Are junior mining equities just options?
When you buy shares of Vale, BHP, or Freeport, you're buying direct production exposure to their mines. When you buy shares of Stornoway or Selwyn, you're buying option exposure to possible future production.
This derivative of possible future production is an option where the company will go into production if the project is good, the commodity stays strong, and the world doesn't end by the end of 2012. Owning junior equity shares creates cheap exposure to the commodity.
At times junior companies trade out of sync with their commodities. The price of gold can go up, but the price of junior gold companies can crash. Part of this comes from the financing risk to investors of every future financing required between tomorrow and production.
A junior is going to access the markets an average of 1.5 times per year over the 10-20 year period of building a mine. If the market is shut down (like during the 2008 crash) in any of the financing windows (when a company needs money) and the company is forced to finance, existing shareholders will get wiped out.
At Oreninc we're starting to view junior mining companies as options where the upfront strike (premium) is the initial investment, and to maintain ownership percentage investors are required to invest in all future financings. There is no buy and hold for most junior equities because if a company is forced to raise money in a bad market, an existing shareholder’s stake will get transferred to new investors.
If a company has a $100 million market cap with 100 million shares and a burn rate of $10 million per year, the annual dilution is 10%. If, however, the market cap drops to $25 million one year, the annual dilution jumps to 40%. Junior companies have to finance every year regardless of market conditions. They can choose to slow down in a bad market, but it's a rare company that only finances in a good market.
The conclusion we draw from this is if you plan on investing $100 in a junior company, either you or the company must keep extra cash around to mitigate the damage done by weak financing windows. A company that keeps 6-12 months cash on hand will be much stronger and less dilutive than a company that finances only once it hits fumes.
Ask the management what their cash policy is. If you buy a company that does not keep a rainy day fund, we recommend taking 40% of your targeted investment, leaving it in cash, and waiting for the next market cycle when the company will be desperate for your cash.
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