Pre Production Sweet Spot
This page compiles from previous blog articles on this well supported investment strategy.
Introduction
The methodology is pretty simple. Buy at Construction Decision after financing and permits are in place. Sell at either First Pour (more reliable) or declaration of Commercial Production (some additional gain but higher risk). The average returns are over 100% in an average of 1.5 years, but you need to spread your bets out because over 20% of them deliver negative returns.
Why Does It Work
- You are paid for the risk of failure
- Certain Investors Only Invest in cashflowing assets
- The market is often backwards looking
- There is value in transitioning from putting money into a hole in the ground to taking money out of a hole in the ground
Lobo Tigre on PPSS
Louis James aka Lobo Tigre of the Independent Speculator Newsletter lays this out most clearly in his Pre-Production Sweet Spot study. He's not the first to notice this upward trend in this part of the Lassonde Curve, but we'll adopt his terminology because I think he lays this out with the most convincing amount of data.
Besides the study linked above, he also gave a good in depth interview on it here:
Kevin MacLean on PPSS
Kevin MacLean, former gold stock fund manager and current chief investment officer for Star Royalties, calls this the risk transition yield.
The second one is risk transition yield that's the phrase that i give to that gain in a stocks price as it de-risks from developing an asset into operating an asset and that could be substantial. I'll give you a i'll talk about that in the developer sector section
uh so the market discounts uh that asset typically to about 17%, not the not the five percent that's going to be there when it's in production but 17% that's an empirical observation i just made over many years back calculating what stocks are trading for because i've had these debates with analysts as a portfolio manager well Kevin used to be buying the stock it's cheap as chips and I'd say we'll back calculate the IRR and this thing says well it's 17%, 18% I said well that's about right so it's going nowhere.
now but here's the math if you have a 10-year mine life that's trading at a 17% discount rate instead of 5% it's trading at 0.6 times NAV. If you're going to go from point six times NAV to 1.0 times NAV that's a two-thirds return 66%, and you can get that in the last six to nine months, sometimes sometimes longer but you know in the last six nine months most of that you can pick up if the mine operates properly starts up properly so you can get a massive return and i did have a number of those names in my portfolio.
Wayne Lam (RBC Capital Markets) on Ramp
Wayne Lam has compiled a data set and corresponding reports on mine construction and ramp and corresponding
In his data set the average construction period is 20 months. The re-rate going into first gold is about 15% and is in the last 6 months of construction. This is much less of an effect than the Lobo Tigre data set that saw closer to 100% increase.
First Pour To Declaration Of Commercial Production
This period is basically on average a wash in the Wayne Lam data set, so if you don't have a strong opinion your default should be to sell at first pour and not hold during this period. However...
There is no single definition of Commercial production, though it is often 60% capacity over a 30 day period. Ramping from first pour to commercial production usually lasts 3-5 months, with 4 months being average. Companies that have stronger ramps, meaning their recoveries and production throughput are closer to the mine plan, not surprisingly have stocks that outperform. It's not huge, we are talking 10-20% gains as a group on the fast rampers. Normal ramp-ups are flat and weaker ramp-ups are down 10-20%.
The data indicates investing in this stage means taking a bet on the relative out-performance of a particular company's execution. It's not a buy the basket and it works on average strategy; on average it is flat.
The out-performance/under-performance carries into the next stage. If you have the ability to handicap odds on the ramp performance of the company it might be worth sticking around for the ones you identify as likely to ramp well.
Declaration of Commercial Production to 90% Capacity
Moving from that roughly 60% of capacity to 90% of capacity can take from 9 months for smaller operations to 18 months for larger operations. That's in addition to the time it took to ramp from first pour to declaration of commercial production. During that time you might see another 15% gain for outperformers and on average flat.
This stage is especially squishy. It's typically the case that the successful companies here got to first pour on time and declaration of commerical production with relatively few complications. They already hit their head grade and recoveries or pretty close at declaration of commercial production. What the successful ones are mainly doing here is getting their throughput up largely through increasing uptime and de-bottlenecking.
Summary
Sell at First Pour continues to be good advice on average. However if you can do better than a coin flip separating companies likely to have smooth ramps from those likely to have ramp-up difficulties you might hold to declaration of commercial production or even all the way to 90% of capacity. But the longer you hold past first pour the more skill you need to have picking winners from losers and the smaller the return for correctly picking.