I’ve had some of my Diggers and Drillers readers asking about capital raisings in the junior mining sector.
I addressed those questions in a recent update to subscribers, and thought the content would also be of interest to Fat Tail Commodities readers.
This marks the beginning of a series of strategy sessions where I dive into different topics related to investing in the junior resource sector.
If this sounds like something you’re interested in, be sure to consider subscribing to Diggers and Drillers for all future updates.
For today, let’s talk about capital raisings…
If you’re not familiar, a capital raise occurs when a business approaches investors for more cash…that could be in the form of debt.
More commonly though, it’s via the issue of new equity.
Small-cap mining stocks don’t produce revenue…that means they don’t usually have access to traditional lending.
Issuing new stock is one of the few options available to management to bulk up the company’s cash position.
As an investor, taking part is entirely voluntary.
However, failing to participate could mean a dilution of your existing holding.
In other words, when a company issues new stock, it can reduce the value of shareholders’ existing shares and their proportional ownership in the company.
With that in mind, how should you approach capital raises in the junior mining sector?
Well, it really depends on market conditions.
Let’s say sentiment is buoyant.
Shareholders tend to look favourably on share issues when the funds are intended for growth projects like exploration drilling.
If the company has delivered high grade hits…even better.
It’s not a coincidence that capital raisings tend to follow drilling success, management likes to use the positive vibes to build up the company’s cash position.
Now compare that to today’s market…
Given many junior mining stocks are now trading around multi-year lows, issuing new stock becomes a hard pill to swallow for investors.
Raising capital in a depressed market is always a red flag for investors.
Cash could be running short.
In this instance, you’re probably not going to get the real story behind management’s need to raise capital.
In my experience, the stated purpose always revolves around some kind of growth ‘story.’
But if liquidity is a problem, you can bet that money is going straight into payroll, bills and debt servicing.
You see, there’s no repercussions for a board promising growth, but instead using the cash to fund short-term liabilities or address problems at its operation.
That’s why you should be on alert to any stock issuing new shares in a bear market.
Another red flag comes from capital raisings on the back of a poor result.
That’s why Diggers and Drillers subscribers Core Lithium [ASX:CXO] recently…as you might recall, the company issued new stock after missing its output guidance in July.
In my mind, any new cash was destined to fix the company’s production issues rather than fund growth ambitions.
But are there instances where capital raisings make sense in a depressed market?
Market selloffs are a great time to acquire new projects.
Given the discounting on offer, there’s a solid case for well-run companies to raise capital in a bear market as a means to expand.
Importantly though, I’d want that company to have a strong balance sheet and a solid track record of operational success.
Companies must earn the right to raise capital in a depressed market.
To use one example, let’s look at copper explorer Carnaby Resources [ASX:CNB].
Some of its recent discoveries have the potential to cross into neighbouring properties.
Merging these tenements into a single unit might offer the company long-term upside.
But without drilling on the landholding first, management must have some confidence in their geological understanding and which direction mineralisation is likely to ‘trend.’
In other words, does the company believe the ore body crosses into a neighbour’s property (tenement)?
There’s certainly potential for this when we look at the location of some of Carnaby’s discoveries.
Given mainstream finance is usually beyond the reach of most explorers, the company really only has TWO options to chase the targets sitting ‘next door’…
It could issue new stock and use this cash to buy-out the neighbouring company.
Alternatively, it could enter into a joint venture (JV) agreement.
Both options allow the company to expand its footprint and build on recent success.
Given the JV won’t require much cash (other than the exploration costs) this option comes with far less risk.
However, the company misses out on gaining full ownership.
That dampens the potential upside if copper prices rise or if the new targets prove highly successful.
It all boils down to management’s confidence in the project and the respective timing in the commodity cycle.
There’re many nuances to consider and it pays to put yourself in management’s shoes to get a real understanding of why a company might be looking to raise cash.
You certainly can’t rely on the stated purpose in the company’s announcements to get the full picture.
Now this is just one example of what a company MIGHT do…I’m not implying CNB is about to take over any of its smaller neighbours!
But how can investors limit the risk of dilution?
Invest in those companies where directors are more likely to behave like shareholders. That is, they own a significant stake in the business.
We have such companies in the Diggers and Drillers portfolio right now.
Now, insider holdings don’t guarantee success, but they do limit the risk of unnecessary dilution.
It’s an important issue to keep in mind if you’re looking to hold your investment over several years.
I hope that’s given you a nice little overview of the world of stock issues and how they’re used during the various stages of the mining cycle.
Plus, some of the traps and tactics to sidestep the risk of dilution.
No doubt, there are many other issues to navigate in junior mining investment.
We’ll cover more of these in future Diggers and Drillers updates.
You can become a subscriber here if you’re interested.
Editor, Fat Tail Commodities