The fundamental principle of value investing is buying shares in companies for less than their book value — theoretically, their breakup value.
This implies a measure of risk, because most companies’ shares don’t trade this cheaply unless they are having problems or out of favour. Despite this, value investing has a very successful track record, although it’s generally considered to be more reliable with large cap companies, as these are subject to far more institutional analysis, which will, in time, ensure that underlying value in the stock is ‘outed’, as the jargon has it.
Does this work for resource stocks?
I’ve come to believe that this approach can work for small-cap resource stocks, in certain circumstances.
Firstly, they must meet several criteria that reduce the level of pure speculation to an absolute minimum:
- Proven reserves
- Stock must be trading at a substantial discount to NPV10 or similar measure of tangible value
- Company must have sufficient funding (including undrawn debt) to bring assets into early production and generate cash flow
- Potential game-changing upside, either via a step-change in production output or through exploration.
- Existing production output providing sufficient cash flow to fund ongoing operations and some development work.
- Ideally, share price near all-time/multi-year lows
As you can probably tell, I don’t invest in pure exploration plays or similarly risky ventures, however tempting the potential upside might be.
What I prefer is to find companies whose share price has tumbled after some kind of mishap, delay or simply an encounter with reality, such as drilling delays, bureaucracy, or a bad run of exploration luck. All of these can deter investors, even when the underlying investment case remains sound.
In my upcoming posts, I will provide some examples of companies I believe fit the mould — I’ll leave you to decide whether you agree!