Digging for Alpha

The transition from fossil fuels to cleaner energy sources, whilst critical for the longevity of humankind, will be a twisting and complicated path. What’s clear is that the route to decarbonisation will be hugely dependent on metals and mining. Without mining, we would have no electric cars, smartphones, internet or cloud services. But new mines don’t spring up overnight, they take significant time to explore and develop before we can extract these all-important metals.

If the world is to transition from fossil fuels to renewable sources of energy, it must find a way to meet the growing demand for the metals needed to make that leap. Lithium, copper and even nickel – the world’s fifth most abundant element – are seen as increasingly valuable because demand is outstripping supply.

Given the actual or relative scarcity of these “green” metals, the race is on to find – and start mining – new deposits. It has been estimated that as many as 330 new mines will need to be opened by 2035 to meet the growing demand for clean energy technologies⁽¹⁾.

But, perhaps surprisingly, it is not predominantly the big mining companies that are leading the search for new deposits. Their principal expertise lies not in exploration but in managing mega mining projects in an efficient and cost-effective way. As such, they tend to focus on mining the world’s largest and best-known deposits. With respect to new deposits, it is often much easier for them to find – and acquire – the companies discovering new mineral deposits. As the common refrain goes, the big mining companies do their exploration in the stock market not in the ground.

⁽¹⁾ Benchmark Minerals, 6 September 2022 forecast.

There are thousands of publicly quoted mining companies, the majority of them small, highly entrepreneurial companies, known as “junior mining companies”.⁽²⁾

Typically, these companies are founded by individuals or families and own a single exploration zone which has yet to be proven commercially viable. Most of these companies will fail. But there are always a few big winners.

And here lies the opportunity – the alpha – for investors. Just as panning for gold is sifting through a lot of worthless rock looking for that precious nugget, so investors must sift through the thousands of opportunities to find the right investment.

To pick the winners, we believe you need to start with the geology. How confidently can you predict and understand the subsurface rock based on: what can be seen on the surface; the evidence you can gather regarding sub-surface structural controls and mineral prospectivity; and drill core samples (typically no more than a few centimetres wide) that have been extracted from exploration holes.

⁽²⁾ S&P Capital IQ Global Mining Intelligence Report (Metals & Mining | S&P Global Market Intelligence (spglobal.com)

Once you are happy with the geological risks and confident that nickel or some other desired metal is present in sufficient abundance to warrant mining, you move on to review the other risks associated with the company. The logistics and cost of creating a mining operation, invariably in obscure out-of-the-way places, should not be underestimated.

It’s about getting people and machinery into place, trucks as big as houses and rock crushers as well as building mines and processing plants. And don’t forget about getting permits and a secure tax understanding, as well as confidence in the level of political stability. Furthermore, the financing and sequencing of the capital and operational expenditures can be challenging. Mining is crazily expensive and to make matters worse, a substantial portion of the costs must be paid up front while revenues (if they ever come) only begin to flow once a mine has started producing.

And there is another risk that investors must consider: management. It is a truism that smaller companies tend not to have the best managers. As a result, they often struggle to build a convincing business plan, access the best resources, and secure sufficient investment.

But where there are risks, they are opportunities. For Tetragon, we see opportunities for outsized returns when an asset manager takes very concentrated positions and contributes intellectual and financial input, as well as working closely with management over a period of years.

It should be said that investing in mining is not for the faint-hearted. It takes conviction, great skill and enormous reserves of patience. The financial returns are likely to be binary: a success will likely return multiples of one’s investment, but failure result in the loss of nearly everything invested. To be successful, one needs to have both the skill and wherewithal to develop winners, as well as the acumen and judgment not to get involved with the many projects out there that are unlikely to ultimately make the grade.

From an investment perspective, the idiosyncratic risks are a question of risk versus reward on each given project, mine or company; and this is the alpha. We believe active input can increase the chances of success, thus improving the alpha. However, from Tetragon’s perspective we also need to think how these investments fit into a broader and larger portfolio. Whilst the specific risks surrounding any given mining project are unlikely to be correlated to any other project, or indeed the stock market, they do of course share some macro risks. The most obvious ones being illiquidity, long duration, not cash flowing (certainly not until meaningful production has been achieved) and of course sensitivity to the ongoing cost of production and the fluctuating price of the substance being mined. These must all be factored into Tetragon’s overall risk tolerances. But, given the nature of Tetragon’s capital – permanent with a long investment horizon – Tetragon is well suited to absorb these risks.