Evaluating investment opportunities

The following is the second of three excerpts from Resources Rock: How to Invest in the Next Global Boom in Natural Resources by Malvin Spooner, founder and president of Toronto-based Mavrix Fund Management, and Pamela Clarke, a former correspondent with The Economist Intelligence Unit in Europe. The book is published by Insomniac Press and sells for C$21.95.

Once you have decided to buy shares in the resource sector, then the hardest part (especially in a boom market) is figuring out which companies are the Real McCoys and which ones are just “promotes” with slick brochures.

The most important factor is to do your own research. The best place to start is by reviewing the web sites of companies you’re interested in, and perusing their annual reports and press releases. Sure, some of the reports can be extremely dull; sometimes it seems like they’re trying to hide information about what they really do behind a parade of monotonous words. But that’s usually not the case. It’s more a matter of the companies not doing a good job of communicating with people outside the industry. Take a look at the management teams at most of the junior and intermediate resource companies. They’re mostly geologists and engineers who specialize in research and exploration and who use a vocabulary that doesn’t always make sense to those of us who don’t spend our summers digging in northern moose pastures or drilling in jungles overseas. This is why bigger companies (and not just those in the resource sector) have departments that are dedicated to recording, corroborating and translating the research of the exploration team and then presenting it to people inside and outside of the company.

Promoting a company’s proprietary and strategic advantages internally to other employees builds morale and instills a sense of pride in the venture. Marketing corporate accomplishments to the general public bolsters the confidence of shareholders, bankers and customers. It’s not by accident that the objective of the entire communications process is to ultimately encourage increased spending on research and development.

– Necessary promotion — We’re all aware of the lengths companies go to to convince us to buy their products. They’ll do everything in their power to ensure that a product is readily available when we finally decide to buy.

The same marketing and distribution principles apply to the investment industry. Investment bankers have developed efficient means of identifying worthy businesses that require capital, and of promoting them to investors with money and financial ambition. Finance professionals maintain close relationships with large corporations that may require funds for acquisitions or to finance internal growth, but they also scout among the multitudes of established mid-sized companies to find players that look like they could make it to the big leagues if they had sufficient financial backing. Investment bankers adopt these large and small companies as clients. Then their research departments study the businesses, translating the research into language and concepts that investors can understand.

– Startup reality — Since it’s tough for most small and mid-size resource companies to get financing, the question arises: how did mining grow to become such an integral part of Canada’s economy? Even the government acknowledges exploration is fundamental to maintaining our global leadership in mining, and tries to nourish the sector with generous tax programs.

The likelihood of investors doling out their savings to a company that “specializes in geologic research and study” is pretty slim. That’s why the sector needs stock promoters. Stock promotion is to mining what advertising is to cars: it’s almost impossible to imagine the product being sold without it. Because junior exploration companies have to compete against hundreds of other similar “products,” their promoter has to rely on razzle-dazzle to attract investors. That’s how they’ve earned their reputation as masters of “hype.”

Hype and “substance” together are a formidable force. Excellent products and ideas won’t amount to anything if they don’t generate sufficient enthusiasm and support. That’s definitely the case in the mining sector.

– Sparking the belief — Without stock promoters, it’s unlikely Canada would have become the global leader in natural resources that it is today. One of the most successful promoters, Robert Friedland, said in 1984 that “if an idea excites the imagination of enough people, the money materializes and the project happens. It happens because there’s a consensus of belief. It may take someone like myself to spark the belief, but it’s the belief itself that makes it possible.”

Most successful mining developments are a combination of geological or engineering talent and determination, and a healthy amount of promotion. It’s not enough that the geologists and engineers believe in the project — unless of course, they’re wealthy enough to finance their own ventures. Someone has to make investors believe in the project in order to raise enough money to make the company’s dreams come true.

Friedland is best known for being an owner in, and promoter of, Diamond Field Resources, which discovered the Voisey’s Bay nickel deposit in Labrador. As its moniker implies, the company was actually looking for diamonds, but in September 1993, two of their freelance geologists, Albert Chislett and Chris Verbiski, spotted a rusty outcrop (a telltale sign for a prospector that there’s an orebody), while flying along the Labrador coast.

In most cases, if prospectors are hired to hunt for diamonds but they stumble across a rusty anomaly, they would be told to ignore it. Instead, Diamond Field made the unusual decision of sending them back to collect samples. Once it was determined that the outcrop did contain high concentrations of nickel, copper and cobalt, there was ample fuel to fire up their promoters.

Many critics and cynics are eager to denounce promoters every chance they get, but in reality it takes a true opportunist to see a real opportunity. Consider this: Diamond Field shares were selling at $4 in 1994. Two years later, when it was clear Voisey’s Bay was a massive high-grade deposit, shares sold for $167 (adjusting for an earlier stock split). That’s the stuff investment legends are made of.

The sheer size of the deposit made it irresistible to Inco and Falconbridge. Senior resource companies love it when a junior or intermediate company discover and delineate an orebody. If it turns out to be big enough to make it worth their time and effort to develop the deposit, then they usually buy it. In this case, a bidding war erupted between the two senior producers. In January 1996, Inco offered to buy Diamond Field Resources for $3.2 billion. One month later, Falconbridge upped the ante by offering $4.1 billion. In the end, Inco took possession of the junior company for an astounding $4.3 billion.

If it weren’t for those two hawk-eyed geologists, and the indefatigable efforts of their promoter, it’s unlikely Voisey’s Bay would be on its way to production today. Many investors made a lot of money, and it is “guesstimated” Friedland personally pocketed roughly $500 million.

But though alluring, these get-rich-quick stories have a downside. . . .

– Real McCoys — Promotion can be used for legitimate and for fraudulent opportunities. So how does an investor learn to distinguish between the Real McCoy and a Bre-X? It’s not all that easy for professional money managers at the best of times. The key points to remember are as follows:

Good promoters are capable of raising money for just about any venture, but they don’t always adopt a worthy cause.

Be suspicious when a promoter attempts to ignite a sense of urgency mixed with greed. “If you don’t act now, you’ll miss out on making a fortune” doesn’t motivate an investor who is interested in out-of-favour industry sectors. Protect yourself by understanding industry trends and knowing company facts.

Try to do at least some of your own research so you won’t have to rely on third-party recommendations and testimonials. Just because others believe in a project doesn’t make it right for you.

Whenever something seems too good to be true, it probably is. As you hone your understanding of business and commodity cycles, study the more talented and tenacious industry professionals and track their careers. While fine-tuning your stock-picking regimen, you’ll begin to recognize the Real McCoys long before they’re promoted.

Above all, don’t be discouraged by these stories. Windfalls like Voisey’s Bay are as rare as the Bre-X debacle. Making money from investing in natural resources is not about striking it rich on a long shot, and most investors don’t lose their money because it was invested in a fraudulent company. Successful investing is all about being an educated investor.