Cycle of a Successful Junior Miner
Firstly it makes sense to look at the generic model that is shown for successful junior mining companies. A model for this is shown in the image below.
As the illustration above shows, as the junior mining company progresses through exploration to development and then onto production, the perceived risk falls. That is because numerous barriers to production are removed, including economic viability of the deposit, and the ability to finance construction of the buildings and machinery required to actually produce. The initial share price rise within stage 1 can be particularly extreme dependent upon the size of mineral deposit targeted. Of course, at the point of exploration, the actual true size of the deposit is unlikely to be known, hence speculators often purchase in the hope that a deposit of greater size than previously forecast, is identified.
That said, the rise pre-production and during production is often of a much higher magnitude because the company can start being valued by the market based on the present value of future discounted cash flows as explained here, rather than being valued on an in-situ basis.
However, I have added an addition to this typical chart in the form of the red 'reality bar' at the bottom of the image. The reality is that the vast majority of exploration projects don't even reach a stage whereby they have an economic study completed on them. A formal economic study may be a Definitive/Bankable/Preliminary Feasibility Study or a scoping study. Moreover, less than 12% of PLC exploration projects will reach some form of long-term production (i.e. excluding tailings or temporary projects). In bear markets that figure drops to less than 7%.
What does that really mean? Well, typically a junior miner will engage in one to four projects at any point in time. To properly explore them will require vast sums of capital to conduct the initial drilling and geotechnical studies, but moreover it often takes between 1-2 years just to complete this initial stage on any one project. With that low success rate in mind, most junior miners will never reach production. Why might that be? In the vast majority of cases it's not because they have been acquired by another company; it's actually because of a range of pitfalls. Therefore, you need to be highly specific when choosing which companies to invest in.
6 Common Junior Miner Pitfalls
Pitfalls exist across each of the three stages identified above, including the production stage. However, since we are looking at why most miners don't reach production, this tutorial will focus on listing common pitfalls affecting companies during their first and second stages (i.e. Exploration and Development).
- Running out of cash: By far the most common pitfall, this occurs because junior miners do not have ready access to debt facilities, hence are reliant upon equity issuances. Should the market for equity issuances decline, or the company fail to convince investors to fund them, then many fold or resort to disposing of projects. This is a much more substantial risk during a mining sector bear market.
- Poor exploration drilling results: This goes to the heart of any mineral deposit. The deposit must be fundamentally attractive from an extraction point of view such that there is at least a possibility that it can be mined economically and be capable of generating a profit. Certain factors such as resource size and mineral grade are important within this; I will cover those concepts in future tutorials.
- Regulatory blocks or mining permits not granted: In some cases companies have been unable to develop exploration assets because they have failed to gain the necessary approval from the relevant authorities either to mine or to construct the facilities required for production. This may be because of environmental or social impact concerns.
- Change in underlying commodity price: There are numerous cases of companies discovering a resource that are commercially viable when the commodity price is high, but are far from economic when the underlying commodity price declines by over 10%. It's important to ensure that the commodity in question is either strategically important or that the commodity has a strong price outlook.
- Unattractive project economics: For a project to be financed, the economics need to be attractive to a lender. Three of the characteristics strongly preferred are an IRR greater than 20%, relatively low CAPEX, and a high NPV. For more details on these concepts, read here. Failure to achieve attractive project economics are a common reason why a mining project may never reach production as it greatly obstructs access to the necessary finance.
- Poor management decisions: This is one of the core risks for any investor given that it is ultimately the management of these companies who are largely culpable for the level of success that shareholders will see. Poor management decisions with regards to certain asset disposals or with regard to relations with mining authorities in the relevant jurisdiction can severely impact upon the likelihood of a successful project. Try to seek out management with proven track records throughout the mining cycle (i.e. those who have performed well in both bull and bear mining markets). Chances are that the experience they hold will enable them to have a higher chance of success again.