I was sitting yesterday with the managers of a fund that specialises in tiny-cap natural resources stocks.
Wounds were being licked; war stories exchanged. I’ve been at wakes that were more jolly.
The sujet du jour was: “when is this bear market going to end?”
And that’s the question we attempt to answer today, as we consider the fate of small-cap natural resource companies.
How long will the bear market in resources stocks go on for?
Oil explorers and junior miners – remember them?
Once they were the must-have, speculative play on the great commodities boom – the investment that really did turn penny stocks into pounds. Now they’re king of dogs in Canine Land.
The party is well and truly over. All that’s left are sore heads and a lot of mess.
How long before the music starts playing again? It’s something I’ve been thinking about a lot. The bad news is, I’ve concluded it will be quite some time (although please bear in mind I’m talking specifically about tiny-caps here).
We need several things to happen.
First of all, commodities prices need to rise – or at least stabilise. But whether it’s oil, metals, grains or softs – the bear market rules. Large producers are struggling to break even. Their focus is on cutting costs and improving efficiency. Increasing their reserves is not a priority.
In a bull market, analysts look at company ‘X’ and say: “Wow! They’re producing ‘Y’ tonnes of product, but they’ve got ‘Z’ tonnes in the ground. It’s only going to cost them ‘A’ to get it out. This company is worth big bucks!”
In a bear market an analyst looks at the same company and says: “They’re producing ‘Y’ tonnes of product, but it’s costing them big bucks to do so. They’re barely making a profit. And all that product still in the ground is going to cost them big bucks to maintain and develop. It’s uneconomic. In fact, it’s a drain on capital. It’s a liability.”
The story’s the same – but the narrative changes.
Today, the market is not assigning any value to so-called resources in the ground. In many cases, they’re actually seen as an unwanted cost.
So the company that is promising to go and find more resources for you? There’s no need for it.
Second, once commodity prices start to settle, we need to see producers make a demonstrable, consistent profit. It needs to be clear that corporate practice has improved. No more beardy-weirdo geologists and shiny-teethed investor-relations people staying at the Savoy when on fund-raising trips.
In the gold sector this is slowly starting to happen. What’s more, the falling oil price, which cuts production costs, is helping profitability, as is the strong dollar – gold is sold in dollars, while input costs are in weaker local currencies.
Third, a period of good numbers will change sentiment, both from investors and from within companies – hey, we can make money!
As profitability improves, they will look to expand production. Then all of a sudden, they won’t be able to produce enough, there’ll be a perceived shortage and eventually they’ll have to expand their resource base – which is where the tiny-caps come in. All the while, the narrative is changing.
But we are still a way from that point.
The simple truth is: booms take a long time to get over
The Nasdaq has, with the exception of 2008, pretty much been in a bull market since 2002. Yet it is still trading below where it was at the dotcom peak in 2000. Even though the underlying earnings and foundations of today’s Nasdaq are infinitely better than they were then, the narrative is different and the psychology is different.
Remember the insanity of uranium madness of 2006-07? It seems like yesterday, but it’s already eight years ago. Uranium went from less than $10 a pound in 2003 to almost $140 in 2007.
The story – and one we all bought – was the looming energy shortage, with hundreds of nuclear power plants being built in China, and a pressing need for them in Europe as well.
Tiny-cap companies that had staked some land in Wyoming or Namibia or Kazakhstan and stuck a couple of drills in were seeing their market caps double every fortnight, until many had valuations of over $100m, even though there was no realistic chance of them ever building a mine.
I remember one company, Canada-listed Laramide (TSX-V: LAM), (whose management I rate). It had made a legitimate discovery in Australia. The share price went from 15c to C$16 in less than three years.
Now it’s sitting at 35c. The management team is diligently carrying the project forward as best it can in the face of capital markets that have completely dried up. There will eventually be a mine there – but it’s still many years away.
Laramide is tracking the price of uranium, which is now around $35/lb. It’s been making lower lows every year since 2007.
The long grind of a post-bubble bear market
That is the cruel way of a post-bubble contraction. It goes on for a lot longer than people expect, and squeezes the life out of all but the most hardy.
The commodities bear market of the 1980s and 1990s, which followed the inflation of the 1970s, is also worth considering. Of course there were rallies. There will be this time around too. If you time it right, sometimes you can double your money. But the bigger story is that they strangle investors.
There are sometimes exceptional companies or an exceptional discovery is made, and so the broader trend of the market is defied – but the key word there is ‘exceptional’.
In fact, I’m currently considering a junior mining play, which I think is ‘exceptional’. But any investment I make will be with my eyes wide open. If I invest, it will be the first time I’ve put any new capital to work in this sector for quite a while. And I will do so fully aware of the fact that what we have on our hands is likely to be a bear market that grinds and grinds and grinds.
If you’re considering looking for bargains at the tiny end of the resources market, that’s what you need to be aware of too.
• Dominic Frisby is the author of Life After The State and Bitcoin: the Future of Money.
Category: Market updates