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Blog January 16, 2014: Canadian Retail Investors: A Rocking Chair Nation or Venture Capital Rockers?


There is a quiet battle underway within the Canadian financial system whose outcome will determine if Canadian retail investors end up strapped into rocking chairs and spoon-fed pablum by the banking establishment or become empowered to play a critical new role in Canada's venture capital market. The outcome will determine if the Canadian institution of resource sector venture capital disappears as Canada becomes a Rocking Chair Nation, or if the junior resource sector survives the current bear market to carry on as an important force of global resource exploration and development. Lined up on one side is the Canadian banking establishment whose long term goal is the creation of a Rocking Chair Nation housed within a nursing home totally under its control, and, lined up on the other side, is Canada's exploration industry and its public market support infrastructure.

Surprisingly, the latter includes many enlightened and sympathetic stock exchange officials and regulators who recognize that structural changes in the securities industry spell the death of the Canadian junior resource sector unless radical reforms are undertaken which allow risk capital to flow freely from a much broader capital pool directly into the treasuries of publicly listed venture capital companies than the reigning "investor protection regime" currently allows. Their bosses, however, reside in the upper echelons of Canada's banks, which is why the radical reform proposal they floated on November 21, 2013 has received very little publicity.

This is a one-sided battle. The reformists want Canadians to have the right to rock and roll on the venture capital dance floor while keeping the rocking chair within easy reach. Their radical proposal is to allow any investor to participate in private placements within certain limits, not just millionaires and a handful of people with insider connections. Canadians already have the right to bankrupt themselves by purchasing lottery tickets, gambling at the casino, and buying as much market traded stock through a discount broker as they have money in the account. They can donate as much as they want to charities which promise various forms of redemption. But they currently do not have the option of putting their money directly into a junior's treasury in exchange for private placement stock instead of putting it into the pockets of existing shareholders or a new breed of "day traders" who electronically intercept incoming buy orders with the sale of stock they neither own nor have borrowed. The reformists do not want Canadians to become compulsive gamblers. They just want Canadians to have the right to allocate what they individually define as their high-risk-high-reward capital to whatever venue they choose, and the reformists want those venues to include making capital available to publicly listed startups, which is what they call technology juniors in the United States, and what Canadian juniors with exploration and development resource prospects effectively are.

The banks want nothing less than to annihilate the dance floor and force Canadians to watch the Lawrence Welk Show from the only seat in the house, a rocking chair they have constructed under the pretense of protecting Canadians from predators Canadians supposedly lack the innate ability to avoid or resist. As a Canadian I find this paternalism very offensive, but have I perhaps been influenced too much by living 20 years south of the border? Do Canadians living in Canada want to be treated as a Rocking Chair Nation, or do they want the unfettered option to be Venture Capital Rockers? The comment period for the proposal ends on January 20, 2014, and if the comments overwhelmingly side with the Rocking Chair Nation vision of Canada, the retail investor exemption will be stillborn. The junior resource sector and Canadian investors need to wake up and understand this proposal which could get rapidly approved if it receives public support. If Canadians conclude that they will be happiest confined to a Rocking Chair, so be it. But if Canadians conclude that Rocking Chairs are good to have in the corner where one can be rocked to sleep, but that there should also be a dance floor where they can play as Venture Capital Rockers, then they need to speak up now and be heard by the regulators.

The forces pushing for a Rocking Chair Nation are already in play through the "client relationship model" (CRM) the regulators have imposed on the financial services sector. On January 9, 2014 the Canadian Securities Administrators issued CSA STaff Notice 31-336: Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations which effectively strips retail investors of the ability to use a full-service broker to place security trade orders. The CSA has accomplished this by arguing that the obligation of the financial services sector is to operate as an "investor protection regime". The CSA's "client relationship model" (CRM) requires a "registrant" (your stockbroker) to "know your client" (KYC) on a real time basis in terms of investment goals, financial circumstances and risk tolerance, "know your product" (KYP) with regard to the securities being bought by the client, and render a judgment about the "suitability" of the security for the client.

This makes a lot of sense when the registrant is in charge of a "managed account" where the brokerage firm follows the hedge fund practice of collecting a percentage fee on the annualized value of the account and possibly even a percentage of the gains (though not the losses). It especially makes sense when the registrant has discretion to implement and manage a portfolio in accordance with the KYC information regularly collected from the client. If an investor wants to hand capital to a portfolio manager and in exchange for a portfolio value fee relax in a rocking chair with confidence that the portfolio will be managed according to best practices, the client relationship model makes perfect sense. But the CRM makes no sense when the client does not want an account at a discount broker but instead wants it with a full service registrant who provides feedback on client orders, sometimes offers alternatives, but generally does what he or she is told to do by the client.

The insidious agenda of the CSA guideline is that any full service broker who takes an order from the client is put at risk of having the client claim down the road when the trade turns into a money loser that it was not suitable and that the broker did not "know the product" and did not "know the client". Since managed accounts by definition do not accept specific orders from clients, the banking establishment brokerage firms are not affected by this restriction on accepting client orders. The guideline targets the dozen or so remaining independent brokerage firms who still cater to investors who are interested in maintaining a high risk portfolio comprised of venture capital listings such as those which dominate the TSXV, of which the vast majority are resource sector oriented.

Most investors are not interested in the details of managing a properly structured portfolio that meets long term objectives usually consisting of capital preservation and modest returns. It is appropriate that an investor hand that portion of his or her overall asset base to a banking establishment controlled brokerage firm whose "managers" assemble the portfolio from a product list endorsed by the brokerage firm. What they generally are not interested in, and definitely should not be, is that the managed account include any allocation to high risk securities. By the time a banking establishment firm designates a "high risk" security as eligible for being stuffed into managed portfolios, it usually qualifies as a "high risk-low reward" security.

Unless you are willing to be very disciplined whereby you keep the majority of your liquid assets in very low risk very low reward cash equivalent instruments such as money market funds while managing the rest as high-risk-high reward investments focused on some arena which you are prepared to be and stay knowledgeable about, such as resource juniors, you should park the low risk portion of your liquid assets in a boring bank broker managed portfolio. The high-risk-high-reward portfolio should be in an account held either at a discount broker where you are entirely on your own, or with an independent brokerage firm where you do have a relationship with the broker but one where it is understood that the broker does only as told and that the outcome of all decisions is your responsibility alone. The CSA, which ultimately takes its guidance from the establishment banks who now dominate the financial services sector, is compromising the ability of independent brokers to have such a relationship with clients who do not want to spend the rest of their lives confined to a financial rocking chair.

In stark contrast to the goal of turning Canadian investors into a Rocking Chair Nation, on November 21, 2013 all the Canadian securities commissions except Ontario's OSC, which is the establishment bank proxy whose most notable regulatory accomplishment has been to demonstrate that the entire Canadian regulatory and financial system was duped by a couple of rogue Filipinos who single-handedly engineered and sustained the Bre-X fraud, published Multilateral CSA Notice 45-312: Proposed Prospectus Exemption for Distributions to Existing Security Holders. The proposed prospectus exemption would allow investors who do not qualify as "accredited" to participate in a private placement up to $15,000 worth within any 12 month period per TSXV listed company that is in full compliance with regulatory filing requirements, provided the investor owns shares in the company some period before the financing is announced.

This prospectus exemption is a radical departure from the Rocking Chair Nation agenda and will dramatically change the role retail investors play in the junior venture capital sector and could, if intelligently implemented, keep the resource juniors alive until macroeconomic and metal price trends pull institutional and accredited investor capital back into the sector. The proposed exemption is out for comments until January 20, 2014 and is expected to attract a vitriolic condemnation from the proponents of the Rocking Chair Nation. Very few people seem to know about this proposed exemption, and during the past week I was shocked to discover that resource junior executives are generally ignorant about this proposal which would dramatically change the way they raise capital. Anybody who wishes to submit a comment, especially with regard to the 9 specific questions asked, should visit the BCSC web site for details and submit a comment by January 20.

The Venture Capital Market Association of which I am part of has published a Response which takes the view that the focus of the regulators should be to regulate the industry understood as the financial services sector and publicly listed companies, and not the investor. The industry, however, has a terrible history exercising its "gatekeeper" role and in my view it is understandable that regulators view the brokerage industry and public companies as ill-intentioned towards the retail investor. At the same time I do not believe it is appropriate to view the industry as incorrigible wolves from whom the investor sheep must be protected by strapping them down into a rocking chair that rocks nowhere other than directed by a paternalistic financial sector whose primary shareholder directive is the enrichment of itself.

I disagree with the VCMA that there should be no limit to the amount a non-accredited investor should be allowed to put into a single company's treasury. The ventures pursued by resource juniors are very high risk by nature, and while they can deliver extraordinary rewards when managed by competent and genuine management teams, mother nature is arbitrary in revealing its riches. Being forced to diversify among high-risk-high-reward juniors is a good way to prevent a retail investor, especially a novice who has not gone to the school of big penny stock losses, from getting caught up in the enthusiasm of the eternal optimists that constitute the exploration sector. I do think the limit should be $25,000 rather than $15,000 because the latter seems to imply that the regulators are targeting retail investors with a net worth well below $500,000 and seem intent on making it not worthwhile for investors with a net worth in the $500,000 to $1 million range to bother with private placements. The CSA suitability guideline contains ominous warnings about a crackdown on investors who declare they are millionaires but resist the privacy invasion needed for a broker to really know if the declaration is true or not.

If this prospectus exemption is adopted, it will transform the Canadian retail investor from its traditional role as the sucker to whom short sellers and existing shareholders sell stock into an empowered venture capitalist who has the ability do give capital directly to publicly listed junior companies of whom the vast majority are involved in the resource sector.

Equity capital inflows for the junior resource sector are now back to the level that prevailed in early 2003 when the bear market that gripped the juniors from 1997-2002 was coming to an end. The prospect of a cyclical turnaround that pulls institutional and accredited investor capital back into the resource juniors on a scale comparable to what happened during 2003-2011 is poor because metal prices, including gold, are nominally still many times higher than they were in early 2003, and are unlikely to undergo price gains with similar multiples in the current macroeconomic environment where global economic growth will at best be a shadow of what we witnessed during China's ascendancy. Although a lot more capital flowed into TSX-listed resource companies during the past decade than demonstrated by the chart above which shows financing activity by TSXV-listed resource companies, as well as traded value of which 70%-75% is attributable to resource sector listings, the TSXV served as the farm team for the TSX whose resource bounty arrived not through IPOs but rather through migration from the TSXV.

Takeover bids involving Canadian juniors were rare during the eighties and nineties, especially for TSXV listings (then the Vancouver and Alberta Stock Exchanges), but from 2005 onwards a phenomenal 243 resource juniors disappeared through takeover bids whereby a smaller company was absorbed by a larger company for cash and/or stock. The value was a remarkable $134.4 billion, much of which was repeatedly recycled in the junior resource sector prior to the 2008 crash, and again during the 2009-2010 V-shaped recovery. Most of these companies originated on the TSXV. During 2014 as it becomes apparent that the declining phase of the bear market is over there will be a flurry of takeover bids that clean out the better remaining advanced juniors at modest premiums from bear market bottoms, of which Goldcorp's bid for Osisko and B2Gold's bid for Volta are recent disappointing examples. Once this inventory of advanced projects or single mine companies is gone, it will be very difficult to generate new advanced projects unless metal prices double or triple from current levels. Except in runaway inflation scenarios, which do not benefit currently marginal deposits, there is no reason to expect a doubling or tripling of real metal prices in the short term.

Just over a year ago on December 2, 2012 I published Bracing for the extinction of 500 juniors or an entire institution? in which I warned that the junior resource sector was caught in a troublesome combination of shrinking financing activity, deteriorating balance sheets, and a resource sector bear market where cost escalation was clawing back the real metal price gains delivered by the substantial nominal price gains in metals during the past decade. On February 15, 2013 Streetwise Reports published an interview by JT Long, Can the TSXV be Saved? in which I described in greater detail the structural problems exacerbating the junior resource sector crisis. On June 18, 2013 at the founding meeting of the Venture Capital Markets Association I gave a presentation on How Bad is it? in which I presented a new set of charts demonstrating the severity of the situation which had become worse than at the end of the 2008 financial crisis.

At the end of tax loss selling in December the number of companies trading below $0.10 peaked at 59.5% representing just over 1,000 juniors. Since December 20 there has been only one day on the TSXV where decliners outnumbered advancers. A bottom has been established and now we are seeing offer side accumulation developing modest uptrends in the better juniors.

I have elected to keep 22 juniors as Spec Value Hunter buy recommendations and assigned just over 60 juniors to the new 2014 Bottom-Fish Edition. More will be added to the SVH recommendations and BF Edition as I research them. It will take time for these juniors to develop their uptrends, but I am optimistic that they will flourish in what could be another sideways year for metal prices.

While these companies I cover as SVH and BF picks are in no danger of disappearing through a suspension and eventual delisting, there are more than 600 juniors with negative working capital that persist as zombies for the simple reason that they are so devoid of any value that creditors are not bothering to collect their debts. The working capital distribution chart above shows that 38% (673) have negative working capital while another 20% (360) are limping along with working capital ranging from zero to $500,000. Only 434 resource junior listings (31%) with working capital of $500,000 to $20 million can be described as healthy, though many of them have become unproductive by going into hibernation because they perceive the prospect of replacing money spent on exploration at higher equity prices as very dim. The chart below tabulates the positive and negative working capital positions according to the trading price range of the company. A staggering $1.4 billion is owed by juniors trading below $0.10, while another $360 million is owned by companies trading $0.10-$0.19. Stock exchange officials and others mumbling that my prediction a year ago appears to be wrong obviously do not understand what it means to be a member of the walking dead.

The Price Range Breakdown chart below for all KRO companies shows that the number of companies with less than $200,000 working capital has swollen from about 500 a year ago to 859 companies representing 49% of the Canadian listed resource sector. I like to use the $200,000 working capital number because that is about what it costs annually to exist as a publicly listed Canadian company not engaged in any potential wealth creation activities.

I have assembled all my charts within the Junior Resource Sector Crisis Center at Kaiser Research Online. As of January 15, 2014 they reflect the balance sheets of all the recently due quarterly and annual financials of 1,409 TSXV-listed companies that are still trading, most of them involved in the resource sector, and 1,764 companies listed on both the TSXV and TSX. The situation is much worse than it was a year ago and the existential crisis facing the Canadian institution of venture capital funded resource exploration and development remains very real.

Since the retail investor exemption as it is currently worded is intended to apply only to TSXV listings, it is a good idea to look at the statistics for just TSXV listings engaged in the resource sector. The above chart shows that 31% of 1,409 juniors (434) are reasonably healthy with working capital ranging from $500,000 to $20 million. Another 30 companies have more than $20 million. But a staggering 43% (601) have negative working capital.

These companies in general have no future because nobody is going to give them cash to repay creditors for money already spent and which did not leave much of value behind. The chart above shows that they owe $1.5 billion of which $1.3 billion is owed by TSXV juniors trading below $0.20. Settling that debt for stock at a nickel, which is about all that can be done, would create 26 billion shares for which there is no audience whatsoever. The chart below shows most of the money is owed by TSXV juniors headquartered in British Columbia, followed by Alberta and Ontario.

The regulators introduced a rule last year which allows juniors to conduct up to a 10:1 rollback in any 12 month period without requiring approval from shareholders. Not every province allows its domiciled companies to do this, but British Columbia is one that does. A record number of rollbacks were conducted in December 2013. These zombie juniors will make $1.6 billion in liabilities disappear over the next 2 years by settling it for paper, conducting a 10:1 rollback, and letting the stock drift back into the pennies where it belongs because the junior has no story and no cash to acquire one. And then the junior will conduct another 10:1 rollback, reducing the remaining issued to a few million shares upon which the management will rebuild its stake through cheap financings that put real money into the junior to pay non-discretionary overhead such as exchange, legal and accounting fees which after the first debt settlement-rollback will all involve cash up front services.

In two years TSXV head John McCoach will preside over a sea of empty shells in which insiders own 90% of the paper, and by then the cyclical upturn he has been counting on to keep Kaiser from being right will have kicked in and Kaiser's gloomy prediction will be demonstrably wrong as these shells whose minority shareholders got wiped out by rollbacks are pressed into service as old-fashioned rig jobs. Unfortunately for the TSXV this surplus of shells will collide with the stock exchange's lucrative business listing capital pool shells, of which it has listed 1,170 since 2002 and whose IPO financings raised $440 million, all of it chewed up as overhead in the pursuit of completing a qualifying transaction before the deadline. This capital raised largely from retail investors and earmarked for the regulation, accounting and legal sectors is slightly less than the $479 million new TSXV "industrial" listings raised by IPO since 2002. Because of the stock exchange requirement that a capital pool have a minimum 150 shareholders holding at least a board lot, the amount purchased by true retail investors and not an "insider" or broker disguised as as an arms length investor has been in pitifully small increments. The rest of the super cheap paper issued to insiders or their nominees is escrowed and released in one-third annual installments once the company completes its qualifying transaction. Once the 600 zombie companies have been reorganized as shells with clean balance sheets, with all the paper controlled by insiders free trading, there will no longer be a market for capital pools.

But there is a small problem just around the corner that may stymie this magical debt vanishing act. The chart below shows the number of companies whose audited annual financials are due each month. If a company does not file audited financials by the deadline the stock will get suspended. Once a stock is suspended it usually has to meet listing requirements to get reinstated after it files its overdue financials. Getting suspended is the slippery slope toward delisting, the death of the company. The auditor cannot sign off on the audit if the auditor is a creditor, and one can rest assured that no insiders reached into their pockets to pay for last year's audit. So there is a scramble afoot right now among juniors to restructure debts owed to their accountants so that they can file their audited financials on time. April is a big audit month for TSXV juniors. Of the 575 filers 236 or 41% have negative working capital.

The crisis in the junior resource sector is starting to attract the attention of politicians and the chart below shows why. Based on annual reports for the 12 fiscal year end months ending with August 31, 2013, the most recent annuals for which audited filings are now due, 1,442 TSXV listings spent just under $3 billion in overhead during their last full fiscal years. Only a small fraction of this amount represents exploration costs which a handful of juniors insist on expensing rather than capitalizing to the balance sheet. Juniors headquartered in British Columbia spent $1.58 billion (53.4%) on overhead. Overall the TSXV resource juniors averaged $200 million in monthly overhead, which is a problem because monthly private placement financing activity by resource juniors has fallen below $200 million. Keep in mind that exploration spending is supposed to be a multiple of overhead expenses. Because juniors explore all over the world, much of the capital raised by the juniors gets spent outside Canada. But a good chunk of the overhead gets spent in Canada. The loss of this revenue will have negative downstream consequences for the Canadian economy, especially British Columbia where most of the juniors are headquartered.

Now is a good time to introduce a retail investor exemption for private placements because retail investors lack any momentum driven reason to be interested in resource juniors. The risk that retail investors will give money to juniors to pay off existing debts, some of which is likely owed to management in the form of accrued salaries, is about zero. The risk that a retail investor will give money to a shell company with a clean balance sheet but no clearly visible and articulated story in place is low. The group from the working capital breakdown chart above that intrigues me the most are the 24% (344) which have between zero and $500,000 working capital. Within this group you will find many real exploration juniors which have continued to generate prospects, but have been unable to raise any money to continue exploration work. These are the companies whose share prices have sunk so low that they are among the 668 juniors (47%) with market capitalizations less than $2 million. Many of these merit being saved and represent good bottom-fishing opportunities for retail investors, provided the problem of how these juniors get fuel into their "exploration" tanks gets solved.

These market capitalizations are so low that a meaningful amount of money cannot be raised without massive dilution, and in any case will be limited to $250,000-$500,000 per six month period unless shareholder approval for dilution in excess of 25% is sought. These companies are typically discovery exploration oriented juniors, which makes them of zero interest to institutional investors, and of little interest to accredited investors until either a discovery hole has been delivered, or a thriving speculative after-market is once again underway. But a speculative after-market in the absence of metal prices doubling or tripling can only materialize if a significant discovery is made by a junior with a very low market capitalization that lends itself to the sort of ten-fold plus gains that the establishment banks dread because big discovery plays like Hemlo, Eskay Creek, Ekati, Diavik, Voisey's Bay and Eleonore cause investors to bolt their rocking chairs and head for the dance floor. If it turns out that the retail investors helped bankroll the discovery through small private placements made possible by the proposed prospectus exemption, and can continue to do so with other juniors just waking up, the junior resource sector will come alive, though probably with a lot fewer pretend exploration companies. An example of the sort of junior which would benefit from retail investors turned into venture capital rockers is Adamera Minerals Corp (ADZ-V: $0.05) which has spent the past two years assembling prospects in the northeastern part of Washington State where it believes many of the past small scale mining districts need to be rethought in terms of contemporary geological models and explored with an eye to finding another Buckhorn Mountain gold deposit such as Crown Resources Corp found during the eighties and which Kinross bought out in 2004. Adamera is the sort of junior which blends in with all the doomed zombie companies but which in fact is still alive and capable of delivering big returns, which is why I included Adamera in my 2014 Bottom-Fish Edition.

 
 

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