Katusa’s Keys: My Method for Investing in the World’s Best Resource Companies
March 13, 2017
Investing in the resource sector has huge potential rewards.
But I won’t sugarcoat it…
It also has huge risks.
Many resource firms simply aren’t worth the paper their shares are printed on.
They might have incompetent managers, low-quality (or non-existent) assets, questionable accounting, or all three. They aren’t worth your time or your money.
However, some resource firms are well worth your money. They are great investments that can deliver huge returns.
I use a simple 6-factor analytical process to find these winners. I call these factors “Katusa’s Keys.”
3. Financial Structure
The first key is by far the most important, so let’s start with it.
Key #1: People
Let’s say you have a major business decision.
It’s come up because you have a large chunk of money set aside. You’d like to see it grow into a much bigger chunk of money…one that can ensure your family’s financial wellbeing.
You know owning good businesses is a cornerstone of building wealth, so you’re going to buy an ownership stake in a local business. It’s a beer brewing company.
You have two potential operating partners in this business…
One is Brad, a 35-year-old guy you’ve spoken with at several cocktail parties. He’s a fun single guy known for being flashy and loud. He wears a big Rolex and drives a brand new Porsche (neither are paid for).
Brad is ambitious, but his business track record is spotty. Several of your most trusted business associates don’t trust him.
Your other potential partner is Charles, a 53-year-old guy who has been doing business in town for over 30 years. He has three kids in school. He drives an old pickup truck. He has a fantastic reputation. Everyone who has worked or invested with Charles raves about his integrity and his knowledge of the beer business. He’s serially successful.
With these facts in mind, who would you rather partner with?
If you’re like me, you pick the guy with modest spending habits, a great reputation, and a long history of success. All things being equal, most reasonable people would rather invest with a proven winner.
You might think this is an exercise with no purpose. But it actually has enormous implications on your wealth.
You and I face this kind of decision every time we consider investing our hard-earned money in a public company. Making the right choice can mean the difference between making multiples on an investment or losing money.
And while making the right choice in the scenario above was simple and obvious, logic often flies out the window when you buy stocks.
My goal with this essay is to help you always make the right choice.
Have You Made This Mistake Before?
There are over 10,000 publicly traded companies on the North American stock exchanges. There are over 3,000 mutual funds.
Throw in hundreds of TV “talking heads” who have differing opinions on everything, and it’s easy for an individual investor to get overwhelmed. It’s easy to forget basic common sense that will help you safely and surely build wealth.
For example, after reading about the choice between Brad and Charles, you probably thought, “Of course I’d rather partner with the proven winner!” But if you’re like most of us, you’ve made the mistake of investing with unproven losers in the past.
Remember, when you buy shares of a public company, you are buying shares of a real business. You become an owner of that business. You are buying a claim on the company’s assets and future cash flows. The managers of that business become your partners.
As I mentioned…if you’re like most people (myself included), you’ve partnered with some people who were either unproven, dishonest, incompetent, or all three. It’s easy to get caught up in a good story and invest without making sure you have solid partners.
But again, when you buy a stock, you become a business owner. That’s why you should treat your money with respect and only partner with proven winners. Success breeds success. Winners tend to keep on winning.
That’s why for me, the single most important factor when analyzing a business is the people running it. It’s even more important than the quality of a deposit or the company’s financial position.
In the resource business, many people think that if you just find a good deposit in the right country, you’ll make money. But an incompetent or unscrupulous management team will make your investment a loser, regardless of the quality of the deposit. They’ll find a way to screw it up.
They’ll dilute your stake by issuing too many new shares. They’ll take on foolish levels of debt. They will panic at bottoms and sell assets for much less than they are worth. They will panic at tops and buy assets for much more than they are worth.
High-quality owner/operators will do the opposite of all that. They will find a way to win.
Everything depends on the quality of the people.
For example, if the metals sector is very cheap, I’m going to want to invest with Ross Beaty. Ross is a serially successful billionaire entrepreneur who built Pan American Silver into one of the world’s largest silver companies. Investors made over 900% in under seven years. He built Lumina Copper into a huge winner in the copper space. Investors made 2,642% in under four years.
Given Ross’ history of success, it’s obvious why you’d rather partner with him than with any one of a hundred other managers. Yet many people decide to partner with those other managers. They choose SPAM over filet mignon.
Another guy I always look to invest with is Lukas Lundin. Lukas is the son of the legendary resource entrepreneur Adolf Lundin…but Lukas is a legend in his own right. I’ve done business with Lukas, and I know him personally.
He’s a first-class person all around. The Lundin name is synonymous with success in the resource sector; they know how to buy low and sell high as well as anyone.
They’ve delivered extraordinary returns to investors, like a 2,508% gain in Denison Mines in under five years…and an 1,138% gain in Tenke Mining in just three years. Investing with the Lundins is how my readers made over 600% in Africa Oil.
Proven winners also tend to attract the right shareholders. I’m talking about expert institutional investors who think long-term. This is key because the other shareholders are essentially your partners in the business. The right shareholders will do what is right for the long-term interests of the business. Getting the benefit of good partners is icing on the cake when you invest with proven winners like Ross and Lukas.
As I mentioned earlier, I’m a big believer in the Pareto Principle. It’s so important that it’s worth going over again. It states that 80% of your results come from 20% of your efforts. For that reason, it’s also called the “80/20” rule. For example, your business may generate 80% of its sales from 20% of your clients.
The Pareto Principle is alive and well in the resource sector. About 20% of resource operators create 80% of the value in the sector.
I’ve even taken Pareto’s principle a step further. Years ago, I coined the 64/4 Rule—I took the 80/20 Rule and subjected it to Pareto’s principle again. The result states that 4% of entrepreneurs create 64% of the wealth (80% of 80% is 64%, 20% of 20% is 4%, hence the 64/4 Rule).
If making a lot of money is your goal in the resource sector, I encourage you to do what I do; focus on the 4% of superstar entrepreneurs who own large stakes in their own companies. Invest with the best. The choice is often as simple and obvious as the choice between Brad and Charles.
Success tends to follow success. Winners tend to keep on winning.
Those are the guys you want your money with. And you want them to have “skin in the game.” Here’s why that’s so important…
Why “Skin in the Game” is so Important to Your Investment Returns
Have you ever waxed and polished a rental car before returning it?
Chances are good that you’ve never done it. Chances are good nobody you know has done it. Chances are good nobody, ever, has done it.
If you take a moment to think about why people don’t wax and polish rental cars, you can correct a major investment mistake that is probably costing you money right now. And you can vastly improve your investment returns.
People don’t wax and polish rental cars for the same reason they don’t mow their neighbors’ lawns: They don’t own them.
Not caring about things you don’t own is simple human nature.
You might be thinking I’m just stating obvious.
But have you ever invested in a company ran by executives who owned little to no company stock? Have you purchased a mutual fund or an ETF that held companies whose managers owned little to no stock?
Have you ever trusted your hard earned capital with managers that don’t have skin in the game?
Chances are very good that you have. You probably own some of those companies right now.
Your holdings are the manager’s rental cars. And they just nicked a telephone pole while you read the last paragraph.
Don’t worry. You’re not alone.
Investing in a company whose managers have no skin in the game is one of the most common investment mistakes in the world. They don’t teach you this critical investment secret in high school, college, or business school. But once you think of it in terms of rental cars, it’s utterly obvious.
Ownership brings a respect and care for expenses, assets, and cash flows that has no substitute. It instantly transforms the mind.
Ownership will turn a salaried manager who thinks nothing of spending $3,000 on nice office chair into a guy who will sit on a bucket in order to save a few bucks.
Ownership will turn a conventional “9-to-5” employee into a guy who will happily work Friday and Saturday night.
On a larger scale, ownership transforms a reckless CEO who plays fast and loose with shareholder capital into a watchful, prudent shareholder advocate. It turns a CFO who uses aggressive, very questionable accounting into a boy scout.
Just think of the indifferent, uncaring people you’ve worked with the past.
It’s virtually guaranteed they didn’t own a piece of the business you were in. The might have stolen company property. They probably wasted supplies. They were hard on equipment. They left paper towels on the bathroom floor.
Now, think of all the extremely hardworking business owners you’ve worked with in the past. They treated equipment with respect. They used supplies carefully. They took pride in their work. They got to work early. If they saw a piece of trash on the floor, they picked it up.
Now take all those little differences and multiply them times a million. That’s the difference between a business operated by managers with no skin in the game versus a business operated by managers who own substantial amounts of company stock.
Which business would you rather own shares in?
What kind of people would you rather work with?
It’s an easy choice for me.
That’s why when I start analyzing a potential investment or talk to managers about placing money with them, my first question is always “How much stock do you own?”
If the answer is “not much” or “zero,” my analysis is finished.
I don’t want my money treated like a rental car.
Neither should you.
The Other Critical Factors For Evaluating a Resource Company
Once you’ve checked the box of investing with the right people, you’re ready to investigate the other five keys.
Key #2: Projects
Turning resource deposits into money is the game we’re playing.
Whether we’re buying a company with existing production, a company developing a single asset, or a company exploring for deposits, we want to invest in high-quality projects that are large enough to attract the attention of majors who will buy them out.
We also want projects with production costs in the lowest-cost quartile of the industry.
We have to ask many questions during this due diligence phase.
Some of the most important are:
– Is the resource there as management claims it to be?
The history of the resource industry has many stories of companies that overstated their assets.
By reviewing the geologic data, we verify the company has the resources it says it has. We want to invest in companies with resources we know are actually there.
– How big is the resource?
This one is obvious, so we won’t go into it much. We’ll just say we want to back companies with large, high-quality, tier-one resources.
These are the resources that are attractive to large producers. They can get bought out at large premiums.
– Where is the resource?
Countries like Canada and Australia have laws that make resource extraction an attractive business.
Some countries in South America and Africa, on the other hand, have histories of confiscating resource projects.
I focus my investments in resource-friendly jurisdictions. I tend to avoid places ruled by communists or warlords.
– How much will it cost to produce the resource?
If a resource is located near highways or railways and an electric power source, the cost to extract and transport it is relatively low.
But if the resource is in a remote area far away from infrastructure, it can cost billions of dollars to develop. Some terrific deposits can actually be worthless because they require so much infrastructure investment.
There are many other factors–such as the metallurgy–that need to be studied to get a better understanding of the potential problems with the project. The right geology is critical to any successful resource project.
Key #3: Financial Structure
If a company has great managers and attractive projects, we’re ready to investigate its financial structure.
We want to see companies with low or minimal debt. We want to see them with plenty of cash to fund their operations. If they don’t have that, they are likely to dilute shareholders by issuing more shares (more on this in a moment).
As discussed previously, we want to see the company’s managers with plenty of skin in the game. We also want to know who the company’s major shareholders are.
Most companies will count some large financial institutions, like hedge funds, mutual funds, and pension funds as shareholders. I prefer to see “strong” institutions as my fellow shareholders.
I’m talking about expert institutional investors who think long-term. This is key because the other shareholders are essentially your partners in the business. The right shareholders will do what is right for the long-term interests of the business.
It’s also important to know if the company has issued warrants and stock options that could be exercised in the future, which would dilute the value of your shares.
Key #4: Promotion
Even the best assets in the world need promotion by strong management teams.
If a company has great potential, the rest of the world needs to know about it. If the world doesn’t know about it, there won’t be anybody around to buy shares and drive up the company’s value.
I make it a point to get to a story before anyone else. Once my readers are in a stock, I want to make sure management has a plan to “spread the word” with institutional investors and financial publishers. This will create the interest in a stock that is needed to drive the share price higher.
Key #5: Catalysts
What is it about the company that will drive up the price?
Is it working on a big discovery?
Is it furthering the development of a high-quality asset?
Is the price of its resource poised to move higher?
These questions must be asked and answered before you make an investment.
One or more catalysts must exist that will drive a company’s share price higher.
Key #6: Price
It’s said that “price is what you pay, value is what you get.” This is especially true in the natural resource market.
You can find a company with great people and great projects, but if you pay too much for your ownership stake, you can still lose a lot of money.
This whole idea comes down to treating your investments like you treat almost anything else you buy. You should focus on finding great values…and not paying stupid prices.
When you buy a pair of shoes, you want to pay a good price. When you buy a house, you want to pay a good price. You don’t want to overpay.
Yet, when it comes to investment, many people cast aside the idea of buying bargains. They get excited about a company’s story and they just buy stock. They don’t pay any attention to the price they’re paying…or the value they’re getting for their investment dollar.
Don’t be a sucker and overpay. Make sure you get good value for your investment dollar. Hunt for bargains.
Please remember these six keys. The market has humbled everyone…from amateur investors to experienced billionaires.
By doing your due diligence and checking these boxes, you’ll set yourself up for resource success.