Identifying the next generation of successful gold miners

LinQ Resources Fund explains how a private-equity company can find the fledgling stars from the army of smaller mining and exploration stocks.
Investing in established gold-mining companies is a way of correlating yourself with the prevailing gold price. There is the ongoing risk that miners must keep finding millions of ounces in new reserves each year merely to guarantee their future existence. Otherwise, investments in the bigger mining companies are a fairly accurate barometer reflecting the price of the relevant metal. As such, investing in either BHP or Rio Tinto is a typical commodity-price play.

A way of sourcing more optionality over the gold price is to find the next generation of quality and higher-growth emerging gold producers. In smaller companies, valuation is a function of risk and return. As these types of companies reduce their risk profile and meet their various strategic milestones, valuation tends to improve. For example in Australia, an exploration company might trade at a projected price/earnings multiple of circa three times projected earnings. After a feasibility study, that same stock might trade at around five times.

In this way, the price-earnings multiple continues to move up the curve. It is driven by the disclosure of information that builds on the story of a gold miner ultimately moving towards production. By the time gold starts emerging from the ground, that price-earnings ratio will have settled at around 15 times.

The difficulty is selecting the gold-mining companies with best prospects of success from the vast number of small companies operating in the sector. Specialist natural resources fund managers say they offer the skill-sets to decipher the foolÆs gold from the genuine bullion.

ôWe base our analysis on an evaluation of the managers, the prospectivity and the growth potential of the mine,ö says Clive Donner, managing director of LinQ Resources Fund in Perth, Australia. ôWithin this you have to understand the project metrics, metallurgy, modeling of the ore body (and its growth potential) and its cost dynamics (both operating and capital costs). Ultimately, though, what you can never change is the geology.ö

Donner is a Rothschild veteran who has worked 25 years as a corporate financier specialist to the gold mining industry. He previously spent almost a decade with Citicorp financing mining projects in Africa and 16 years with Rothschilds in Australia where he spent the first six years heading up mining project-finance activities in Western Australia and the next 10 years in venture capital/funds management specifically in the resources sector globally.

He is the founding MD of LinQ Resources Fund, which is structured as a closed-end investment trust investing in small- to mid-cap resource companies, mainly by acquiring equity stakes. It also structures convertible notes for mining companies, creating a debt instrument, sometimes collateralised, that can convert into equity if the emerging miner proves to be a success. Such a structure can minimise early-stage risks of investing in smaller gold mining companies and also provides a yield enhancer for the fund.

ôYou need a diversified approach to smaller cap stocks because of the execution risks. Those are the pre-production risks running through to the commissioning risks involved in mining,ö adds Donner. ôWe invest long-only, because the small- to mid-cap companies in our portfolio are not big enough to take short positions, we are about 60% invested in emerging producers.ö

LinQ Resources stands virtually alone in its role as a hybrid private-equity provider specialising in natural resources and mining. It listed on the Australian Stock Exchange in early 2005 and the value of its underlying investments has doubled during that time. Its portfolio usually contains approximately 35 investments. At present, its principal holdings are CopperCo and Wedgetail Exploration, both based in Australia, and Elkedra Diamonds and Riversdale mining, in Brazil and South Africa respectively.
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