Thursday, 17 May 2012

Negative feedback loops and financing risk

So it appears my first pick on this blog (Tigray Resources) has thus far been an utter stink bomb.  Perhaps it goes to show just how important some of Mr. Buffett's concepts are, being Margin of Safety and Circle of Competence. I violated both for three reasons: 1) I have a fascination for spin-outs and thought this was a case wherein management was trying to get in on the best asset of Canaco for themselves, 2) I previously met management at  a retail investor's conference and trusted them, and 3) I was lured by the prospect of quick profits.

In hindsight, this was a very expensive way to reinforce things I knew beforehand.  By observing many multi-baggers in the small cap Canadian mining market over the past few years (before the bubble burst around the time of the Fukushima incident), I had lost appreciation for what an accomplishment it is for a company to achieve a 15-20% compound annual growth rate in earnings. When metal prices are climbing and the market is in a "risk on" mood, the junior resource companies seem to experience a positive feedback loop where their share prices rise, thereby triggering analyst coverage and subsequent equity issues or IPOs, followed by follow-up sell-side reports loaded with optimism.  Before this loop reverses course, investors forget about financing risk (i.e. the fact that these companies are not self sufficient and are thus at the whim of markets when more money is needed).

Tigray has lost more than 80% of its value since I began investing in it.  At its current price of $0.28, the stock needs to nearly quadruple in order for me to break even.  Even if I had more hard earned savings to average down my cost base at new low, I cannot commit any greater a percentage to speculative stocks than I already have.  So where did I go dead wrong?  Well, there are two main places.  First of all, I did write about how Tigray is effectively tied to the hip of the company it got spun out of (Canaco Resources).  Canaco finally reported its initial resource estimate yesterday after delaying it two times, and it was about half of market expectations in terms of number of ounces and grade. Tigray's price was already beaten up before this announcement, but I assume a lot of Canaco investors "pulled the chute" on both holdings upon the news.  As you may know, the Canaco management team still runs Tigray as no independent management team has been installed since its spin out in September 2011.

But the primary risk I underestimated here was the possibility of a negative feedback loop triggered by market worries about financing risk.  In Tigray's case, I believe that much of the price devaluation has to do with the fact that market participants were aware that the company will need to experience some kind of share dilution in order to continue drilling.  The most recently reported cash balance appeared in the slide presentation that was posted on Tigray's website in early April and at the time, there was $2 million remaining in the company's coffers. With a monthly burn rate of ~$1 million, it is possible that the cash balance is near zero.  It goes without saying that an equity issue at the current price would effectively restructure the company and wipe out shareholders. For example, if $10 million were to be raised tomorrow at $0.28, this would result in the number of shares increasing by close to 80%!  And equally frustrating is the fact that the $10 million raised would not even last one year.  But how do I explain the drop from $0.90 just a few months ago to the current level? I think the answer is that as investors realized the company is running out of money and will need to use its stock as a currency, they began to walk out the door. As the price declined and it became more apparent to the market that management has few alternatives besides issuing equity to restore its working capital, more left as the lower price meant that when the share issue happened, it would be more dilutive to current shareholders. On so on and so on...

The only things I see that can snap Tigray out of its funk are the following: 1) A sudden surge in gold/copper prices - maybe QE3?  Certainly out of any market participant's control.  2) An unexpected sale of the near-surface gold gossan delineated at the Harvest project (probably contains ~500K ounces) to Sinotech, which would have the financial means to mine this resource. This would provide Tigray with a sum, which I do not care to speculate about here, to use as working capital and continue its drilling program.  Otherwise, Tigray will either have to state that it is freezing its second phase of drilling or complete a massively dilutive round of financing.  If management were to step in and support another round of financing, this would be positive in a way as it would show their confidence in the project; however, my equity would still get wiped out in the process.