At the 2013 Cambridge House Vancouver Resource Investment Conference (VRIC), Sid Rajeev, the head of research at Fundamental Research Corporation, presented his outlook on 2013 and why mergers and acquisitions (M&A) might be something investors want to put on their radar for the upcoming year.  In particular, Rajeev focused on the mining and exploration sectors and laid out his reasoning as to why increased M&A activities are likely to continue over the near to mid-term.

The presentation itself was well-laid out and explained five key factors acquiring companies use when considering a purchase, such as

1. Location & quality of assets
2. Synergies
3. Stage of development
4. Financial position
5. Valuation

To access the slide deck from the presentation, click here.

Paying attention to costs

What was most interesting about this particular presentation was the connection Rajeev made between the performance of precious metal prices relative to the performance of the TSX Venture and precious metal companies.  Specifically, he highlighted that free cash flows for mining companies have dropped 39% per annum in the past three years largely as a result of increasing capital costs.

In other words, the cost of developing mines has increased substantially leaving less money in the hands of the companies themselves.   As a result, in order for larger mining companies to pursue a project (and the smaller companies that may be running them), the economics have to make sense in this high cost environment.    This helps to explain why there has been such a divergence between the rising prices in precious metals without an expected increase in the stock prices of mining companies for precious metals.

For investors, this means that the fundamental case for investing has to factor in rising costs, something that introduces substantial uncertainty when trying to value a potential investment.  For risk-averse investors, steering clear of uncertainty has made more sense than embracing it.  With all the pessimism, however, stock prices on quality projects (i.e. those where the economics and costs are contained) have become attractive, which is the base case for Rajeev’s outlook that 2013 might see increased M&A activities.

Tips for investors interested in mining & exploration companies

After his presentation, we spoke directly to Sid Rajeev and asked him about his take on the many junior companies at the VRIC and how investors can navigate the precious metals sector.

According to Rajeev, there are a few important things investors can and should be doing in order to separate better opportunities from poorer ones.

Tip #1: Be Picky

The first thing to do is to be very picky.  At the VRIC there were a large number of precious metal exploration companies.  Given his analysis on the sector, he suggested a large number of those companies may not make sound investments at this time.   Many projects aren’t being developed because of rising costs, so  a great deal of the “exploration” is simply a transfer of investor money into the ground.  Companies that get created with a focus to meet investor demand instead of being created with a focus around quality projects are especially risky for investors.

Tip #2: Evaluate fundamentals before making a decision

A second suggestion Rajeev offered was to stay away from speculation and rumour.  While a tip from friends or neighbours might sound tempting, stick to evaluating the fundamentals before making any decisions.  While one cannot become an expert overnight, becoming familiar with the basics of the area investors are interested in is a small but important step most investors can make, according to Rajeev.  For example, understanding different types of deposits, what makes a good or bad grade and what makes a good location are all thing investors can do relatively easily.

Tip 3#: Look into the management team’s performance

In addition, Rajeev offered an important potential red flag to pay attention to when looking at a company.  When evaluating the management team of exploration companies, do some digging into whether members of the team hop from project to project without any indication of major successes (either in discovery or production).   Individuals who move between mining and exploration companies without a track record of creating successful projects don’t inspire confidence with professional investors. A ‘gut-check’ for do-it-yourself investors to ask is “if the professionals don’t accept it, why should I?”

There are opportunities to be had

While the outlook in the near term might seem challenging for junior companies, according to Rajeev’s research, the latter part of the year might see some strength in the TSX Venture.  As his presentation laid out, there is value to be found if you’re willing to hunt around for it.

When the investor sentiment turns too negative, sometimes the proverbial baby gets thrown out with the bathwater.  In the case of junior mining and exploration companies, if investors approach them the way a major investor would, on the merits of the fundamental components listed earlier, some reasonable opportunities may present themselves.

As it turns out, when looking to invest in mining and exploration companies, investors should still be prepared to dig beneath the surface of the marketing and stories they hear at conferences like the VRIC.