(The following
article was re-posted by Sprott Asset
Management LP in Sprott’s Thoughts)
No matter how good the resource, if the management team is making the
wrong decisions for shareholders, you could see the opportunity disappear.
You want managers who stand to win big if they succeed.
In a previous article, we highlighted one measure called the General and
Administrative Expense Ratio (G&A). This measures how management puts
shareholder money to work. A high G&A ratio means a company is spending a
lot on overheard – little of investors’ money is actually going into the
project, where the upside potential of the company lies.
There is a second important metric to look at: management ownership of
the company.
‘Skin in the Game’
Management ownership represents the ‘skin in the game’ – the more they
have to lose if things go bad, the more we can count on their decisions being
good for other shareholders as well. This vested interest shows how much the
team believes in a project.
If management has no ‘skin in the game,’ why should they care if the
share structure gets diluted or if the stock is rolled back again? They can
just re-price their incentive options when it looks like they can make a quick
buck.
Using Q2 2013 data from 412 precious metals companies, mostly from the
TSX and TSX-V, we looked at the average ownership of companies by management.
This is an important benchmark for the industry.
It is impressive that such large number of companies – over 30% — is in
the smallest slice in terms of management holdings. These companies especially
could be ridden with conflicts of interest.
For instance, if managers discover that their project is not feasible
–say if their resource is too small – will they divest remaining resources to
shareholders? Or will they keep spending money on a project that is destined to
fail, stringing shareholders along to keep making a six-figure salary?
How management ownership changes over time…
While a company advances, it will need to raise money to continue
growing its project. If the managers deliver on advancing the resource,
institutions and funds will often enter the story.
So let’s look at the “smart money” — the banks, mutual funds,
investment advisors, hedge funds, or other investment companies. These
investors can make mistakes too, but they have the resources to perform hefty
due diligence. A small junior backed by a sophisticated financial organization
can be a good sign.
Take a look at the chart below; you will see that as projects advance,
the ownership levels tend to shift from management teams to funds and
institutions.
Average management ownership is highest in the exploration phase. That
percentage is diluted as the company matures and raises more capital from
outside groups. Conversely, fund and institutional investment is at its lowest
when the company is most risky and increases as it gets closer to commercial
production.
Looking even further into the different stages of natural resource
companies, we can see what the trends look like in more detail.
In our sample, management ownership stays fairly constant through the
development stage. As projects move forward, they are de-risked at a steady
pace. After the 43-101 stage, the project is established enough for funds and
institutions to increase their ownership dramatically from 19.1% to 31.3%.
We also compared ownerships between small producers and medium
producers.
We took small producers to be companies in commercial production with
quarterly production below 30,000 ounces of gold or 1,500,000 ounces of
silver. Medium producers were any that produced above those benchmarks but
are not considered majors. For instance Osisko, B2Gold and First Majestic were
medium producers.
As you can see, the smaller producers had larger management ownership
and lower institutional ownership than medium producers.
So companies tend to start off with management owning a lot of shares
and the rest owned by retail investors. But as the project becomes less risky,
those initial investors see their ownership diluted out by “sophisticated”
investors that enter the companies later on.
As investors, we want to own the companies where the management team is
heavily invested in its success. The more early-stage and risky the project,
the more important we expect management’s exposure to be.
As the project develops, ownership will likely pass from initial
shareholders and management to more sophisticated investors with typically
lower risk tolerance.
Depending on the stage where your company resides, the above guidelines
should help to discern which companies have healthy levels of management
interest, and which companies are too highly diluted to create substantial
incentives for management, and to align their interests with shareholders.
Editor’s note: How important is management
ownership?
I (Henry Bonner) took up the question with Jon Sebastian, an Investment Executive at Sprott Global Resource Investments Ltd.
“Management owning a big chunk of the company is fundamental,” he said.
“Lack of management ownership is a fatal flaw for a natural resource junior and
should be grounds for removal from your portfolio.
“There is no better way to ascertain that you can trust a management
team to do the right thing for shareholders than if they are big shareholders
themselves.”
Substantial management ownership is a ‘first-pass’
criteria for investors, but there are many other factors to consider before
investing in any resource exploration company. You can contact Jon to discuss
opportunities in natural resource exploration at 1.800.477.7853 or at jsebastian@sprottglobal.com.
This information is for information purposes only
and is not intended to be an offer or solicitation for the sale of any
financial product or service or a recommendation or determination by Sprott
Global Resource Investments Ltd. that any investment strategy is suitable for a
specific investor. Investors should seek financial advice regarding the
suitability of any investment strategy based on the objectives of the investor,
financial situation, investment horizon, and their particular needs. This
information is not intended to provide financial, tax, legal, accounting or
other professional advice since such advice always requires consideration of
individual circumstances. The products discussed herein are not insured by the
FDIC or any other governmental agency, are subject to risks, including a
possible loss of the principal amount invested.
Generally, natural resources investments are more
volatile on a daily basis and have higher headline risk than other sectors as
they tend to be more sensitive to economic data, political and regulatory
events as well as underlying commodity prices. Natural resource investments are
influenced by the price of underlying commodities like oil, gas, metals, coal,
etc.; several of which trade on various exchanges and have price fluctuations
based on short-term dynamics partly driven by demand/supply and nowadays also
by investment flows. Natural resource investments tend to react more
sensitively to global events and economic data than other sectors, whether it
is a natural disaster like an earthquake, political upheaval in the Middle East
or release of employment data in the U.S. Low priced securities can be very
risky and may result in the loss of part or all of your investment.
Because of significant volatility, large dealer spreads and very limited
market liquidity, typically you will not be able to sell a low priced
security immediately back to the dealer at the same price it sold the stock to
you. In some cases, the stock may fall quickly in value. Investing in foreign markets
may entail greater risks than those normally associated with domestic
markets, such as political, currency, economic and market risks. You
should carefully consider whether trading in low priced and international
securities is suitable for you in light of your circumstances and financial
resources. Past performance is no guarantee of future returns. Sprott Global,
entities that it controls, family, friends, employees, associates, and others
may hold positions in the securities it recommends to clients, and may sell the
same at any time.
Sprott
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