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What's Nothing Worth? by Dave Forest August 28, 2009

How to Value Zero The Virtue of Going Big Dirty Analysis The Real Way to Value a Deposit The $34 Trillion Guillotine Manila, Hong Kong and Singapore Is investment analysis a science or an art? There are those who believe that stocks and bonds can be directly broken down into numbers, which can then be pulled apart and analyzed to reveal a definitive answer as to the best place to put our dollars. Others believe that investment is more "squishy". Success requires having a good "feel" for the markets, and relying more on consideration of common-sense attributes of the opportunities at hand. This debate is particularly challenging when it comes to the mining business. For years, mining was a largely unsophisticated business. Miners found high-grade ore at surface and simply began digging it out. When the ore ran out, they stopped. Nowadays, things are much more complicated. There are an army of economists, engineers and geostaticians (that is a real profession) out there specializing in breaking down mineral projects into numbers. And then analyzing those numbers to see if a deposit is worthy of mining, or should be thrown back onto the geological scrapheap. Having spent the past week climbing over a mineral project in Colombia, I had many pauses to consider the issue of valuing a deposit. Mining exploration and development is one of the riskiest businesses in the world. The odds that any given package of rocks will host enough ore to make a mine are incredibly low. Probably less than 0.1% (more on that in a moment). And yet this is a business that must get done in order for the world to get its "building block" materials. The business can also be stunningly profitable, if a venture succeeds in identifying an important new deposit. One of the most challenging parts of mineral development, and particularly exploration, is figuring out what a given deposit or prospect might be worth. Some observers say that valuing mineral projects is an impossible task. We can only rely on our "gut feeling" about whether a piece of ground has the right stuff to be a mine, based on a survey of the rocks. But some (including many major mining companies) have tried to take a more quantitative approach to valuing projects. They have designed systems to hang harddollar numbers on pieces of ground in the middle of nowhere that may or may not turn out to be mines. The issue of valuation is also crucial to investors. If we can hang a value on a project, we can figure out how much we should be willing to pay for a share in the company that

owns the ground. This week, we delve into this fascinating issue, looking at some of the strategies that have been devised for valuing mineral projects. There are good arguments to be made that some monetary value can be attributed to a property, based on fairly simple calculations. There are also some important caveats about what analysis can and cannot tell us when it comes to value. In the end, the evaluation of mineral projects turns out to be a little science and a little common sense. But I'm getting ahead of myself. Let's start with a look at how this whole debate got started. Here we go. How to Value Zero One of the questions I get asked most often is, "How do you value junior mining companies?" This is a complicated matter. Traditionally, investment analysts evaluate companies based on metrics like net earnings, cash flow growth or market share. These kind of measures fail with nearly every junior mining outfit, because almost none of these companies have revenue. Let alone cash flow or earnings. Junior mining companies are generally involved in either of two businesses. Mineral exploration or mineral development. Explorers are the companies that have ideas about where on Earth important mineral deposits might be located. They try to raise cash from investors to go into the field and test their ideas by taking surface samples of rock, doing geochemical or geophysical surveys, digging trenches, or drilling holes to collect rock samples and geological information from the depths of the property. Development-stage companies are more advanced. They own properties where a mineral deposit of some description has already been identified. Someone in the past has done sampling, surveying, trenching or drilling on the property and proved that there is indeed mineralization in the underlying rocks. Development companies seek money from investors to complete additional work on the property (usually drilling) to expand the known size of the deposit, increase the grade, or otherwise improve the known qualities of the ore. Both exploration and development activities are important to the mining industry. Mines are a depleting resource. The mining operations we have on the planet today are steadily running out of ore. At some point they will reach the end of their useful life, and have to be shut down. So it's critical for the industry to discover new, significant deposits. Or expand known sub-economic deposits to the point where they can be profitably developed and help keep up the global supply of metals. Here's the challenging part. Neither exploration nor development generate any revenues. No one is going to pay a company for drilling holes in the ground. Or digging up little patches of soil and analyzing the arsenic concentration. In fact, these activities cost companies money. Almost every junior mining company on the planet is net negative in terms of cash flow. They're paying to do their work, and not generating a dollar of profits from the enterprise. I've been asked a few times by analysts from other sectors what the

P/E ratio is on a given junior mining stock. The answer is invariably that the E is nothing, so the P/E ratio is presumably infinity (the result of dividing any number by zero). This sounds impressive, but it's actually a sign of a company bleeding cash that has only a limited time until it runs out of funds and needs to refinance. (There are a rare few exceptions to the zero-cash-flow rule for junior miners. I saw one company developing an extremely high-grade silver vein in China. Management was driving an exploration adit to test the extent of the vein. But the material they were tunneling was running 2,000 grams per ton silver. Selling this "waste" as direct-to-smelter ore, the company was making millions quarterly. More than enough to cover its expenses.) This situation defies traditional analysis. You can't run an earnings analysis on a junior miner. These companies do not pay dividends or have retained earnings that can be invested for future growth. Basically, they are producers of information. They carry out work that gives us a glimpse at the rocks beneath our feet. Then they report their findings to the market and hope that investors will like the data enough to buy the stock. The Virtue of Going Big How then can we analyze a junior mining company? We know that some of these companies do generate tremendous wealth for shareholders, despite never having cash flow or earnings of any kind. A major mineral deposit can be worth tens of billions of dollars. Junior companies that have collected information proving that a project contains a major deposit have been rewarded many times in the past with a buyout from a major mining company. Creating huge capital gains for shareholders. Is there no systematic way we can select our investments from amongst the thousands of junior mining companies around the globe? Does value simply not apply when it comes to the business of mineral exploration and development? Is an explorer with a $50 million market capitalization indistinguishable from a $5 million market cap company engaged in the same business? Not entirely. Many analysts have tried to come up with strategies for valuing exploration companies. Mining consultants SRK Australia spent considerable time developing valuation models for exploration projects, to be used in fairness opinions for property sales. Most such models come down to one basic idea: expected monetary value theory (EMV). EMV is a method of valuing an asset based on probabilities of successful outcomes. Let's look at a quick example. Suppose Pierce Exploration is exploring for porphyry copper deposits in northern Chile. As analysts, we look at other major copper porphyries discovered in this area. These known deposits have been turned into operating mines, and we can therefore value them using traditional discounted cash flow analysis. Looking at the operating mines, we find that the average net present value is, say, $500 million. This means that generally, the kind of target that Pierce Exploration is looking for can be reasonably expected to be worth $500 million. If Pierce's exploration program is

successful. We all know that few exploration programs deliver a major deposit. In fact, Mitsubishi (one of the world's largest mineral developers) estimates that only one out of every 1,000 exploration projects results in the discovery of an economic ore body. That's a success rate of 0.1%. Very low odds. Suppose we look at all of the historical exploration completed in the area where Pierce is working. We find that 1,000 exploration programs have been carried out over the years, and 10 major porphyries have been discovered. A 1% success rate (the odds of discovery here are somewhat better than Mitsubishi's global average). Under expected monetary value theory, we would conclude that, assuming Pierce is of average skill in exploration (more on that in a moment), the company has a 1% chance of discovering a target worth $500 million. We would derive the value of the project by multiplying the "size of the prize" in a successful outcome by the odds that this outcome will actually materialize. So a 1% chance of a $500 million discovery would be worth $5 million. This is the proper price for a "lottery ticket" giving us a shot at a large payoff. Dirty Analysis Whenever I discuss the above EMV concept, I always get a lot of skepticism from longtime investors in the resource sector. Even my own partners often take me to task for "mathematizing" a simple business. Indeed, most investment in the exploration sector gets done based on investors' "gut instincts". Looking at the available information on a project, investors get a feel for whether the project has an acceptable chance of success, and whether the project comes an acceptable price, in terms of the market capitalization of the owning company. This is a sector where "dirty" analysis is the norm. There are indeed a number of valid criticisms of the EMV theory. First, how do we calculate the average value of a company's target deposit type? We said in our above example that the average northern Chilean porphyry deposit is worth $500 million. But in reality we would have a hard time locating enough information for enough deposits to calculate an exact, meaningful figure. And values are dependent on things like metals prices and discount rates. Changing these "soft numbers" will alter our target values, and therefore our EMVs for an exploration project. Calculating the odds of exploration success for a region is even more difficult. We will have an extremely difficult time figuring out how many exploration programs have been attempted historically. Some programs will have been forgotten or the data lost. Giving us an inaccurate calculation of the number of finds per number of attempts. The odds will look better than they are. We also have to remember that, even if we could calculate an average success rate, this is an average. If we use this figure to calculate Pierce Exploration's chances of success, we are assuming that Pierce is an average exploration company. In reality, Pierce's management could be brilliant explorationists with greater-than-average odds of identifying a major ore body. Or they could be fly-by-night promoters with little geological skill, who have next to no chance of making a discovery. Thus it is extremely

difficult to gauge the odds of success for a particular company, as opposed to the industry as a whole. And odds of success have a big effect on our expected value. The Real Way to Value a Deposit Do these hang-ups mean that EMV theory is useless in valuing junior mining projects and companies? At the considerable risk of being labeled a "data geek", I would argue that my experience has been EMV still provides several useful principles that can be applied in analyzing junior mining. The first point to recognize is that expected values are not going to be exact. It's nearly impossible in practice to determine all the input parameters to the point where we could meaningfully say that Company A's projects are worth $7 million and Company B's are worth $9 million and therefore Company B is the better buy. EMV applied to mining is a rough tool. It wasn't made for fine engraving. However, we can use EMV to identify under- or over-valuations in more extreme circumstances. Suppose Pierce Exploration's market cap rose to $50 million during a period of great investor interest in copper companies. We could use EMV to backcalculate what sort of project Pierce would need in order to justify this valuation. Suppose we know that in general copper porphyry mines in Pierce's exploration area are worth between $250 million and $1 billion. There might be a couple of outliers, but we're pretty sure that we're unlikely to find mines worth $50 million or $5 billion. Giving Pierce the benefit of the doubt, we assume that the company might reasonably discover a deposit worth $1 billion. We wouldn't expect the company to come across a "superporphyry" worth $2 billion, when the most valuable deposits found to date are only running at $1 billion. Assuming $1 billion as an "upper limit" value for Pierce's potential prize, we can do the math on what odds of success are needed to justify a $50 million valuation. In this case, a 5% success rate would be needed to account for Pierce's valuation. This is 50 times the generally-accepted odds for the exploration industry as a whole. And a study of any major mining district around the world will show success rates that fall well short of 5%. Projecting 1-in-20 odds for an exploration program is simply not reasonable. No matter how gifted Pierce's management might be. We can infer with certainty that Pierce is overvalued at its current share price. (I can hear my partners interjecting here to point out, rightly, that many $50 million exploration companies have proceeded to climb to valuations of $100 million or $200 million during times of "mania" in certain metals sectors. This is certainly true. However, to buy a $50 million exploration issue is to bet on profits from speculation. That is, momentum buying that drives a stock well beyond a reasonable valuation. Speculation can undoubtedly be profitable. But it is a different business from investment for which EMV theory would be used.) There's another important lesson that investors can take from the EMV framework. The bigger the potential prize, the bigger the expected value of the project. Given that the odds of discovering any kind of deposit (large or small) are about the same, we can

assume that a shot at discovering a world-class deposit worth $1 billion should be valued at more than a project giving us a shot at a small deposit, worth perhaps only $50 million. This is where things get a little "squishy". How do we know if a company's exploration project is exposing us to a chance at a major find or merely a small, marginal discovery? There are a few qualitative tests we can do to find out if a company is looking for the "right stuff". First and most simply, are there other major deposits located in the same region and hosted within the same geology as the project of interest? Going back to our example, if we see that Pierce Exploration's project is surrounded by billion-dollar porphyries that occur in similar host rocks as are known to be present on Pierce's ground, we have an indication that the project has a reasonable chance of discovering a highvalue deposit. All the more so if Pierce's ground is known to host other features associated with known major mines in the area, such as alteration, geophysical signatures or structural features like faults. In such case, we could reasonably assign a higher potential value to the project, increasing the expected value of the project. (As a side note, I had the "educational" experience of seeing this principle in action through an investment in a gold project in Madagascar. The project had excellent indications of hosting gold, including gold-bearing soil samples, trenches and even a history of small-scale mining. What I should have paid attention to, however, is the fact that Madagascar hosts no known major gold deposits. Now, this doesn't mean there aren't any major gold mines waiting to be found in the country. But it does mean that we don't have confirmation that the right geological conditions ever prevailed in Madagascar to generate large gold deposits. This is a significant handicap to the expected value of a project. We simply don't have a good handle on how large the prize might be. This sort of exploration project should be discounted in value to account for its unproven geologic model.) A simpler way of determining whether a company can be assumed to be legitimately seeking a large ore body is to ask corporate management what size of deposit they believe could be found on a project, and why they believe so. If management has a reasonable explanation as to why they believe their land could host a major ore body, they are ahead of a majority of exploration companies. Too many companies simply rush out and drill a gold-in-soil anomaly without any reflection at all on what type of ore body they might reasonably expect to discover. This is failing before you even begin. A good exploration team will determine not only that a project has a reasonable chance of hosting ore, but also that the project has a reasonable chance of hosting ore in a quantity and grade that will allow for a high-value mine. Buying the opposite company, the one with a remote chance of discovering something that doesn't matter anyway, is poor investing. Of course, there will be management teams out there capable of scheming up reasonablesounding, but completely untrue explanations as to why they have a shot at making a major discovery. This is why there's ultimately no substitute for a good geological review of a project. But my experience has been that the majority of companies that are so unskilled as to acquire a poor-odds mineral project will be equally unskilled in coming up with convincing falsehoods about the potential of the geology. If they know enough to

construct elaborate geological fantasies based in scientific reality, they probably know enough to identify and acquire real projects of merit, eliminating the need for misdirection. The $34 Trillion Guillotine I mentioned a few weeks back that the U.S. Department of Treasury was set to launch one of the most important pieces of financial legislation in years. This month this shoe fell, with Treasury introduced new proposed legislation for regulating over-the-counter derivatives. This measure, which has been sent to Capitol Hill for approval, didn't get a lot of press. But its effects on the financial sector (in the U.S. and worldwide) could be enormous. Derivatives are investment instruments linked to the performance of other investments and financial metrics. For example, a derivative contract on interest rates might require the seller of the derivative to pay the buyer a certain amount if interest rates rise above a certain level specified in the investment contract. Some buyers of these contracts use them to hedge against economic uncertainty. If I have a business loan and I know that I cannot service my payments at interest rates above 8%, I might buy a derivative contract that requires the seller to send me cash if rates rise above this level. This way, I am "insured" against the future. But derivatives have increasingly been used for speculation. These instruments offer buyers and sellers a way to bet on almost anything imaginable. The price of a stock. The value of currencies. The value of commodities. The credit-worthiness of a given company. Investors have done so much betting with derivatives that at the end of 2008 there was an estimated $34 trillion worth of these instruments outstanding around the world. We're talking about a lot of money here. Many observers see this as a guillotine waiting to fall on the financial sector. The sheer size of the space suggests that some sellers of derivatives could get stuck with trilliondollar cash calls if the world moves against them. How many loans have gone bad over the past year? Many of these had "credit-default swaps" written against them. This form of derivative is purchased by the loaning party. If the loan goes bad, the seller of the credit swap must pay the loaner some portion of the value of the loan. A sensible insurance policies for lenders. But if many loans go south at the same time (as has happened the last several months), this results in a lot of cash calls. The sellers of the swaps may not be able to pay, and could themselves be pushed into bankruptcy. Creating a "domino effect" of corporate failures. Treasury is trying to make sure this doesn't happen. That's why they've introduced new legislation to regulate derivatives. Currently, most derivatives are written as "private" contracts between two parties. There's very little transparency as to how much a derivative contract is worth as an asset, or what the potential liability is to the seller if they come out on the wrong side of the contract. Treasury wants to improve "price discovery" on derivatives by requiring that all contracts be registered through a central

clearing house. Here's the most critical part of the proposed new rules. Treasury also wants every derivative contract to be traded on an approved exchange. Exactly the way the stock of public companies is. Why is this significant? For the exact reason Treasury mentions: price discovery. The rules are designed to hang an exact value on every derivative in the world. At the end of the day, we'll be able to check a quote on the price of a given credit default swap, just the way we can with a share of Bank of America or any other company. This could be a game-changer for groups that hold derivatives on their books. Up until now, the rules have been very vague about how derivatives should be valued. We just don't know what number derivatives holders have been chalking up in their ledgers to account for these instruments. Very likely, derivative owners have been carrying their holdings at the maximum possible value. If and when the new system comes into being, these groups will be forced to re-value their derivatives to match the market price. Obviously, this could result in some serious write-downs and asset impairments. Not good for the balance sheet, and a potential trigger for more bankruptcies down the road. The rules are, at this point, just a proposal. But Treasury is pushing hard on politicians to get them passed into law. Should they succeed, Treasury is looking to implement the new rules within 180 days. Meaning the guillotine could fall as early as the second quarter of 2010. Keep this development on your radar screens. Manila, Hong Kong and Singapore I'm back in the office after a whirlwind five days in Colombia. The visit spanned a whole spectrum of activities. At the beginning of the week we mounted up mules to take a sixhour criss-cross of our new gold-copper project in Antioquia province. Then it was off to Bogota to put on suits and meet with our in-country lawyers. Both parts of the visit were very satisfactory. I'm looking forward to being back in Colombia soon. In the meantime, it's on to another part of the world: Asia. I've got a quick week in the office and then I'm off to Manila to meet with some of my partners. This will be my first visit to the Philippines. I've always found Asia to be fascinatingly diverse, and from what I've heard, the Philippines is about as diverse as a single country can get. Imagine 180 languages in such a small space! It should be a great experience. My partners and I will also be using the jaunt to Asia as an opportunity to drop by Hong Kong and Singapore. There's always business to be done in these hubs. If you're in the area, drop me a line. In the meantime, have a great "back to school" weekend. I can already hear all the parents out there breathing a sigh of relief! Here's to high-value projects, Dave Forest [email protected] Copyright 2009 Resource Publishers Inc.

Note The information provided in this newsletter is based on the independent research of Dave Forest and Lahar Resource Investments Inc. and is intended solely for informative purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade any securities or commodities named herein. Information contained in this newsletter is obtained from sources believed to be reliable, but is in no way assured. All materials and related graphics provided in this newsletter and any other materials which are referenced herein are provided "as is" without warranty of any kind, either express or implied. No assurance of any kind is implied or possible where projections of future conditions are attempted. Readers using the information contained herein are solely responsible for verifying the accuracy thereof and for their own actions and investment decisions. Neither Dave Forest nor Lahar Resource Investments Inc, make any representations about the suitability of the information delivered in this newsletter or any other materials that are referenced herein for any purpose whatsoever. The information contained in this newsletter does not constitute investment advice and neither Dave Forest nor Lahar Resource Investments are registered with any securities regulatory authority to provide investment advice. Readers are cautioned to consult with a qualified registered securities adviser prior to making any investment decisions. The information contained in this newsletter has not been reviewed or authorized by any of the companies mentioned herein.