Investors have again begun flirting with the junior mining sector. Will it lead to a love affair or is it just a tryst? Derek Macpherson, a mining analyst with M Partners, believes it is still too early to be taking on high-risk, high-leverage names. In this interview with The Gold Report, he advises investors to carefully choose low-risk companies, even in this early stage of a rising gold price environment.
The Gold Report: Canada's Globe and Mail reports that gold miners wrote off $17 billion in 2013. Does that encourage investors seeking greater exposure to precious metals to ignore the bigger names and look more closely at small-cap gold and silver equities?
Derek Macpherson: I think it makes investors a little more selective. During the last upturn in the gold market many of the big-cap companies purchased and built large, lower-grade projects; these projects have seen the majority of the write-downs over the last two years. This does not necessarily mean that there are no good big-cap mining equities; but it forces investors to be selective. However, many of the small-cap equities have undeservedly sold-off with their larger peers. We believe this creates an opportunity for investors to selectively add to their portfolios.
TGR: The junior mining sector is seeing some renewed interest from suitors, but is not yet the market darling. Do you believe this investor flirtation is likely to lead to a long-term love affair or is it more akin to a tryst?
DM: I think it's a little too early to tell. We're at the first or second date stage and we don't know whether this is the one or if it's a short-term fling. It is still too early to be investing in high-risk, high-leverage names. It fits well with our investment thesis and what we talked about the last time we spoke, which was that we like low-risk names even in the early stages of this rising gold price environment.
TGR: Low-risk names. Would you deem this a value sector right now?
DM: There are definitely some value plays in the sector, names that have been unjustly sold off, and there are some opportunities to catch them as they come back and their businesses recover.
TGR: In your last interview with The Gold Report you said, "In a rising gold price environment there was more room for error, and setbacks didn't have as large an impact on project economics." We're now in a modest rising gold price environment yet a number of companies have trimmed costs including some that you cover. Is this a sweet spot?
DM: If we are in a longer-term gold price rally, the best time to get in is at the very beginning. The thing that drives up or is perceived to drive up the gold price is inflation, which is also what drives up underlying costs, something we saw in the last cycle. Early on it was a great time to get in and it was a great time to build projects. That's when the most money was made. Then as the market got a little bit more frothy, we saw costs start to chase the gold price up and margins started to contract. Now is the time for investors to start taking a second look at the mining equities and start to invest.
TGR: Nonetheless, these equities present significant risk. Grade, jurisdiction and a simple mine plan/geology are common ways companies mitigate investor risk in this sector. In your coverage universe, how would you rank those?
DM: We view grade and simple mine plan/geology as 1A and 1B. With high grades there is more room for error, helping de-risk a project. Similarly, a simple mine plan, like most heap-leach projects, also creates that lower risk environment. Companies don't necessarily need higher grades for that. Second would be jurisdiction. A company can take a little bit more jurisdiction risk with minimal impact, but if the grade or the mine plan doesn't work, the project doesn't work.
TGR: Are there some other risk mitigators that ought to be included in that list?
DM: There are two other things that investors sometimes overlook: management and the balance sheet. They will see a great project with great grade, but they will often overlook the management team. A company needs a strong management team to deliver on a project's potential. In this environment, there are good management teams out there that have done it before, which help de-risk a project. The second thing that sometimes is overlooked is the balance sheet. Investors definitely want companies with balance sheet flexibility-low debt and a strong cash balance-which helps de-risk projects, particularly as they are ramping up.
TGR: Some of these junior equities have seen dramatic price rises since the beginning of the year and even before that in some cases. There was a bit of a rally in late 2013. How should investors approach those names? With caution?
DM: Investors need to make sure a company has strong fundamentals and a valuation that should allow the rally to continue. Some of those names that have really moved in late December and early January were coming off tax-loss selling. We saw a number of equities rally on that alone, going down toward the end of 2013 with tax-loss selling and then rebounding in early 2014. From a trading perspective, after a strong rally investors want to wait for equities to take a pause, or even pull back a little, before stepping into names that continue to have attractive valuations.
TGR: You cover some companies that are now mining base metals. What's a brief forecast for zinc and copper?
DM: We continue to prefer zinc to copper. With a number of large zinc mines coming offline and few ready to be built, we think that there's an opportunity for zinc to recover. While we are bullish on zinc in the medium term, near term we are only modestly bullish because of the amount of inventory that's in the LME warehouses that has to be worked off before the likely supply deficit starts to impact pricing.
For copper there are a number of large projects sitting out there. While some of them have been delayed and that takes the pressure off the oversupply in the near term, any kind of bullish move in copper could move those projects back into the construction pipeline. We're a little bit more neutral on copper and its pricing going forward.
If investors are going to be in that mid-cap base metals space they need to stay with companies that have material growth to support the current multiples. We continue to like Imperial Metals Corp. (OTCPK:IPMLF) [III:TSX]; it has material growth on the horizon.
Saving that, we suggest that investors look a little further down cap and look at the discounted valuations in the base metals space.
TGR: Imperial Metals is an established company. Where does it fit into Canada's base metals producers?
DM: Imperial is going to end up being one of the larger mid-cap producers once Red Chris is ramped up to the 30,000 tpd level. We're looking for its production profile and free cash flow to more than double once Red Chris is in commercial production. That puts Imperial at the top end of the midtier space. While we only model a 30,000 tpd asset at Red Chris long term, we think that the opportunity exists for Imperial to materially expand production, but there are limited details on what that may look like.
Imperial is looking at May 2014 for commissioning. We model Q3/14, which is about a month later, but Imperial so far has been delivering on its critical timeline items. The key thing that we're watching for is the Iskut Extension of the power line. Imperial is completing that themselves and is scheduled to be finished in May 2014, the same time commissioning is supposed to start. We view that as probably the highest risk to both the project timeline and the budget.
TGR: Any parting thoughts to leave with us?
DM: We're starting to see some positive signs in the precious metals space. While we like what we're seeing currently, I think investors should still continue to be selective and focus on low-risk names in this early stage. If this is the early stage of a longer-term rally, we think that's where the money is going to flow first.
TGR: Thanks for your insights.
This interview was conducted by Brian Sylvester of The Gold Report.
Derek Macpherson is a mining analyst at M Partners; before joining M Partners he worked in mining research for a bank-owned investment dealer. Prior to entering capital markets, Macpherson spent six years working as a metallurgist. Macpherson has a Bachelor of Engineering and Management in materials science and a finance-focused MBA.
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