Does Your Junior Have Competent Management? – Rick Rule
Sprott Asset Management USA Chairman Rick Rule shared with me his most essential insights to investing in natural resources. In a previous post, I related why Rick views the exploration industry as the “research and development” side of mining.
So how does this affect our investment strategy in the natural resource sector?
“We have established that exploration is a knowledge business,” Rick begins, “and that a small number of sector participants generate the overwhelming majority of the industry’s economic success. These two realizations are key to improving your chances of success.”
“This type of market is an example of what social scientists term ‘Pareto’s Law,’ or the ‘eighty-twenty rule.’” The rule holds that eighty percent of the work is accomplished by twenty percent of the participants. The really productive people are the top 20% of those top 20%, and the worst are the bottom 20% of the lowest 20%: “In a large enough sample, the ‘lips’ of the bell, the outlying 20% on both extremes, can be run through the same performance dispersal curves. Thus 4% of a population contributes in excess of 60% of the utility associated with a class of tasks, while a very different 4% of the population contributes 60% of the disutility.”
Rick believes this concept is highly valuable when applied to the mining industry. In order to pick the winners, he says, you must have the ability to view the entire field as a spectrum. Each management team will fall somewhere on the spectrum – most around the average – but those on the higher end of the bell curve become exponentially more valuable. So investors should seek to determine the quality of the management team independently of the value of the current project they are undertaking.
“The key for investors is to evaluate management teams based on their past performances in similar situations.”
Beware of teams whose past successes were in areas different from where their current project is located: “It is important to see that the participants in past successes are directly relevant to the task at hand. A mining entrepreneur might reference past success where he or she was successful in operating a gold mine in Archean terrain in French speaking Quebec. This is very impressive, except that this same promoter now proposes to explore for copper, in young volcanic rocks, in Spanish speaking Peru! The identified skill sets must closely match the chosen task.”
Past success in the relevant field is an invaluable tool to filter out the truly productive industry participants, says Rick, especially since most companies will immediately fail this test: “More than half of the management teams you interview will not be able to point to a history of success relative to the task at hand.”
So being successful in the “research” end of the mining industry is, according to Rick, about picking the best elements in the market. How should you approach a management team about their current project? Once they have established enough credibility that we care about their project and their views, what should we look at next?
“Making money and adding value in mineral exploration is a function of answering a series of unanswered questions. Management must have first established sufficient credibility that we care about their answers. They must identify and defend their thesis based on the evidence at hand. 90% of the management teams you interview will be unable to present a reasoned argument for pursuing their project and to justify the approach they are using.”
“So let’s examine the questions one by one.”
“Is the process by which an exploration team proposes to pursue their target valid or optimal? Does it in fact address the most essential questions that will determine whether the project is a success?”
“Does the management team possess the requisite skill sets to conduct the process and efficiently answer these questions?”
“Does the management have a reasonable estimate as to how much time will be required to answer these questions? How was the estimate established?”
“Does the management know how much money will be required to answer these questions? How much will it cost to run the company during that time? If there are capital shortfalls, how, when, and from whom will the shortfall be addressed?”
“How would the management quickly ascertain that the project was unsuccessful – meaning that the target is not of sufficient value to justify further exploration? This is a very inconvenient situation for management, which may result in a reduction in their equity and options values. They may construe disappointing exploration results as threatening to their salaries. In most exploration projects, we expect that exploration will be unsuccessful at establishing a resource, but the ramifications of this outcome are rarely discussed be management.”
“What valuation range will we have if exploration does result in the discovery of a resource? Too often, exploration teams pursue targets where even ‘success’ will produce a paltry reward relative to the risks. Small mines have as many problems as big mines, but they cannot make you big money.”
“Finally, is management’s estimate of the potential economic value of a project well-reasoned?”
Rick believes these questions are essential to ascertaining with confidence that your team is competent, knowledgeable, and will efficiently deploy their shareholder capital.
Rick Rule founded Global Resource Investments in 1994. Global provides brokerage and investment banking services to high net worth individuals, institutional investors, and corporate entities worldwide. In 2011, Global was acquired by Sprott, Inc., a public company based in Toronto, Canada, which has in excess of $9 billion in assets under administration in the resource and commodity sectors.
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