Franco-Nevada’s Harquail: Short-term investment focus has to go

David Harquail, president and CEO of gold royalty company Franco-Nevada, first came to the Prospectors & Developers Association of Canada (PDAC) convention when he was a kid in the sixties. His job was to transport rye and scotch from his dad’s car to the suite the exploration geologist had booked at the Royal York.

As potential investors examined the targets on the hand-coloured geological maps spread out over the bed in the smoky suite, Harquail remembers the tinkling of ice in their glasses.

He also remembers that before they left, quite a few of those investors would hand over a cheque to the elder Harquail, James, who had worked for mining legend Thayer Lindsley before going on to form a number of exploration syndicates.

“I think those investors — because they were getting a one-on-one with the fellow that was coming up with the project and executing on the project — they had a pretty clear view of what their odds of success were and what they were buying in terms of the prospect that summer,” Harquail told an audience in Toronto on the opening day of the PDAC convention in early March.

“That was a different era, and none of those things that they were doing there you could probably do today.”

Opening up the popular commodities and outlook session at the convention, Harquail noted that face-to-face communication with investors is missing. Instead, companies deal with a lot of intermediaries: brokers, analysts and fund managers who are not risking their own money.

Moreover, investors are in too big a hurry to get their money back, and their short-term focus is at odds with the long-lead nature of mining.

In the last 12 or 13 years, Harquail says investors have embraced four short-term investment themes, each one lasting for two or three years: optionality, net present value (NPV), growth and cash flow.

“What I find fascinating is that in an industry that’s been around for millennia, investors are coming up every two or three years with a totally new investment theme for the business,” he said.

“I think each of these things has led to a lot of problems, and as an industry, when we see what investors want, we actually give them what they want.”

The first theme of optionality focused on growing ounces, and on metrics like market capitalization to resources, reserves or production. With the aim being leverage to the gold price, all-important factors such as risk-reward and quality of ounces didn’t enter the equation.

That was followed by a focus on NPV or net asset value (NAV), and in response, the industry super-sized projects. “The best way to get a maximum NPV or NAV is to make the project as big as possible and deliver those ounces as quickly as possible,” Harquail said.

The focus on NPV meant higher risk because more upfront capital was required. It also made projects a bigger target for non-governmental organizations, and meant more issues with the local communities and governments because of the projects’ bigger impact.

The growth theme in the mid-2000s had investors taking on too much risk with development stories in frontier countries, on the promise that the company would get a rerating after achieving production.

Today, a lot of CEOs are maximizing cash flow and paying dividends to shareholders.

“I think again, the institutional memory has gotten hazy and this is not going to end well,” he said, comparing the current period to that in 2000–2001, after the Bre-X scandal.

Then, as now, there was no risk capital available for exploration. With the gold price at US$250 an oz., the industry stopped exploration, put off greenfield projects, deferred sustaining capital and started high-grading mines.

While investors were satisfied for a couple of years, there were repercussions down the line.

“The mine lives shorten very quickly, the closure liabilities move up because they’ve been discounted a decade or two decades away — now they’re coming much closer,” Harquail explained. “And soon, the credit agencies look at these companies on a liquidation valuation basis. When that happens, the debt trades down, then the equity trades down as well. Because the liquidation valuation on companies is not pretty, and these companies, if they don’t reinvest in their operations, will be valued on that basis and investors will again be angry at the CEOs for not thinking ahead.”

Harquail said that another reason investors have poured so much money into the wrong projects (the mining industry recorded $60 billion in writedowns last year) is that they have forgotten the purpose of National Instrument 43-101 reports. The reports were introduced to eliminate fraud, not to improve technical standards, he noted.

In the past, people seemed to have a better understanding of the low odds of success in mining.

As a fund manager in the 1980s, Harquail says he found that less than 10% of opportunities provided a great rate of return. But wading through projects that are mediocre or just above average was worthwhile, because “fantastic wealth” is created by that top 10%.

“For us the challenge was with mediocre orebodies. You have to be lucky to make any money, and on the better-than-average ones, the trouble was most of them got developed at the peak of the commodities cycle in time to ride it down — so you had to be lucky in the execution and the timing in order to make a good return on these projects.”

Perhaps the short-term money that mining companies have tried to appeal to over the past decade or more isn’t the right source, Harquail said, noting that new sources of money with longer-term horizons are entering the industry, such as sovereign wealth funds, private equity and pension funds.

“My respect goes to the get-rich-slow guys,” Harquail said. “Ones that think like an owner and can articulate a business plan — they’re not compromised with what the market’s doing in the short-term, and they don’t over-promise on the risks.

“They work on the premise that the market is a wonderful servant, but a lousy master. Initially, it’s a little harder to raise that money, but if you stay consistent, I think you get the investors that you deserve. This is a much more sustainable business, and I think that get rich slow going forward is the only way to succeed.”

— This story originally appeared on www.miningmarkets.ca, a sister publication of The Northern Miner.