THH – Pre-Discovery And Beta Plays in Low/High Sentiment Environments

In this article I will discuss why I think an investor must be aware of the changes in Risk/Reward in some types of companies that comes with sentiment highs and lows…

Beta Plays

The merits of Beta plays at sentiment low extremes

Buying banked success that is selling for less than <50% of its value and would have an expected return of say 300% at the next sentiment high is a low risk “buy and wait” case with great Risk/Reward…

A future reward is a matter of WHEN and not IF.

The problem with Beta plays at sentiment high extremes

Buying mature (low to no growth) companies that are trading at overvalued levels means that they will sooner or later crash all the way to the next sentiment low as the sentiment cycle repeats…

A future price decline is a matter of WHEN and not IF.

Pre-discovery plays 

The problem with pre-discovery plays during sentiment lows

At sentiment lows the immediate reward from discoveries tend to be extremely muted unless the discoveries are exceptional almost regardless of valuation. On the flipside the immediate punishment in case of unfavorable drill results is typically brutal to the downside almost regardless of valuation. In short it is basically an extremely rigged game against the pre-discovery speculator which has no backup value which could get revalued at the next sentiment high. In my opinion the worst Risk/Reward cases in this environment are cases where pre-discovery juniors risk killing perhaps their only legit target…

In practice a bet on pre-discovery plays during sentiment lows provide the following scenarios:

• Mediocre Discovery (<5% chance of happening): Maybe a 20% bump
• Exceptional discovery (<1% chance of happening): Maybe a 50%-100% bump
• Failure (~95% chance of happening): -30% to -50% and might stay dead until the company can raise money (and dilute) again

Not only is the immediate Risk/Reward absolutely terrible but if there is no margin of safety (banked success) as a backstop then speculators/investors do not even have the hope of a 300% revaluation thanks to sentiment unlike Beta plays.

The merits of Alpha plays at sentiment high extremes

In a very hot sector environment one can see favorable soil, chip, trench and drill results lead to material revaluations to the upside. It can even get frothier than that as seen in Garibaldi Resources which I think almost reached a Market Cap of $500 M in 2017 before a single assay was out. Today one can probably buy 50 Moz of decent gold for less than that.

In a hot environment the marginal investor is focused on UPSIDE and NOT RISK. In a hot environment blue sky POTENTIAL is happily priced in. In a hot environment a company can make a discovery and get an incredible revaluation as the marginal investor is mainly focused on how much he/she can make if blue sky materialized and little to no attention put on the risks of blue sky not materializing. During the copper frenzy on the ASX a year ago or so we could see copper juniors with pretty lackluster drill intercepts shoot up 100% in a day as an example.

If there was ever a time for pre-discovery plays with no margin of safety it would be in a hot market environment where a discovery story will not only be “paid” on a discovery hole but maybe 30% of blue sky potential up front as well. Right now the opposite is true as Potential is trading at multi-year lows and even banked success (100% de-risked success that has already come to fruition) is selling at a >50% discount.

Discussion

Care and maintenance – “Wait it out”

If I ran a pre-discovery junior in the current environment with no real margin of safety and maybe only one serious target I would put everything on care and maintenance until sentiment returns. I have already seen some juniors do this. Sure, it will still lead to a negative reaction because anything that is perceived to be negative will get sold off even though it’s probably the best course of action. But the important thing is that the case is at least preserved and it opens up opportunities for patient speculators to do some bottom fishing and wait for sentiment to return.

Private Placements

If a good pre-discovery play is cheap enough, has some access to capital, has no real way of killing the story if the company decides to drill, and you get say 2-3 year full warrants then I would certainly do some due diligence and consider it at least.

Most important things

Alpha: I think the most important thing is that one would not want to be a in a junior right now that at best could get say a 30% pop in case of a very unlikely discovery and at worst could kill a grassroot target via drilling.

Beta: I think staying power is worth its weight in gold right now. Some beta plays such as producers might be having troubles with cash flow and lets say a company can survive for 6 more months of this environment consisting of subdued gold prices and rising cost inflation… And the big turn happens 7 months from now. In that case it would be to late and the company will not be on board for the mean reversion. If the turn comes just before the six months are up then of course the mean reversion will provide unthinkable returns. BUT I would rather have a high probability of getting say a future 400% return than a 30% chance of getting a future 800% return. Again, I think one should rate Beta with considerable staying power higher than the highest possible Beta which might come with considerable risk of not even being around for the inevitable mean reversion.

To sum up

Good R/R right now (IMO):

• High margin producers with staying power
• Advanced explorers/developers with no debt that can simple stop working and halt costs (Ability to wait it out)
  • Preferably with growth potential (Alpha) as well which will also fetch a higher price at a sentiment high

Bad R/R right now (IMO):

• Low margin producers with high fixed costs
• Pre-discovery plays which risk killing the story in a sentiment environment where success is not rewarded enough to offset the risks

… Note that this is just from my personal Risk/Reward perspective. What actually will happen is that some companies that might be very close to closing up shop might end up rising the most (This could be a marginal producer that saw the metals turn up just before it went bankrupt). But our goal as investors is not to come up with the highest possible reward scenario without accounting for risks. Our goal is to have the highest long term compounding results as a product of sound investing strategies in the face of an ever unknowable future. I already know that I will miss the highest flyer from bottom to peak and I am OK with that because, again, the goal is to have the best long term results over years and decades.

Lastly I would just point out that a high quality Alpha play, with probable growth ahead, is something I think has great R/R in all environments and has been my bread and butter over the last >2 years.

I recommend reading my piece titled: “Miners: Yes it is a ‘Rigged’ Game, But it Always Changes”

Examples of primarily Beta but with some Alpha:

• i-80 Gold
• Dolly Varden Silver
• Cassiar Gold
• Mayfair Gold
• Montage Gold
• Cabral Gold
• Golden Tag
• TriStar Gold

Best regards,

The Hedgeless Horseman