is not doing well at this time as there is a downturn in the small-cap sector. My 30 years in this industry have taught me that the broking industry is one that is very robust. It is incredible how they can survive for this long. My relationship with brokers is in a ubiquitous phrase; the broking industry gives you the umbrella when it has stopped raining. It is very frustrating, but I do understand why that is the case. The brokers are only interested in no lose stories, and they negate bad stories by being lined with options and shares that are or will be “in the money”.
This is a commercial world, and that is a simple truth. Hence, when these guys start coming to you, be very aware that all the walls are lined, and you are the fuel that the vehicle needs to get going. They are given the incentive to approach you and compensation has been given to them in case they lose you as a client. Brokers play an essential role in helping companies to promote however I am open to thinking that in today’s social media world, companies can do a lot of promotion internally with the right personnel.
Don’t get me wrong. I am not saying that the brokers are all shonky hub stealing people in suits. What I am saying is that they are in this business to make money. The everyday investor is also in this business to make money. All I am alerting to is that investors should understand the motive of the introduction. There is always going to be a level of conflict of interest as they make money for companies in getting you to invest, but that is just the nature of the game. The other way to look at this is that you would not get the opportunity to make money without them.
5 – Market Perception of the Commodity
Market perception of the commodity is obvious, and as I explained in my previous blogs with zinc (Zinc Market- What happened to the price surge?; 7 Interesting Zinc Companies on the ASX), market perception may not necessarily be the market reality. In the first part of 2018, I started telling people that I believe that the simple commodity like nickel and copper will flourish. At that time, cobalt was still the darling with many commentators always saying, get cobalt and all your worries will be over. At that time, I think Cobalt pricing was near USD 92,000. As I write today, the price of cobalt is around USD 32,000.
Nickel and Copper are showing good signs of recovery, and simple commodities such as iron ore are now back in favour. As I tell my associates, I don’t need to have lithium as I don’t need an electric car, but I need the essential metals to have that car. The next EV story could be hydrogen or tungsten or vanadium, but I need the nickel, copper and the iron in any of those scenarios.
Gold is a good example. After the crash in 1999, it was USD 240/ounce, and today it is over USD 1300/ounce.
Market perception, in my opinion, takes into consideration, timing, price upside and demand upside. When all three points are aligned, then, in my opinion, that is a good thought.
It is never easy to decide what is a good investment or the right timing and I am not professing that I am an expert. The more I write, the more there is to share, and suddenly I realise that there is an endless amount of mines field that I have seen and heard over my 30 years. For example, it was only recently that I realise that no more than five personalities control the whole mineral resource small-cap sector in Australia. Everyone else feeds from them and deals are done in a myriad of ways in companies that are related to or friendly to these identities. I don’t mean that in some illegal manner, what I mean is that they have positioned themselves well over time in projects that are in their portfolio.
To get a good look into whether the investment is a good move, one needs to understand how the market works in this industry. It is easier for the likes of myself to understand if there are any big holes in the presentation, but it is also impossible to say that a bad reputation means a bad investment. In some cases, you can make a lot of money with a functional promoter with a lousy project. Sometimes, it is the opposite.
When I started this blog, I thought I could cover everything that I wanted to say. However, it appears that I have already written too much and there is still so much to share. I guess that this means that I will have to do the rest in another blog. These 5 points are just a rough guide to what I think I know, so there is no need to crucify my thoughts. I have been wrong, and luckily for me, I have been correct most times 🙂
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