When are classic bottom-fish criteria useless?

The classic bottom-fish criteria I have for decades used to sift through the resource juniors during bear markets are structure, capital, people, story and value. There is a sixth criterion I call "history", which long time followers will recognize as what I once called "background", something for which I have a newfound appreciation. I emphasize "bear market" because during bull markets classic bottom-fish do not exist. Unfortunately, the resource sector is currently stuck in a bear market, and so it is timely to revisit bottom-fishing concepts.

Intellectuals love the word "structure", but in the bottom-fishing context it has a very simple meaning encapsulated by the following question: is the ownership of the stock distributed in such a manner that under the right circumstances an orchestra will materialize to deliver Beethoven's Ninth Symphony in a manner that receives a standing ovation. But when you think about this metaphor, it should become clear that "structure" is in fact a very complex subject, one that is increasingly interwoven with "history". In practice we search for "structure" by specifying that a certain percentage of the issued paper be owned by insiders. Unfortunately, the technical definition of an "insider", namely an officer, director or employee of the company, or some sucker who managed to buy more than 10% of the issued stock but has zero influence on management other than the threat of hammering the bid at a delicate moment, leaves out much of the orchestra whose presence and nature has to be indirectly inferred.

"Capital", in contrast, is much more straightforward because its size shows up in the company's financial statements, the balance sheet to be precise. In its purest form it is the unencumbered cash owned by a junior after deduction of all liabilities. Forget about all the other items carried as current or long term assets; in the world of resource juniors they generally have zero value. Cash is king in a bear market because a bear market deflates the market value of intangible assets towards zero. The resource juniors also tend to establish title to assets in good times through time staged payment agreements where a default on an upcoming payment wipes out the value of past payments. Cash rich juniors can inherit such agreements at steep discounts to the sunk cost. Although cash earns little in an economic downtrend because of low yields, its scarcity imbues it with substantial leverage in securing ownership of non-cash assets at distressed valuations. So we search for absolute working capital amounts as well as its percentage of market capitalization, and then we drill down into the notes to the financials to discover to what extent this capital is pre-destined to exit the treasury.

If you are starting to think that "capital" is not really that straightforward, congratulations, you are on track to discovering why "capital" is the most dangerous criterion on which to base your bottom-fishing strategy. In severe bear markets companies literally trade below their cash breakup value, for which our search engine has a parameter, namely working capital as more than 90% of market capitalization. Rather than getting super excited when our search delivers hits in this category, we become deeply suspicious, because this condition hints at either bad structure, bad people or both.

Either management decides to mobilize a normal course issuer's bid to soak up paper at the breakup value so that cash stalkers do not get an opportunity to buy a large enough position to dislodge management and divert the cash into their own pockets (rest assured that their declarations to the effect that they are saving minority shareholders from the predations of entrenched, self-serving management are as true as the same declarations made by entrenched management about the "dissident" raiders), or it resorts to one of the dozen plus cash vanishing acts we have documented during 3 decades of bad bottom-fishing experiences. The cash vanishing act is a topic worthy of a dozen blogs, which will be furnished in due course as we encounter particularly egregious variations of this form of legal theft in the emerging bottom-fish cycle.

In real estate they insist that it's all about location, location, location, and in the junior resource sector they invariably insist it is all about people, people and people. Both principles intuitively make sense. One newsletter machine is so obsessed with "people" it has figured out a way to make all the key criteria start with the letter "p". It bases its analysis on the potential of the people to peddle the paper purchased at privileged prices by pumpers pretending to provide prudent prospects to a populace predestined for pauperism. Quality of management is without question a necessary condition to making more than a modest profit through a resource junior. And the best telescope for the future is a retrospective of the people's past.

Judge them not by their words, but rather by their deeds, is the acid test we use at Kaiser Research Online to evaluate the people behind a junior, which is much easier said than done. To help us we have the People Tree, which lets us see all the companies for which the current insiders of a junior are also insiders, not just as a list, but as snapshots which reveal the people, structure, capital, story and history, at least as expressed by the stock chart. Each branch in the tree can become the trunk for its own tree, which has turned KRO into a bigger time waster for some KRO members than Facebook as they mutate into spidermen leaping from one web of people connections to another as they become addicted to the rush that comes with shrinking in infinite world into one limited to seven degrees of separation. The People Tree does not network non-insiders such as former insiders and the brokers that show up as placees in TSXV private placements; the incestuous circularity requires so much computational power that we deploy it only offline for the benefit of KRO staff in the style of Odysseus safely tied to the mast.

By now I should be addressing "story", "value" and "history", but that would be to go beyond the point of this blog, which is to argue that the classic bottom-fish criteria of structure, capital and people these days are no longer the cinch combination to pick bottom-fish winners. Consider this search engine set: working capital greater than $5 million, working capital at least 25% of market cap, shares issued 20-50 million, price less than $0.50, insiders own more than 20%, and not delisted. (KRO members you need to be logged in for this link to work!)

The rationale behind this bottom-fish criteria set is basic. In the current market climate a bottom-fish needs at least $5 million working capital or management might be content to just live off the money until we are back in a raging bull market where the presence of capital is irrelevant because lots can readily be raised at stupid prices. Such a level of capital is likely to be preserved for when a good story achievable at a good value comes along. The working capital must be more than 25% of market capitalization because this is a sign that the market is discounting any existing "story" that may be the essence of the company, if such a story still exists. The higher the percentage of market cap represented by working capital, the less speculative premium assigned to the story and thus the better the speculative value inherent in the story. And if the company is already a shell, it is better to have a low premium assigned to the people; it really is quite amazing how bear markets will discount even superstars! By limiting issued shares to 20-50 million shares I avoid rolled back shells with no liquidity, as well as overly diluted companies with too much paper in unfriendly hands. A stock with 20-50 million shares issued likely has a complex structure of the hidden orchestra sort needed for a big speculation cycle (more jargon -- the unfolding of a story as reflected by market activity). I also want this stock to be trading below $0.50 because I am lazy and do not want to deal with the math required of a purist value investor. Finally, I want official insiders to own at least 20%, which is a pretty stiff requirement for a junior with 20-50 million shares issued, but one that is important because either insiders have put up a lot of personal dough for their stake, or they are beholden to a third party which provided the bulk of the capital for reasons hopefully not linked to stupidity. This criteria set is a sign of visibly committed and motivated people in control of a reasonably cash rich junior which may own a story the market has decided to dismiss as virtually worthless.

On May 28, 2012 this search generated 11 hits, some of which surprised me and are itching me to discard this blog comment and chase after them. The list, however, contains one specific company which illustrates the moral of this blog comment, and which is present because I tweaked the search criteria to make sure it showed up in the list. This potential bottom-fish is Troon Ventures Ltd. Troon has 28.3 million shares fully diluted, $8.7 million working capital as of December 31, 2011 which is 75% of its market cap based on a stock price of $0.41, and has a stellar board of directors who directly own 29% of the issued stock acquired at $0.25 in late 2007 (check out the Troon People Tree to assess management's diverse and impressive track record). And when you dig into the people section of the KRO Profile, Troon has an army of influential brokers who got plugged in with $0.45 stock in 2008. What Troon does not have is a story, and thus no speculative value other than in the possibility that management might come up with a story. As far as history is considered, the shareholders who bought into the Norgiant story during the nineties were obliterated in 2002 through a 5:1 rollback, since which no story has been seriously presented to the market. Troon has no history because the insiders chose to wipe out the investors that had supported the Norgiant story based speculation cycle.

The predecessor was a bottom-fish recommendation twice prior to the rollback, based on a Big Anomaly style story which asserted that Troon shared ownership with another junior of a large land package in Quebec which had been mismapped as the Grenville Province, but which in fact represented a hitherto unrecognized extension of the Abitibi Greenstone Belt that was prospective for polymetallic VMS deposits. Targets were generated through a combination of till sampling and geophysical surveys, but no discovery was generated by drilling during the nineties while the market still believed in such an outcome, with the result that Troon became a shell that sleep-walked through the past decade until a major structuring event in 2008 which brought on board a who's who of movers and shakers. Troon was a member of the Bottom-Fish 2009 Edition, but I gave up at the end of 2011.

On May 28, 2012 the TSXV moved Troon onto the NEX board for failing to maintain listing requirements, a development which reduces the flexibility otherwise available to management in terms of securing a flagship story. The moral of this blog is that bottom-fishing can be very treacherous, especially if structure and people turn out to be defined by a circle of celebrity friends willing to toast each other's accomplishments but unwilling to collaborate in a manner where everybody makes music whose benefit is not disproportionately distributed.