Case Study On The Hazards Of Exploration Stocks

It's webbed by Smart Money, and it originally comes from Barron's Online. It makes for a sobering report for gold-exploration speculators. Two exploration companies, NovaGold and Seabridge, have market caps of $1.12 billion and $948.19 million respectively. The stock price of each is $6.10 and $25.36 respectively. At these prices and market caps, one would expect them to be solid producers. And yet, neither has produced an ounce of gold.

The article, entitled "Is There Gold in Them Thar Hills?", explains why both are selling at large market caps: each is sitting on a deposit that makes for an "elephant" field - more than ten million ounces of gold for each. However, Novagold was hammered down in 2006 because its feasibility-study estimate proved to be unrealistically high.

In a sense, the above is a variation on the oldest story in the book. Gold-exploration stocks are not unlike tech stocks, in that the most dazzling product (or deposit) attracts the most optimism. Both are susceptible to an auto-catalytic mania, in which overvaluation feeds on itself: the overvaluation is taken as a sign that there's something quintessential about the company, which justifies even higher valuations; etc. I note that neither NovaGold nor Seabridge is terribly overvalued with respect to dollars per estimated ounce of gold in the ground, but it's fields like those that tend to generate said optimism. Beofe NovaGold's scandal, the stock was selling at above $20 per share.

That's the risk of investing in hot exploration companies: the highest levels are nosebleed levels. One way around it is to focus upon less exciting exploration stocks with mid-level deposits, ones that aren't worth a takeover bid right now. These stocks don't offer the chance of becoming billion-dollar behemoths, but they aren't susceptible to the hype and excitment that elephant-field stocks are. Of note is the main barrier facing any exploration company that's otherwise mine-ready: capital costs. Even if a company has a solid feasibility study with an acceptable internal rate of return, the amount needed to bring the mine into production may be too daunting to secure bank financing - and too dilutive for a secondary offering, or private placement, to secure the needed funds. Typically, private placements offer warrants as part of the deal with a strike price that's 25-50% above the offer price. The typical deal offers 1/2 of a warrant per share with an expiry date of 18 months. In order to get the funds through a private placement, therefore, involves a lot more dilution than is immediately the case unless the warrants are destined to expire worthless. [One side effect is that the company may have more money in treasury than it needs if the warrants are exercised. I should note that an exploration stock with a hot property can get away with a straight private placement without warrants, as has been the case for Nova and Seabridge.]

There is a case to be made for an exploration company that holds an unglamorous, mid-range deposit because its capital costs are relatively low. It's unexciting, but few people lose their heads in such a situation. Also, the downside is lessened: such stocks typically have low market caps. However, those kind of stocks also lack the upside potential that an elephant company has and they're usually not worth taking over.


Even major producers have their problems. This Montreal Gazette article explains the troubles that Kinross Gold has had with its flagship Paracatu mine in Brazil: its ore has proven to be more difficult to process than previously expected, which took a bite out of its third-quarter earnings last year. Also dogging Kinross is a possibly inadequate internal rate of return of its huge but low-grade Cerro Casale deposit. The capital costs for the latter have ballooned from $2 billion to an estimated $3.6 billion. The other company mentioned, Aginco-Eagle, has had trouble with two of its newly-opened mines: one had lower grades than expected, and the other had a slower-than-expected ramp-up.

Such are the risks: no-one really knows what's down there until a mine is actually opened and brought onstream. Until then, what data there is, is based upon (possibly overoptimistic) estimates.


Update to the last: As it turned out, Agnico-Eagle's fourth-quarter results beat the Street by five cents per share: 31 cents instead of an expected 26. Kinross swing to a profit of an adjusted 21 cents per share, which was better than analysts expected; the estimate was for 16 cents. The company also announced it was selling its 50% interest in the above-mentioned Cerro Casale deposit to Barrick.

So, the above-linked Gazette story could be chalked up to jitters...but those risks still remain for the sector as a whole.