When looking at junior stocks, one must develop filters. We recommend looking at junior stocks based on four important measures: sector, management team, stage of development, and deal structure. Order of importance is up to the individual investor. This is the first post in a series of four that addresses the above four topics.
An important step before investing in junior companies is deciding which sectors to focus on. When choosing sectors, look for natural barriers to entry, examine supply and demand dynamics, and compare companies within the sector.
We like markets with natural barriers to entry. Take the steel industry, for example. There is general agreement that steel demand will remain strong for the foreseeable future due to rapid growth in Asian demand. Yet not every part of the steelmaking process is an equally good investment because the various stages have different levels of barriers. Profit flows to the naturally constrained parts of the value chain.
· Iron ore and coking coal mines: Currently, the coking coal and iron ore markets have solid barriers to entry controlled by a combination of oligopolies, difficult logistics, and a lack of high-quality undeveloped resources. Going forward, iron ore producers and juniors have a strong natural limit to competition. This is coupled with a strong demand structure that has no product substitution that can compete with steel.
· Shipping companies: Currently, owning a shipping company is a lousy business. In good years you make a fortune. However, there is no long-term barrier to making ships. Any government that wants strong coastal employment and has a bit of ocean-front land can build a shipyard. The technology has not fundamentally changed for 40 years, and the ability for customers to substitute one ship for another is easy.
· Steelmakers: Steelmakers have more barriers to entry than ship owners but fewer than miners. However, they also suffer from an ability to add capacity when times are strong and no government desire for rationalization when times are weak. Therefore, steelmakers are prone to excess capacity being built.
In the steel industry, miners have strong barriers to entry. Shippers and steelmakers do not. Buy the miners, hedge by selling short the steel mills.
Look for commodities in high demand and short supply. A good commodity cannot be easily substituted.
When looking at demand, consider this: without certain commodities, economies and societies would crumble. Strong commodities include copper, platinum, coking coal, iron ore, and oil. We need each of these commodities for essential functions like electricity production, emissions filtration, steelmaking, or energy. These are the basic building blocks of a modern society. It is impossible to imagine a world without steel for building and copper wire for electricity.
Many factors can affect supply. We could write for pages about how the iron ore oligopoly and the lack of new copper deposits limit supply in those sectors. We could also write about how South Africa’s “use it or lose it” mineral policy has resulted in too much platinum being planned for exploitation. In a good investment, supply limitations must be driven by either natural barriers to production or a political or economic barrier that is very difficult to change.
The temptation is to buy any company that looks good without knowing or understanding its competitors, but competitors define the quality of a company. As an investor, it is important to compare companies within sectors. Unless you know what a good copper company looks like in grade, location, and management, you cannot tell if the company you are focusing on is worth an investment.
However, while you should compare companies within the same sector, it is no use comparing companies across sectors. When comparing diamonds and lithium, for example, the definition of a good location is completely different. For diamonds, a good location is wherever the diamonds are. In the lithium sector, however, investors expect roads, power, and water in the region before they will even look at a project. When you compare across sectors, location becomes very hard to judge. This is one example of a sector-dependent factor.
Choose sectors where competition faces natural barriers to entry. Supply should be controlled by Mother Nature, demand should be driven by China and the rest of Asia, and logistics should be tough but feasible once built.