SA Interview: Investing In The Natural Resources Industry With Laurentian Research

Jul. 24, 2021 7:30 AM ETDECPF, ELEMF, ELE:CA23 Comments20 Likes
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Summary

  • Laurentian Research, a Ph.D. in geoscience, worked as a natural resources industry insider and invested successfully for years, before launching a Seeking Alpha Marketplace service to share his unique investment insights with a rapidly growing community of value investors.
  • How to gain an edge through in-depth research, how to get exposure to natural resource plays while assuming relatively low risk, how a natural resource company can have a wide moat, and key lessons learned from investing in the industry are topics discussed.
  • Laurentian Research shares a long thesis on Diversified Energy and Elemental Royalties.

Feature interview

Laurentian Research, a Ph.D. in geoscience, worked as a natural resources industry insider and invested successfully for years, before launching a Seeking Alpha Marketplace service to share his unique investment insights with a rapidly growing community of value investors.

The Natural Resources Hub is his premium service, designed to help subscribers attain consistent and high RoR at low risk by applying value investing principles to the natural resource sector and digital resource space. Members get investment ideas pitched in the form of trade alerts backed by frequent in-depth research reports, weekly market commentary newsletter, a lively friendly chat room, his prompt responses to your questions (in private if preferred), and a suite of Google Sheet-enabled tools loved by busy people.

We discussed the opportunity in the natural resource sector and non-U.S. companies, why investment opportunities arise from the unintended consequences of the social movement to decarbonize the economy and his preferred way to express a directional view on a commodity.

Seeking Alpha: Walk us through your investment decision-making process. You invest in volatile natural resource stocks - can you discuss factors you look for that limit risk? What strategies do you employ?

Laurentian Research: I follow the value investing approach in investment idea generation, security research, and portfolio management.

Idea generation:

A lot of my investment ideas are directly sourced from the natural resource extractive industry itself. The natural resources sector, which is particularly coopetitional and collegial (perhaps more so than many other industries), has numerous industry information-sharing forums, scout check meetings, and technical symposiums. An investor can gain precious insights from the events organized and journals published by industry organizations, e.g., HGS, PESGB, AAPG, GSA, AGU, Mining Indaba, PDAC, and etc., insights that are unavailable to him if he only engages in desktop screening, insights that can be learned ahead of Wall Street before they are distorted by the biased investment banks. Scuttlebutt with my industry network often helps eliminate dubious projects and scammers early in the idea generation and investigation process.

I also get a flow of ideas from desktop screening, social media, and the members of The Natural Resources Hub, many of which are industry executives, technical experts, fund managers, professional investment advisors, and HNW individuals.

Investment research:

For an investment idea to qualify for in-depth examination, it has to pass an AMMoS smell test, which stands for the Assets, the Management, and Margin of Safety.

For a commodity producer, I require the underlying assets to have

  • low finding and development (F&D) costs, and operating costs (OpEx), relative to the realized product price - because the low cost means low risk and resilience in the commodity business - and

  • a readily expandable production capacity so as to capture the maximum benefit in commodity upcycles.

For an explorer/developer, such as Tier One Silver (OTCQB:TSLVF) and Adriatic Metals (OTCPK:ADMLF), I require that it be highly probable that the flagship property has the above qualities once on-stream.

As for the management, I'd like to see a verifiable track record of successfully shepherding projects to fruition on schedule and under budget, which, as epitomized by the Earthstone Energy (ESTE) and Minera Alamos (OTCQX:MAIFF) teams, usually entails technical resourcefulness, credibility in the financial market, entrepreneurism, financial conservatism, and frugality. I want the management to have substantial skin in the game, such that its self-interest is demonstrably aligned with that of retail investors.

As rare as top-tier assets and great management is a sufficiently large margin of safety on the way in - that helps limit risk. Fortunately, I go hunting in the land of the cyclical plays, where great assets - despite the high quality - are periodically sold off at incredibly low prices during the downcycles.

  • In valuation, I practice Greenwald's three-tiered valuation system, i.e., the asset value, earnings power value, and growth value. Asset value can be estimated with better accuracy and precision than earnings power value and growth value. Generally speaking, I am suspicious of earnings power value and growth value because their estimation involves a lot of unknowns.

  • Because I use mid-cycle commodity price assumptions in the NPV calculation, it follows that the best time to back up the truck is when the commodity price is below the industry average cash operating cost. A recent example of such a sweet spot is in March and April 2020, when Mr. Market gave away quality assets run by superb management at a huge discount to the asset value. When others are capitulating, I can have peace of mind to buy because I know the shut-in of high-cost assets will invariably lead to violent bounce-back of the commodity prices.

Portfolio management:

Portfolio management is about still making a lot of money on the portfolio level despite all the mistakes one makes in stock picking. I spend the majority of my time and energy monitoring portfolio components with regard to the progress in operations (or the lack thereof), the behavior of the management, and the share price movement relative to the intrinsic value, and investment theses are iteratively updated.

  • When an investment thesis of mine is refuted, I immediately exit the position on profit or loss.

  • If positively surprised, I add to the position whether the stock is dropping or rising.

Thanks to the selective culling and padding, my portfolio as a whole is supposed to gravitate toward low-risk, high-return ideas. Winning positions, such as GeoPark (GPRK) at one point and Minera Alamos today, may attain >15% weight. I never set out to have diversification for its own sake.

My exit strategy is informed by more of the observations of the general industry condition than company-specific insights. As a discipline, I exit a natural resource position when neighboring properties of lousy quality get financed and developed, executives of dubious reputation land on the front page for pricey M&A deals or living large, and/or a consensus has emerged that the underlying commodity will remain at levels as high as twice the mid-cycle price permanently.

So, I mostly practice long-term value investing. In addition, I also have event-driven investment plays that are anchored by a near-term event. Occasionally, if the emotional shift of the speculating crowd is verifiably predictable, I trade alongside or against the crowd, as I did successfully in the case of California Resources (CRC) in 2017-2018 prior to its famous bankruptcy. That said, as we enter the second half of the commodity cycles, I expect myself to progressively withdraw from swing trades.

SA: What area of the market do you focus on?

Laurentian Research: I was educated in geoscience with a Ph.D. but I have read widely on epistemology, religions, psychology, history, economics, behavioral finance, business strategy, and investment theories. I have worked for many years at the intersection of the natural resources sector and what I call the digital resources space. I consider those two areas to be within my circle of competence.

I love the natural resources sector because, as I believe, it has the maximum information inefficiency in the entire market as a result of widespread misunderstanding and hyper-cyclicity. Discerning value investors are well-positioned to take advantage of that information inefficiency and make great profits at relatively low risk. The oil patch is currently being treated worse than a leper, thanks to the radical decarbonization movement. Few investors in the market actually understand mining, much less junior explorers and developers, which are generally lumped into penny stocks even though many of them own sources of critical metals that are supposed to power modern life and the green economy. Then, there are the notorious commodity cycles, which periodically give investors generational opportunities to exploit and profit from.

In contrast to many investors who dread commodity hypercyclicity, I believe one can really thrive on commodity cycles, as shown by my actual investment record seen live by The Natural Resources Hub members. Of the 54 natural resource positions currently in my portfolio that I bought over the past few years, to date there are five 5+ baggers, three 4-baggers, four 3-baggers, six 2-baggers, seven 1-baggers, and 29 recently-opened positions delivering from -19% to 99%. Risk proactively managed and entries well pinpointed, natural resource stocks can deliver amazing returns.

Within the natural resource universe, I am agnostic to commodity types and jurisdictions as long as the stringent investment criteria of mine as outlined above are met. As it turns out, the vast majority of the natural resource extractors that I end up investing in are western companies that are headquartered in countries like Canada, Australia, the U.K, and the U.S. but operate in resource-rich jurisdictions in Australasia, Africa, and the Americas.

SA: You have a dual focus on natural resource ideas and what you call digital resource ideas, which are a special kind of wide-moat businesses. I am aware that your digital resource focus by itself may warrant a separate interview, but can you briefly explain how it fits into your portfolio? What does a wide moat look like if the company is ultimately selling a commodity? Can you give an example?

Laurentian Research: Thanks to the dual focus, my portfolio is structured barbell-like. At one end are the low-risk secular growers in the digital resources space, mostly GARP plays that deliver 15-35% annualized EPS growth, which collectively deliver secular growth, provide growing dividend income, and hedge against the volatility of commodity cycles. At the opposite end are the high-risk natural resource ideas that are swing-for-the-fences cyclical plays that may generate breath-taking returns when some of them work out. The barbell portfolio structure as such helps me limit risk on the portfolio level without sacrificing capital appreciation potential.

A natural resource extractor can be wide-moated too, if it produces rare commodities at globally lowest operating cost. A supreme example of a wide-moated miner is Nornickel (OTCPK:NILSY), which produces nickel (at negative cost with co-product credits), 40% of the world's palladium, and platinum and copper from mines in the Taimyr Peninsula, Russia. You may replicate Costco (COST), Novo Nordisk (NVO), or even Google (GOOGL), but how do you replicate the Talnakh and Norilsk mines of Nornickel, which are truly unique in the solar system?

SA: Looking back at your best (and/or worst) trades from your years of successful investing, do you see any common denominators in them? What key lessons have you learned in terms of what to look for (or watch out for) in researching companies?

Laurentian Research: I like businesses with high-quality assets, the intrinsic value of which can be fairly accurately estimated. And I like honest, able, and shareholder-friendly management. With a good estimate of asset value at hand and peace of mind regarding the management, all I have to do is sit back and wait for a sufficiently large discount. Those three criteria are the common denominators in all the trades that worked out for me, except for the event-driven plays I also pursue. My investing experience indicates those investment criteria tend to lead to more bang for my buck at substantially lower risk than the prices of the underlying commodities or relevant ETFs.

As I explored the approaches to apply value investing principles to the natural resource sector, I have made countless mistakes. I learned the following lessons the hard way:

  • Do not compromise on the quality of the assets and the management. Insist on getting a discount on the asset value, and don't pay for earnings power or growth. Estimation of the earnings power value and growth value may appear to be mathematically precise but it involves too many assumptions and oversimplifications.

  • Relatedly, don't chase the so-called torque to commodity prices, and don't fall for the theory of debt leverage quickening wealth building. Torque is a fancy word used by Wall Street to disguise high costs, while leverage is usually how an investor loses his proverbial shirt.

  • Don't trust a CEO who doesn't do what he said he would do, who is spendthrift while overpaying himself at the expense of shareholders, who hides behind excuses and refuses to take responsibility for the performance of the company, and who is full of himself. The best CEO is always entrepreneurial and usually has skin in the game.

  • Don't come to the market preoccupied about which direction a commodity is going. Why do I invest in natural resource stocks without knowing where the underlying commodity is going? Because my investment system doesn’t depend on commodity price prophecies with granularity.

SA: Can you discuss the different ways to express a directional view on a commodity and which one you prefer and why?

Laurentian Research: Some successful investors follow the top-down approach in investment research. They usually form a macro view on a particular commodity, and then go out to find an investment vehicle - usually an ETF or futures - to express that directional view.

However, I practice the bottom-up approach to arrive at investment ideas. Usually, it's high-quality assets and/or superior management that first attract me to an investment idea. Most of my investments wind up being in individual stocks. I don't trade ETFs because I cannot stand their inclusion of mediocre components alongside good ones. I don't trade futures because I think I can better manage risk by monitoring business operations in progress.

That doesn't mean I only invest in individual stocks. As a matter of fact, some of my favorite ideas are specialist financiers that hold a portfolio of natural resource assets. For example, Queen's Road Capital (OTCPK:BRSGF), one of my investments in this category, is run by the legendary mining investor Warren Gilman who is building a portfolio of convertible bonds on advanced tier-1 mining projects in safe jurisdictions. (Beware the amendments to Exchange Act Rule 15c2-11 though, since Queen's Road Capital is currently on the list.) I am also a shareholder of a number of royalty firms, a type of business I like for its asset diversification, perpetual exploration optionality, scalable business model, and high-profit margin. However, the royalty space is getting increasingly crowded, with the average EV/EBITDA having risen to 24X.

SA: What commodities/companies will benefit or suffer from the secular trend towards lower greenhouse gas emissions, electric vehicles, etc.? Which ones are attractive from the long or short side because the market has mispriced the impact? Are a large number of fossil fuel reserves/projects doomed to be “stranded assets” - why or why not?

Laurentian Research: There is no doubt the social movement to decarbonize the economy has become a formidable force to be reckoned with these days, as evidenced by activist firm Engine No. 1 claiming three seats on ExxonMobil (XOM) board of directors. Like any other well-intended social movement, I believe this one will have unintended consequences with lasting impacts. As the human race enthusiastically launches the social engineering project of decarbonization, I expect a whole bunch of bargains will result in the natural resource sector.

  • Even as the green movement intensifies, ironically, the demand for gasoline in the U.S. has begun to surpass pre-Covid levels on a seasonality-adjusted basis; U.S. air passengers through TSA checkpoints - indicative of the demand for aviation fuel - have recovered to 15-20% shy of the pre-Covid levels; European air travel is not far behind, currently 37.5% below the 2019 levels as of July 10; LNG users are scrambling to sign purchase contracts in an apparent short supply; the U.S. coal exports have surged since the 3Q2020 according to the EIA. However you cut it, a worldwide fossil fuel short supply appears to be impending.

The decarbonization movement is playing an important role in bringing about the developing oil crisis. As it were, the OPEC+ and the green revolutionaries work in concert to restrain oil production. Strong demand in the post-Covid world in combination with curtailed supply has led to the elimination of excess oil inventory, and may soon erode the spare production capacity. With capital spending cut-back in much of the past seven years, it is doubtful whether there are sufficient low-cost reserves to meet the demand down the road. It is possible some high-cost resources will need to be de-stranded to quench the demand.

In previous cycles, laissez-faire determined which producers shut in on an oil crash and what producers ramped up production during the upswing, thus curing extreme gyrations of the oil price. In this cycle, the "visible hand" of the green revolutionaries assumes the role of arbiter to pick the winners and losers. Per them, the losers will be the supermajors, which are being forced to fire-sell assets, lower hydrocarbon output, and invest in sub-economic renewable energy projects; the winners will be the independents, national oil companies, and Russian oil companies that are not under the thumb of the environmentalists and are hence free to respond to high oil prices, and that will also benefit from the oil fields purchased on the cheap from the supermajors. In view of the emerging bifurcation of the oil industry competitive landscape, coming into 2021, I sold all my holdings in the supermajors and plowed the profit into high-quality oil companies that are better-positioned to reap the benefit from the ongoing oil upswing.

In parallel, the demand for metals/materials is projected to soar in response to strengthening pollution regulations, rising renewable energy, and emerging EVs:

  • palladium, platinum, and rhodium for autocatalysts;

  • platinum for hydrogen fuel cells;

  • uranium for zero-carbon power generation;

  • nickel, cobalt, lithium, and manufactured product graphene for energy storage devices and battery applications;

  • silver and tin for EVs, and etc.

Going forward, the prices of these metals/materials will be driven not only by increasing industrial applications but also by the scarcity of skilled labor and mining equipment.

SA: You’ve covered a number of non-U.S. companies - in general do you think there’s a greater opportunity here compared to U.S. companies? Is this one way you’re able to find under-the-radar ideas?

Laurentian Research: There are a number of nuances here: in which jurisdiction a natural resource company owns and operates its assets, where the company is registered and headquartered, and on which stock exchanges its stock is publicly listed.

Jurisdiction - along with all the above-the-ground risk factors, such as fiscal regime, social license, accessible infrastructure, and skilled labor, that come with it - goes into asset quality assessment as part of my stock picking. As a top-ranked jurisdiction, the U.S. has world-class hydrocarbon and mineral provinces at home, e.g., the Permian Basin and the Nevada precious metal camp. However, there are a number of hydrocarbon provinces outside the U.S. where oil and gas can be produced at lower costs, and there are a lot of international mining provinces that are richly-endowed with minerals the U.S. imports. And some of these international natural resource provinces are excellent jurisdictions to operate in too.

Many natural resource companies choose to be publicly listed on the Toronto, Australian, and London stock exchanges, where natural resources-oriented venture capital is available for start-up mining and energy concerns. Take Diversified Energy Company Plc (OTCQX:DECPF), which is an Alabama-headquartered company, owns and operates assets in the U.S., but chooses to mainly trade first on the AIM and then on the LSE market. As a result, although the U.S. market has a good representation of large-cap mining and oil/gas stocks, numerous small and micro-cap natural resource stocks are found on the TSE-Venture and ASX with secondary listings on the OTC markets.

Now, back to your question, small and micro-cap stocks tend to be under-covered by investment banks and largely untouched by AI-capable algos. Adding the commodity hyper-cyclicity, small and micro-cap natural resource stocks end up being the most information-inefficient corner in the market. That suits me well because that's where I go hunting for under-the-radar investment ideas that promise multi-bagger returns at relatively low risk.

SA: A recurring question in this interview series is about the mispricings created by the coronavirus and its short and long-term impact – can you weigh in on this?

Laurentian Research: It is inevitable the Covid-19 pandemic will eventually die down; we are most certainly not to be condemned to the perdition of yearly recurring coronavirus outbursts. It was hypothesized the pandemic might cause lasting changes in people's flying habits; however, TSA checkpoint data suggest U.S. air travel has nearly recovered to the 2019 levels, not far behind the pace of recovery of gasoline consumption.

The mispricings resultant from the pandemic have to a large extent disappeared. My favorite Covid recovery plays, the Mexican airport operating trios Grupo Aeroportuario del Centro Norte (OMAB), Grupo Aeroportuario del Pacífico (PAC), and Grupo Aeroportuario del Sureste (ASR), have recouped the ground lost during the crisis, meaning my holdings in them have on average doubled in value since April 2020. Having recently reclassified them as dividend growth investing prospects, I plan to continue to hold these wide-moat stocks in anticipation of resumption of dividend distribution in the next couple of years.

There is still a lot of good value to be found in energy and mining equities judging from the absurdly high free cash flow yields seen in the sector but, as far as the Covid-resultant mispricings are concerned, they have recovered nicely:

  • The benchmark oil price WTI is now 18% higher than the pre-Covid high. Oil stocks as represented by Energy Select Sector SPDR ETF (XLE) have risen by 131% from the March 2020 bottom and come to only 15% shy of the December 2019 levels.

  • Most metal prices recently reached their respective multi-year highs, with palladium, gold, and iron ore near all-time highs; copper, aluminum, and tin near 10-year highs; silver, nickel, platinum, uranium, and zinc near their 8, 7, 6, 5, and 3-year highs, respectively. SPDR S&P Metals & Mining ETF (XME) has more than tripled (+215%) from the March 2020 bottom to reach a 7-year high.

At this time, only in the remaining coronavirus hotspots can the pandemic-induced mispricings still be found. For example, Covid-19 infections in Fiji are reportedly coming back, which is considered to be one of the risk factors behind the recent weakness of Lion One Metals (OTCQX:LOMLF), a gold explorer/developer operating in the country.

SA: What’s one of your highest conviction ideas right now?

Laurentian Research: As a custom, I maintain a smorgasbord of high conviction ideas, catering to the range of risk appetites and time horizons existent among The Natural Resources Hub members.

In the oil and gas patch, Diversified Energy Company exemplifies the high-potential, low-risk hidden gems that I like. A stock Peter Lynch would love, Diversified pretty much has to itself the "boring" niche of acquiring and producing from old natural gas wells that nobody else wants. Thanks to its unique and financially conservative business model, the company has been able to post peer-crushing profits in good or bad times. Acquisitions with no competing bidders around resulted in years of value-additive growth. Diversified recently entered the Gulf Coast region, thus ushering in a new chapter of explosive growth; there, it already made three acquisitions in the last two months, growing production by 38% and EBITDA by 39%, with two of the three deals done in JV with Oaktree Capital. With some $1.7 billion of ammunition between the JV partners to fund additional transactions, I expect growth to continue at a good clip in the foreseeable future. The sweetest thing about this company is it is still under the radar. An investor is being paid well-covered, >10%-yielding dividends to wait for the market to wake up to this multi-year compounding prospect. The fairyfly in the ointment is that, until the stock is up-listed in the U.S., shareholders will have to tolerate the foreign tax withholding on dividends and, depending on the brokerage, foreign security fees for now.

In the mining space, Elemental Royalties (OTCQX:ELEMF) epitomizes the high-potential, low-risk hidden gems I have been pitching to the members of The Natural Resources Hub (see here). Elemental made its debut on TSX Venture Exchange in July 2020, boasting three royalty-paying assets. Since then, the young and energetic management team pulled off the acquisition of three gold royalty assets in Australia (Karlawinda, Laverton, and Western Queen) from South32 Limited (OTCPK:SOUHY). Having recently poured first gold, Karlawinda alone is expected to double royalty revenue for Elemental in the first full-year production of the mine (2022). Two additional assets are scheduled to come on-stream in 2022, setting the stage for the company to increase its royalty revenue by some 184% by end-2023. Additional upside lies in new acquisitions in the pipeline and the exploration optionality that Elemental stands to enjoy at zero cost. As a recent IPO that goes largely unnoticed on the market, Elemental currently trades at half of the valuation metrics of its peers. I believe a re-rating is overdue now that Karlawinda is producing. It does need to refinance an expensive US$25 million credit facility, which the CEO expects to happen in 2021.

SA: Do you have any final thoughts to add?

Laurentian Research: In my opinion, indexation may have entered the involution phase when the harm it causes to investors outweighs the benefits it delivers. I think it is high time for investors to search beyond FAANG-dominated index funds and esoteric ETFs for value depressions, where high returns can be had at low risk.

A commodity supercycle is unfolding in front of our eyes, fueled by worldwide economic recovery in the post-Covid era as well as the emergence of renewable energy. Generational opportunities emerge among natural resource equities - which are still deeply undervalued due to the protracted bear markets in recent years and thanks to the decarbonization movement - but may not remain cheap for long. This is truly an exciting time to be a natural resources-focused investor.

***

Thanks to Laurentian Research for the interview.

Laurentian Research is long ELEMF, LOMLF, ASR, PAC, OMAB, DECPF, BRSGF, NILSY, MAIFF, ESTE, TSLVF, ADMLF

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