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Mike Kachanovsky: Navigating the Discount

Apr. 15, 2011 3:09 PM ET
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Mike Kachanovsky: Navigating the Discount
Source: Brian Sylvester of
The Gold Report  03/25/2011

The terrible tragedy in Japan is shifting markets worldwide. Mike Kachanovsky, a consultant to both resource companies and institutional investors, believes the volatility has created a finite opportunity to scoop up resource stocks on the cheap. In this exclusive interview with The Gold Report, Mike explains what impact the devastation could have on the performance of rare earth companies, as well as how to navigate discounted stocks to avoid the duds.

The Gold Report: Japan recently experienced one of the strongest earthquakes in recorded history and suffered a devastating tsunami. It's certainly a terrible tragedy. In a recent commentary, you said the disasters could result in a buying opportunity for rare earth element (REE) plays, which seems counterintuitive. Can you explain that investment thesis?

Mike Kachanovsky: The rare earth metals sector is a very tiny sector, but Japan accounts for about 25% to 30% of all the rare earth metals consumption in the world. China recently said it would restrict its REE exports, which puts pressure on a lot of Japanese industries.

The market is now discounting rare earth producers because the catastrophic disaster in Japan could translate into a reduced demand from the country. This created some significant discounts in rare earth share prices. However, it is my opinion that the area affected by the earthquake only accounts for a very small percentage of the Japanese economy and the disruption will be fairly short term. As tragic as it is, I expect the economy to recover and overall consumption of REEs in Japan to stay steady. So, the discount will probably be a very short-term event.

Also, even though China exports roughly 97% of the world's total rare earth production, some estimates predict that China will have no additional export capacity as soon as 2015. It will consume all of its production domestically. This is a more serious consequence in the long term that would more than offset any decline from Japan.

TGR: What are some rare earth plays that offer a good value right now?

MK: Rare earths tend to be very volatile stocks due to all the media attention they've received of late. To combat that volatility, it makes sense to buy the good-quality juniors in the dips or the companies that are trading at a discount to their peer group.

One company that I own and have been following for years is Commerce Resources Corp. (TSX.V:CCE; Fkft:D7H; OTCQX:CMRZF). This company has a brand new discovery play on one of its properties in Quebec, Canada, and it just recently announced a compliant resource of more than 100 million tons (Mt.) of fairly high-grade mineralization.

That's significant for two reasons. First, Commerce trades at a significant discount to other companies with advanced REE plays that have compliant resources. Only a handful of companies are this far advanced, most of which trade at much higher multiples than Commerce, so the company presents a fairly good discount. Second, the deposit remains open to further expansion as the company does further exploration. Chances are, the story is going to get better as the company continues on with its drilling program. It's also important to note that Commerce trades at a discount on the basis of its rare earth element leverage, but it also owns and controls an advanced, exotic metals play with niobium and tantalum. Investors are practically getting those resources for free.

TGR: How does the size of that resource compare to something like Avalon Rare Metals Inc. (TSX:AVL; NYSE.A:AVL; OTCQX:AVARF) Nechalacho project in the Northwest Territories?

MK: Both deposits are fairly advanced and have a very large tonnage that would sustain a long-term mine life. Nechalacho has advanced through prefeasibility studies and is much more likely to develop into a mine at this point. Commerce's Eldor deposit has seen exploration drilling only—no metallurgical, preliminary or prefeasibility work done to advance it—so, all we can compare at this point is total tonnage. The reason Avalon has a much higher market cap is because Commerce is still at an early phase.

TGR: What other companies are trading at a discount to their peer group?

MK: I like Medallion Resources Ltd. (TSX.V:MDL; OTCQX:MLLOF) and Quantum Rare Earth Developments Corp. (TSX.V:QRE; LSE:BR3; OTCQX:QREDF), but Pacific Wildcat Resources Corp. (TSX.V:PAW) is a company that is very exciting and is overlooked currently.

Pacific Wildcat has two projects in Africa. One of them is a past-producing tantalum and lithium mine that the company believes will be in production by this summer. It also has a rare earth element—niobium mine in Kenya that it's working toward getting into production. The company's stock trades at a very low multiple relative to its peer group. It's a new listing and hasn't gotten a lot of attention. Pacific Wildcat is a stock that I believe can make a strong run as sentiment swings back to positive for the rare earth sector as a whole.

TGR: Who is involved with that company? I believe there's some noteworthy management there.

MK: The senior people involved with Pacific Wildcat have been around exotic and specialty metals their whole careers. That's important because some other newcomer juniors have an interest in REEs only because it's a popular sector that a lot of investors are tracking right now. When investors are examining a company, they should ask themselves: Are the people running the company experienced? Do they know what to look for? Do they have a good track record of advancing projects? Have they been around long enough before the market got hot in that particular sector? The answer is 'yes' for the people behind Pacific Wildcat.

TGR: Are there other impacts from Japan's crisis that have caused you to change the way you invest?

MK: The initial market reaction to the disaster in Japan was extreme, and stock markets around the world are sold off. Commodities, in particular, were getting hit very hard. The market seems to be pricing in almost a recessionary-type scenario. Some market watchers would have investors believe that a disaster of this magnitude is actually bullish for commodities because it's going to stimulate demand through the rebuilding process. But my investment philosophy has always been to buy aggressively at the dips and to be a contrarian. During any strong selloff, I am active as a buyer in a lot of stocks. This disaster hasn't changed my investment philosophy. I think you have to be prepared to take advantage of market weakness when investors are selling—if there's no real fundamental weakness and the market reaction has been overdone. It's a good time to be a buyer.

TGR: How do you believe the disruption in the Japanese economy will impact the gold price?

MK: Gold also went through a mild selloff immediately after the disaster. Gold was just recently at its all-time high and perhaps needed an opportunity to consolidate. The drop in the gold price was relatively modest. Also, if you step back from what's just happened in the last week and look at the dollar over a yearlong period, it isn't showing much strength. It's still sitting at the lower end of its range. Investors aren't fleeing to the dollar as much as the media has been projecting. Asian investors traditionally have been very gold-friendly and tend to move some of their money into gold in times of crisis. The drop in gold prices is a short-term blip. The price will recover as things start to settle down. The market is more likely to see a flight of capital into, rather than out of, gold based on the aftermath of a crisis like this.

TGR: Many of our readers know you as 'Mexico Mike' from your website, smartinvestment.ca, which covers investment opportunities and other news in Mexico. What sort of things are you looking for from companies operating in Mexico?

MK: One of the great things about Mexico is that a company can take a project from initial discovery and advance it through to production in a very short timeframe. It's also a relatively low-cost operating jurisdiction.

Juniors and producers in Mexico have had a fantastic run during the last six months because as metal prices ran higher quickly, the profit margins at a lot of these companies spiraled higher. Even if there is some consolidation in metals going forward, these companies are still making a lot of money currently. The exploration upside for these companies is also very strong because they have funding from operations and profitability. They can divert much of that money back into enhancing the value of their resources in the ground and building mineral inventory.

Obviously, I'm still very excited about Mexico juniors; however, when we spoke about them last year, they were all priced at a discount. It was the right time to be a buyer. Now, some of that discount has been corrected by the market and they're more fully valued based on their future potential.

As an investor in today's market, I'm focusing my attention on finding companies that are at the lower end of their price range and undiscovered by the market. Some of the early stage explorers, for example, that are holding great property areas and are actively drilling, but haven't yet achieved significant discoveries. Those companies are trading near their bear market lows from two years ago.

TGR: Have you found some companies that fit that bill?

MK: I like Galore Resources Inc. (TSX.V:GRI), which controls a large property in an area where there have been two significant discoveries in recent years. It has accomplished some early stage success in its exploration; and, if it can follow up those early stage results, it could be in pursuit of another big mineral deposit. Galore trades at a very low market cap of about $14 million—it's still in the bargain range, but it's speculative. We don't know if the company is going to find anything. If it is successful, however, the stock could possibly go up several hundred percent. It makes for a good speculative play.

TGR: Galore is exploring the Dos Santos property, which is right next to Goldcorp Inc.'s (TSX:G; NYSE:GG) Camino Rojo property. That seems like it might offer some potential.

MK: Canplats is a good example of a stock that traded at a very low market cap just a couple of years ago, while it was actively drilling at Camino Rojo. Once it achieved just that one discovery success, the project was acquired by Goldcorp at a huge premium. Investors in Galore would be very happy if the same value curve was followed.

Another company that I am excited about right now is US Gold (TSX:UXG; NYSE:UXG). US Gold has been advancing its El Gallo discovery in Mexico. It has all the characteristics of a solid, speculative investment—superb management, well financed and a steady stream of strong exploration results. The company just completed a large financing and decided to invest $50 million into gold and silver directly. That says something about the management's philosophy; they believe the metals are headed higher and are willing to buy gold with the corporate cash they will eventually need to advance this deposit. US Gold was one of my top-five holdings last year. It's gone up about 300% since then, and I have continued to add to my holdings because I believe it has much greater upside ahead.

TGR: Are you a fan of Chief Executive Officer and Chairman Robert McEwen?

MK: Yes, I am. He's one of the characters of the industry. He has a superb track record of building companies. He's a visionary. He's not shy with the media and he makes what seem like very outrageous expectations. However, in this bull market for precious metals, he's been proven right at every stage. I think he's the ideal leader for a junior mining company. I respect what he's accomplished in his career and I still expect great things from him in the years ahead.

TGR: McEwen is also a significant shareholder of some other mining companies, such as Minera Andes Inc. (TSX:MAI; OTCBB:MNEAF) and Lexam VG Gold, Inc. (TSX:LEX; OTCQX:LEXVF; Fkft:VN3A).

MK: There is also one other company in which Rob McEwen has invested—Sniper Resources Ltd. (TSX.V:SIP). President Scott Baxter was the former president and CEO of Tone Resources, which was acquired by US Gold a couple of years ago when it was consolidating Nevada gold trends. Baxter then went on to form Sniper, and McEwen has invested directly into that company. Sniper is another one of those early stage exploration plays that is very active and has solid management. It's currently drilling, has three gold prospects and established gold trends in mining-friendly jurisdictions like Nevada, and the stock trades at a very low market cap. I like the upside potential—it's an ideal speculative investment. I look forward to what the company can accomplish as it continues with its drilling.

TGR: Are there any other names you'd like to leave with our readers?

MK: Another company that isn't getting much attention right now but is a superb advanced-stage play is Pretium Resources Inc. (TSX:PVG). The company was spun out of Silver Standard Resources Inc. (TSX:SSO; NASDAQ:SSRI). Pretium controls about 35 million ounces (Moz.) of gold in all categories on its two projects and more than 150 Moz. silver. Exploration is ongoing at both projects, so it's likely those resources are going to continue to increase. It's relatively unknown, has a very tight market structure and has an opportunity to become a 'go-to' stock as more investors discover what the company is doing. It's a very high-quality company that trades at a very modest market cap relative to the amount of resources it controls. Strong upside built in, so I think it's the right time for investors to have a look at that one.

TGR: Do you have any forecasts on the macro picture of the market?

MK: We are early in the curve, in terms of where I believe the ultimate long-term price trend is going for both gold and silver. It's going to become much more volatile. Down days of significant magnitude are going to be part of the story that investors will have to deal with if they're going to venture into this sector. Investors need to stick with a strategic approach and look for value in companies with proven management that are able to withstand the high degree of volatility that will be part of the story. There's a lot of money to be made for investors who can get involved now and stay invested for years to come.

TGR: Thanks for speaking with us, Mike.

Mike Kachanovsky is an independent consultant providing analysis on resource companies for institutional investors. He has visited more than 100 mining projects worldwide. Mike's writing is presented in numerous investment publications and he also contributes to several resource newsletters.

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1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Commerce, Avalon Rare Metals, Medallion, Galore Resources, Goldcorp and Lexam VG Gold.
3) Mike Kachanovsky: I personally and/or my family own shares of the following companies mentioned in this interview: Commerce, Avalon, Medallion, Quantum Rare Elements, Pacific Wildcat Resources, Galore Resources, US Gold, Sniper Resources and Pretium Resources. I personally and/or my family am paid by the following companies mentioned in this interview: Commerce, Galore and Sniper Resources are paid advertisers on my website.

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