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I Smell Smoke But Where’s the Fire? Buy Junior Mining Stocks When People Hate ThemKal Kotecha “Shouting fire in a crowded theatre” is a popular old adage for speech or actions made for the primary reason of creating unnecessary panic. Warren Buffett has adopted this saying into a metaphor that ties in the idea of swinging investor sentiment. Warren Buffett has said that Wall Street is a little like a movie theater that has a special rule where if you want to leave the theater you need to find someone outside the theater to take your seat. This is because for every trade there has to be both a buyer and a seller. This analogy is useful in understanding why investors can collectively behave irrationally and drive stock prices up or down far beyond their intrinsic value. When consensus is reached about what the next big thing will be, everyone piles in, paying any price to get a seat for the box office movie of the year. At other times, people see smoke in the theater, and everyone wants to rush out but there are no buyers and so the prices crash as sellers try to offer an attractive price for someone else to take their place. Savvy value investors look for instances where there's smoke but no fire, enabling them to get good companies at substantial discounts to intrinsic value. Well, investors have caught a whiff of smoke in the junior resource space and nobody wants to be left holding the charred bag. But God gave us 5 senses for a reason; you may smell smoke but do you see where it’s coming from? It would be hard to believe that everything is burning and this is where value investors begin their quest. Value investors will agree that the market is efficient. All available information is quickly incorporated into stock prices but this information is not always right. Information that is widely accepted by the majority will mean a trend will occur and changes in asset prices will be unavoidable. For example, Yahoo sold at $237 per share in January 2000, but in April 2001, it was at $11. The true value of Yahoo could not have changed so quickly in that amount of time and thus, one can see that the consensus view lead to a market error somewhere along the way. This example of a single stock can be translated to the entire market as exemplified in the market pendulum model. Stock markets are like a pendulum because they are always attempting to get to a resting point or fair value. But the market is subject to human emotion and consistently swings to both sides of fair value as people switch from fearless to scared and back again. These ups and downs are part of the natural cycle of the market and are referred to as bull and bear markets respectively. Recognizing the current position in cycles is not about predicting the future but awareness of what is going on in the present. The years leading up to the 2008 Financial Crisis were marred by unrestrained financial optimism and deregulation which led to increased marketplace risk. Following the consensus view in the market means one will achieve consensus or average returns. In this case, investing in an index could achieve the same result with little effort. But if one wishes to achieve superior results then one must be different than the consensus. Contrarianism involves thinking and acting differently than the consensus, even if it is unpopular. But contrarianism is not always doing the opposite of what everyone else is doing; it involves doing your research and buying when everyone else is selling and selling when everyone else is buying. The current pessimism surrounding the junior resource market has largely contributed to the fall in price. But the beautiful thing about pessimism and hate towards a market sector is that there is plenty of room for error. Fantastic opportunities arise when great companies have been undervalued due to negative news that does not have a long term impact on the company. So how do you determine which stocks in a beaten up resource market are great buys? By understanding the essential principles of intrinsic value and the margin of safety. The principle of intrinsic value determines the worth of a stock through a combination of the price and the condition of the company. No matter how great a company is, it may not always be a good investment. As Howard Marks, renowned for his insightful assessments of market opportunity and risk, says in his book The Most Important Thing: Uncommon Sense for the Thoughtful Investor, “Investment success doesn’t come from “buying goods things,” but rather from “buying things well.” The principle of the margin of safety involves minimizing risk and, therefore, minimizing the potential loss of one’s money. Dealing with risk is a necessary part of investing as stock price fluctuations occur and are often unpredictable. Investors who understand that perceived risk is compensated with returns and that if the risk perceived by the herd (general investors who follow the majority) is less than the actual risk, then the returns will outweigh the risks. When consensus thinks something is risky, the general unwillingness to buy it pushes the price down to where it is no longer risky at all since all optimism has been driven out of the price, given that it still has intrinsic value. Using qualitative and quantitative approaches for evaluating stocks is essential for identifying their intrinsic value and margin of safety. Quantitative analysis uses different ratios to identify stocks with an earnings yield (earnings per share divided by the stock price) which exceeds the yield of a 10-year government bond; stocks priced lower than the company's net asset value with weak earnings and other problems discounted in the price, yet the company has a good balance sheet and low cost structure; stocks that trade at a discount to fair market value with financial characteristics better than alternative investments; and stocks where one can believe returns will dramatically improve due to a governance and management culture shift, the sale of a losing division, or a change in the supply/demand dynamics in the industry. For example, in the case of junior mining companies, their ability to produce resources at a cost below their market price is essential for the sustainability of the company. Qualitative financial analysis uses subjective judgement based on information that cannot be quantified. The qualitative analysis of an investment can include a company's governance practices and ownership structure, management and incentive programs, employee turnover and labour relations, research and development, products and services, competitive strengths and weaknesses, capital intensity, and accounting policies and disclosure practices. For example, junior mining companies should be judged by their ownership of mines, the quality of these mines, and how management has executed similar projects in the past. Determining whether this data has been incorporated into the stock price or not is essential when seeking undervalued companies. Junior mining companies are hitting lows, made apparent by the amount of M&A occurring in the industry with attractive valuations to boot. Investors’ disappointment with gold, silver, and copper to name a few has caused the 3-year downward trend to persist. Do you smell smoke? Investigate the source! I’d say that the herd is done shouting fire and smart investors are filling up their baskets with goodies. Don’t forget to do your research, check your facts, and invest in a contrarian fashion; obtaining superior results, by definition, means you cannot do what everyone else is doing. With all of this to consider, please visit our site at www.JuniorGoldReport.com and sign up for your FREE newsletter and stay informed in the junior mining space. References Browne, C. H. (2007). The Little Book of Value Investing. Hoboken, N.J.: Wiley. Marks, H. (2011). The Most Important Thing: Uncommon Sense for the Thoughtful Investor. New York: Columbia University Press. Murcko, Tom. "An Analogy to Understand Value Investing"InvestorWords.com. N.p., n.d. Web. 20 May 2014. Value Investing. (n.d.). Evans Investment Counsel. Retrieved January 17, 2014, from Evans Investment Counsel ### Kal Kotecha Junior Gold Report is a website dedicated to informing the public about gold, silver, and metal companies. For Junior Gold Report's FREE newsletter, please visit the website. Kal Kotecha MBA is the editor and founder of the Junior Gold Report, a publication about small cap mining stocks that is read and enjoyed by thousands of investors. He was the editor and creator of the Moly/Gold Report, which focused on critical analyses and open journalism of companies profiting from the precious metals sector. The scope of his current activities include worldwide onsite analyses and reporting of developing companies. Kal has previously held leadership positions with many junior mining companies. 321gold Ltd |
