What's up with Small Resources?

On Friday I received an email from Hedley Widdup from the Lion Selection Group (LSX). Lion Selection is an Australian Listed Investment Company that is focused on investing in small resources companies. Their investment universe requires that they carefully watch for signs of where we are in the mining cycle. After verbalising his thoughts to shareholders and media many times in recent months, Hedley decided to crystallise his thoughts in the article below which he sent through to me. Thanks Hedley.

What’s up with Small Resources?

by Hedley Widdup, Fund Manager, Lion Selection Group Ltd, ASX:LSX

If the annual Diggers and Dealers conference had been scheduled for May this year, it would have been a sombre affair. But it wasn’t – it takes place next week in Kalgoorlie, and what a difference only two months has made to sentiment. And sentiment, for the annual gathering of Australian optimists, is all important.

Shares of most mining enterprises took a battering between mid-2011 and 2013. Major miners recovered first and staged collective ~20% price appreciation during the last financial year. The mid-caps were less convincing but nevertheless look to be on an up-trend. Pre-production exploration focussed juniors continued to suffer throughout 2013, whilst it remained very difficult to raise all important exploration and development funds. In fact, for a period it seemed that even good news could precipitate share price weakness as the volume in the market was often viewed as a selling opportunity, and negativity was fairly indiscriminate. Since roughly the middle of 2014 (post 30 June?), sentiment towards explorers has been remarkably different.

It’s like a switch was flicked that allowed the market to appreciate good news out of explorers, and there are loads of examples – THX, KGL, MEP, TON, MTA, KDR to name but a few. In each case, trading following company’s respective announcement of drilling results led to a multiple rerating of the company’s shares well above their trading ranges of the last 12 months. This is great news for the junior space – the slow starvation of liquidity over several years was like a death of one thousand cuts and these events show that there is investor interest in risky exploration plays. Whilst very encouraging, it’s too early to be calling a new boom. It’s worth thinking a bit more carefully about what has brought about this sudden reinvigoration of investor interest in exploration juniors and what it means for the stage we are at in the mining investment cycle.

First of all, a mining boom is characterised by pervasive optimism, greed rules over fear and the rising tide lifts all (or most) boats. Right now we are seeing very selective performance. It’s arguable that the average speculator is targeting high risk situations, where it is still too early to see if there is a semblance of a viable project yet, over companies with much better defined projects (but no news) that have been caught up in the otherwise general malaise towards explorers. There are a range of specific themes that have captured market attention:

• Drill results – especially where width and grade are suggestive of a potentially economic discovery
• Graphite – a longer term theme than the last two months, and perhaps overlapping with the present market interest in technology enterprises
• Nickel – following the enforcement of a nickel laterite ore export ban by Indonesia, the increase in nickel prices has favoured producers and explorers

Overlying these themes, the broader Australian market is looking highly valued. That’s not to say we think a correction is imminent, but after a couple of years of market funds flowing into yield stories in a persistent low interest rate environment, it’s getting harder to pick further value growth situations. In searching for growth, it’s quite likely that punting money is now actively looking for riskier stocks, and can be deployed quickly when an opportunity presents. Having experienced such falls, resources look “cheap” (as in cheaper than they were) and whilst this condition has persisted for some time, many commentators are now saying that it is now dangerous to be betting against resources. These remarks make it seem the herd has changed direction, which is all important as whilst there are sellers around any resurgence of interest will be absorbed by pent up selling. This is the final ingredient for the mining sector to build towards the next boom.

As a sector, mining has experienced a flush out since mid-2011. Through this time, fear presided over a general lack of investor appetite broadly for mining stocks, and the stocks that suffered the worst have been explorers. Now three years on, fear has grown weary, select commodity spaces have rallied and greed looks to have reappeared.

There are now many positive signs that we have passed the bottom of the resources market, however mining booms never start quickly. Available funding for companies exploring or developing projects is still low. This will increase over time, especially as investors experience share price increases in their punting portfolio. Major miners remain in “reverse” M&A mode, as their new generations of leaders steady their ships on cost and jettison non-core projects. There are acquirers in the market – namely ambitious mid-tier miners and groups funded out of China, however the transactions taking place are mainly opportunistic and driven by the asking price being acceptable to the buyer. When the majors once again become acquisitive, it’s unlikely they will wait for deals to come to them, and their appetite may be enough to move the market.

Diggers and Dealers is a soapbox opportunity for promotional junior resources companies, and to have seen a revival of sorts for the presumed dead speculator buck sets the scene for yet another optimism fest in Kalgoorlie next week.