A reader wrote in to ask about a certain gold prospecting company. There’s been little news and share prices are down. Should shareholders worry?
Well, shareholders exposed to risk in exploration companies should always worry.
Exploration is HARD!
But in that case, there was no reason to be particularly worried.
Remember that mineral exploration is an extremely difficult business. Even people who have discovered multiple deposits that became profitable mines don’t always succeed at finding another. Industry veterans say that only one in 300 discoveries becomes a mine. And there’s no way to count all the thousands of targets geologists evaluate and discard before they pick one to explore in hopes of making a discovery.
The baseline expectation for all exploration efforts is failure.
Why then do I invest in such a crazy venture?
Because the value added is huge when a company that has nothing makes a significant discovery. Mathematically, any value at all is infinitely more than zero. In terms of practical results on the stock market, a discovery can drive a stock up 10x, 20x, and more.
But how does one decide which exploration companies to bet on when they all seem to have great stories? Even the ones that really do have great stories often fail!
There are ways to vastly improve the odds of this sort of speculation:
• Back a great prospect generator. A prospect generator is a company that acquires a portfolio of prospective properties and then options them to joint-venture partners who pay for the super-high-risk exploration work. In exchange, the optionee gets most of whatever is discovered. Typically, the partner gets 70%, leaving the prospect generator with only 30%—but none of the risk. That’s great, but even when it leads to success, it doesn’t do so on any sort of schedule. Lack of news, or even disappointing news from one of a prospect generator’s many projects, doesn’t change the basis for speculation. In short, speculation on prospect generators requires patience.
• Bet on an exploration company with cash flow. These are hard to find, as most exploration companies have no revenue at all. They raise money by issuing new shares and then pour the cash into holes in the ground, usually coming up with nothing. But sometimes an exploration company that’s been around for a while retains royalty revenue on a past discovery that’s now a mine operated by another company. Or sometimes, the company has a side business, like drilling, or mine-site cleanup, that generates revenue. It’s rare, but sometimes an explorer makes a small but profitable discovery and uses that revenue to explore for something bigger and better. Companies with great people, solid targets, and income to help they keep going until they succeed can be great speculations.
• Buy well-structured private placements. A private placement is when a company issues new shares to raise money on the stock market. Of course, convincing investors to put money into something as risky as exploration in a company with no revenue requires an incentive. Usually, this takes the form of a warrant to purchase shares in the future at a set price or by pricing the offering at a discount to current market prices. Often it’s both of these. The discount is nice if you can get it, but the warrant is where the real value is. You only exercise the warrant if share prices rise above the set price—in other words, when you’re guaranteed to make money. That may or may not happen, but the shares you get in the placement may do well, or they can be liquidated to recover (much of) your initial investment if they don’t.
• Buy an already successful explorer. We can make the most spectacular returns if we guess which companies are going to make a discovery before the fact. Problem is, I don’t know anyone who can do this reliably. I can’t do it. Famous speculators like Rick Rule and Doug Casey can’t do it. Even the best exploration geologists in the world can’t do it. That’s why we rely on the methods above. But once a discovery is made, the risk profile of a company changes drastically. Investing in a company that has “a bird in the hand” and is delivering round after round of value-adding exploration results rarely results in a 10-bagger (1,000% gains), but it can. More important is that it can easily double or triple our money with much less risk.
If an exploration play doesn’t put the odds in my favor in one of these four ways, I’m not interested. That’s it. No “ifs,” “ands,” or “buts.”
Now you know.
