August 2010’s Penny Shares to Watch…

This month’s penny shares to watch:

• Are these the ultimate penny shares?

HAMBLEDON MINING (HMB), DISCOVERY METALS (DME)

• How to invest like a Dragon…

EXPANSYS (XPS)

Are these the ultimate penny shares?

(This article first appeared in Penny Sleuth in July 2010. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)

The financial models of small mining companies are very straightforward. That’s one of the reasons I like them!

You start with the amount of ore that is mined. Next you calculate how much metal can be extracted, which is a factor of the recovery rate and the grade. Then you multiply this by the price of the metal, and deduct three things:

1.    Running costs.

2.    Initial capital investment amortised over the life of the mine.

3.    Whatever must be paid to the government.

After that, the only thing you are left to worry about is the discount rate that you apply to future earnings.

So if it’s that simple, why are the share prices of junior miners so volatile? There are three reasons.

Three reasons mining offers the ultimate in penny share excitement

The first is that many junior mining companies are not yet at the stage of actually producing anything. Indeed many never get there.

The second reason is that, although there are few moving parts in the equation determining the value of a mine, these can move about quite a lot. In particular, of course, the world price of metals can make wide swings in just a few weeks. Let’s think about that.

Say it’s costing you $3 per lb to produce copper. Suddenly the copper price moves from $3.30 per lb to $2.70 per lb. That’s not an uncommon scale of move for copper. But for the miner it’s the difference between comfortable profitability… and a terrible financial squeeze.

Finally, plenty of problems can come out of left field and totally whack your plans. For example, a new hostile government, some expensive equipment that does not work, power shortages or bad weather. There are all sorts of things that can hijack the best of mining ideas.

But once a miner gets into production the risks are considerably reduced. As a dodgy explorer progresses to being a bona fide producer, its shares can make a nice upwards move. In fact, if they get it right and really hit the big time, miners can be the ultimate penny shares…

And here’s what’s really exciting about today’s Penny Sleuth. There are a number of junior miners I’ve seen that were set up with little more than a blank sheet of paper a few years back. Now, though, they are at or close to the production stage. Just last week my ear was bent by two of them.

Two small time miners with high hopes

The first is HAMBLEDON MINING (ticker: HMB). Hambledon’s Sekisovskoye gold mine in Kazakhstan is already producing, but to nowhere near its full potential. And it’s had a catalogue of those glitches I mentioned earlier hamper its progress…

A Hitachi excavator suffered from engine failure; the machine used to crush the rock did not work; and snow storms, blizzards and winter temperatures of -30° not only made the task of open-pit mining extremely challenging but froze the piles of crushed ore.

So Sekisovskoye has fallen some way short of its potential production. But news last week suggests that things are back on track. The mine achieved its highest ever production in the second quarter, averaging 2,900 oz of gold per month as well as close to 5,000 oz of silver.

The plan is now to add underground mining to today’s open pit operation, and raise annual production to 100,000 oz of gold by 2013.

Broker Fairfax expects ‘cash costs’ (day to day running costs) to fall from $560 per oz to $380 per oz. Even on the assumption that the gold and silver prices fall back slightly from today’s levels, the shares trade on under four times Fairfax’s projection of 2012 earnings. That certainly makes Hambledon worth a closer look.

The small cap that could be sitting on a “new copper province”

Cold weather is hardly a concern of DISCOVERY METALS (ticker: DME), which is close to producing its first copper from the Boseto project in Botswana.

The world copper price dropped 20% in the last quarter. But chief executive Brad Sampson did not seem too concerned. That’s despite the challenge of raising the $150m or so necessary to purchase a concentrator and sundry other equipment.

Sampson seemed very relaxed about this when I met him last week, and a few calculations reveal the reason why. The mine should be able to produce 38,000 tons of high grade copper annually. That’s worth some $250m at today’s price. Meanwhile, the cash costs of production will be about half this.

That margin of profitability will soon pay off the initial capital investment, leaving a healthy profit for shareholders.

What is more, Discovery has several other likely prospects on its license area in the Kalahari Copper Belt of western Botswana. It reckons that it could ultimately develop not just a single copper mine, but a whole new copper producing province.

Sampson knows he can sell the product. ‘In the next twenty-five years,’ he told me, ‘the world will consume more copper than in the whole of its history to date. We need to find an extra million tons per year. So our 38,000 tons is just a drop in the ocean.’

So while the shares of junior miners have recently suffered from one of their regular blips, neither Sampson nor any other mining executive doubt that the long-term prospects remain extremely bright.

Despite the hazards this is still very much a sector to follow. I’ll be looking out for opportunities suitable to feature as recommendations in a future issue of Red Hot Penny Shares.

How to invest like a Dragon…

(This article first appeared in Penny Sleuth in July 2010. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)

Hooray! A new series of Dragon’s Den is under way. I love this programme. I love the courage of the aspiring entrepreneurs and the cool appraisal of the Dragons.

Of course, this is entertainment and is not an accurate representation of the business world. But it comes closer than many business reality shows. And both entrepreneurs and investors can learn some valuable lessons.

In today’s Penny Sleuth, I’d like to show you some of the tricks we can learn from these switched-on businesspeople. And I’ll reveal an interesting penny share minnow that has one of the Dragons on its board.

The way of the Dragons

According to government figures, the entrepreneurial spirit is flourishing. In garages, spare bedrooms and garden sheds all over the land about a thousand new businesses are being set up each day.

Last year, 395,327 new businesses were registered, a figure topped only once in the last 25 years. In a few years time, some of these entrepreneurs will, no doubt, be coming to the stock market, seeking the backing of new investors.

We need to be prepared. We need to know how we should assess these new investment opportunities. What questions must we ask?

Let us learn from the Dragons. These are the four rules that they follow.

1.    Dismiss the loonies

OK, so it is a bit unfair to characterise them as loonies. But some of the people who walk up those stairs into the Den seem to have very little common sense.

I am not suggesting that you need a university education to be a success in business – far from it. But you do need to be able to present a coherent story and have a grasp of the basic numbers.

Every new business must have an idea of its target revenue, a simple multiplication of price versus quantity sold. And every business has costs of raw materials, labour, premises, and so on. At the very least, entrepreneurs should have a grasp of these numbers.

2.    Back the enthusiasts

However promising is the initial idea, the business still has to be properly managed and the product has to be sold. People respond to enthusiasm. Employees like working for bosses who are upbeat. Customers and suppliers need to trust the new business and respond positively.

Personality is critical. You don’t need to be a hard-nosed, self-centred megalomaniac – as is the impression sometimes conveyed by The Apprentice. But you need to have the ability to get things done. And that requires energy and powers of persuasion.

3.    Sell a product that is needed, not wanted

Many are the entrepreneurs who have entered the Dragon’s Den and unveiled something that few people, if any, would ever want to own.

At the start of this series, a rather nervous looking inventor tried to persuade the Dragons that a ‘No Entry’ sign could be improved by a little flashing light indicating in which direction it was safe to travel.

In response to a question from one of the Dragons the inventor admitted that he had met the Head of the Highways Agency. This person had told him that she saw no need whatsoever for his innovation. Exit the entrepreneur and his hopes of financial backing.

A similar fate befell a young man who had invented a battery-powered rotating shaving brush. Has anybody ever yearned for such a thing?

By contrast, you may recall one entrepreneur who had the Dragons fighting to back her after she exhibited a clever magnetic device that enabled wires to be threaded through cavity walls. This ingenious little invention solved a common headache of any electrician.

The message is this. It is much easier to sell a product that people actually need than one that they have to be persuaded to want.

4.    Don’t overpay

The Dragons always drive a hard bargain. I doubt whether they ever pay more than three times the projected profits of a business. This means that if the business delivers, they will make a handsome return. But they also know that they need some big successes to cover those that will inevitably fail.

If, like me, you enjoy the Dragon’s Den, you may sometimes wish that you could invest alongside the Dragons. Well now you have an opportunity.

Are you in or out?

This week Peter Jones has injected two of his companies into eXpansys (ticker: XPS), the AIM-listed online retailer of mobile handsets. These are his web design and marketing services company, PJ Media, and the distributor of SIM cards, DSNS.

Peter Jones now has 43% of eXpansys and broker Cenkos has high hopes for the new group. It forecasts a £6m profit this year, rising to £14.2 two years from now.

Jones has been in the hot seat, presenting prospects to City investors. But have they been asking the right questions? This is certainly an interesting share to watch in the years ahead.

Good investing,

Tom Bulford
Editor, Red Hot Penny Shares

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(This article first appeared in Penny Sleuth in July 2010. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)