In December of 2002, Southwestern Resources announced spectacularly rich intervals of gold mineralization from tunnel sampling at its Boka Gold Project in northern Yunnan Province, China. The market took notice and responded by increasing Southwestern’s market capitalization fivefold in as many weeks. In July 2003, with a backdrop of high gold prices and pent-up demand for the next “big score”, the company announced substantial high-grade drill results. The market added another C$250M to Southwestern’s market cap over the following 4 months.
Investors weren’t the only ones to take notice; a flock of junior mining promoters poured into China, eager to duplicate Southwestern’s apparent success in an obviously underexplored and target-rich environment. These companies, together with a dozen or so newly minted, China-focused juniors, signed over 100 deals for mineral projects throughout China. Investment bankers and brokers did their part by raising over C$200M to fund these ventures.
By the end of 2003, companies that had acquired or announced their intention to acquire a mineral property in China (the “China Juniors”) witnessed share price gains of over 350% (see Figure 1, below, for a representative sample). This market excitement became known as the “China Effect”.
By the end of February 2004, the market’s demand for Chinese mineral projects had been soaked up. The paper from over C$200M in financings was piled high and the hold periods on restricted stock from past private placements were coming off. Investors, sensing the party was over, headed for the exits. The China Juniors as a group lost an average of 250% of their share price over the next seven months (see Figure 2, below). This sell-off was further encouraged by a $35 drop in gold price (as you know, it’s the relative movement in the gold price that affects movement in share prices ― the absolute price was still enjoying historically high levels, in nominal terms) and the market taking a more skeptical view of Southwestern’s discovery. The China Effect was correcting.
In hindsight, it seems obvious that the excitement surrounding the early results from Southwestern’s Boka Gold Project and the ensuing flood of China-related financings and promotion spawned a classic market bubble in mid-2003.
One would expect that during this period, China juniors would have been overvalued, and indeed, the sharp correction that followed in February 2004 supports this theory. To complete the bubble cycle, there should come a prolonged recovery period where these stocks are undervalued before they stabilize at a fair price relative to their non-China peers. Although the historical price data, charted in Figure 2 above, suggests that this recovery has not yet occurred (and that the China juniors continue to be undervalued), it is inconclusive.
It is possible to compare the relative valuations of the two groups on the basis of the incremental market capitalization they can command per dollar of cash in treasury. The higher the percentage of cash a company must hold per dollar of market capitalization, the less value the market attributes to the non-cash ‘assets’ of the company, e.g. mineral projects, management expertise, corporate strategy, etc. If a company is trading ‘at cash’, the market is not attributing any monetary value to its non-cash ‘assets’. I have prepared such a study below in Figure 3.
Figure 3: Comparison of percentages of cash per market capitalization between China and non-China focused juniors.
Figure 3 indicates that the market capitalizations of the China Juniors are composed of 33.4% cash versus 15.5% for the non-China juniors. Assuming these samples are representative of the two groups, the non-cash ‘assets’ of the China-focused companies are currently being discounted by 115%. There are two ways to interpret this finding:
- The China-juniors were oversold when the bubble popped in February 2004, and the current discount, the product of an inefficient market, represents a temporary aberration; or,
- The market is consciously applying a discount to the valuations of China-focused juniors.
The first interpretation seems probable. Historically, companies become overvalued when their sector is near its peak and undervalued at its trough. This is due in large part to the psychological influences on investment decisions. Investors tend to rush into sectors that are hot and exit those that are cooling off. The junior mining market is especially prone to this sort of hysterical, momentum-based buying/selling and resultant exaggerations of valuation, because it is relatively illiquid, and therefore, inefficient.
The second interpretation, that the market is consciously applying a discount to Chinese mineral projects, would be justified if China were perceived as a lousy destination for mineral exploration spending. This, however, is not the opinion of mining and mineral exploration executives.
The Fraser Institute, in its Annual Survey of Mining Companies, measures the overall attractiveness of a particular jurisdiction for mineral exploration from the responses of executives from mining and mineral exploration companies representing annual exploration budgets totaling over US$640M. The data is used to create an index from 1 to 100 (the higher the score, the more attractive the jurisdiction).
Figure 4: Mineral Exploration Investment Attractiveness Index from Annual Survey of Mining Companies. Fraser Institute, 2004.
China received a rating of 62 on this survey, which means it is perceived by mining and mineral exploration executives as a more attractive jurisdiction than the worldwide average. Surprisingly, China ranked higher than traditional producing jurisdictions such as Argentina, the Yukon, Newfoundland, and Utah. This reflects numerous positives about China: highly prospective and underexplored geology, low-cost operating environment, and an abundance of low-cost skilled labor. In time, it’s likely that the market will recognize these advantages and correct its bias against the China juniors.
Bottom line: China-focused juniors are undervalued on a cash-per-share basis relative to their non-China peers. An inefficient market has not yet recovered after the bursting of its bubble and still labors under a lack of appreciation for China as a mineral exploration destination. The China-juniors are therefore likely to improve in the short to medium term as they move back toward parity with their non-China peers on a cash-per-share basis. For contrarians, there are surely some excellent buying opportunities available within this market segment. Just don’t expect them to last.
Daniel Earle is President and CEO of Roxy Resources Ltd., a mineral exploration and development company focused on advanced-stage gold and copper projects in China. Prior to his involvement with Roxy, he worked as a geologist with a TSX-listed company and in the research department of a large independent brokerage house. Educated as a mineral engineer, specializing in exploration, at the University of Toronto, Mr. Earle donates his services as a guest lecturer on topics related to the industry.
You may contact Mr. Earle by e-mail at [email protected]