A better way to invest on the Venture Exchange
February 19, 2012
Proposed: To develop and implement an investment decision model that, in reference to the TSX Venture Exchange, renders current practices obsolete.
The Venture: The Venture is the world’s leading exchange for junior resource stock investment. It currently includes more than 1200 metals and mining companies and almost 300 oil and gas companies. Most investment opportunities on this exchange would fairly be described as speculative, many extremely so.
The players: Investors in this market fall into four broad categories, including: institutional investors; professional investors; retail investors accessing outside counsel; and retail investors without counsel. Professional investors would include those who both invest on their own accounts and provide investment counsel to others. Brokers, analysts, advisors, and newsletter writers would be included in this group.
The process: The process for making fundamental investment decisions varies widely in sophistication across these groupings of investors, and also within these groupings. This would include, at one end, detailed study of individual companies in the context of sectoral and whole market analysis, and at the other end, anonymous tips in casual conversation.
The challenge: This marketplace defies traditional analysis based on ‘going concern’ financial statements. Leaning heavily on financial statements, ‘big board’ companies are valued on the basis of expected future cash flows. Many listed companies on the Venture do not generate operational revenues, eliminating a key contribution to the delineation of value. Expected future cash flows remain, for most listed companies, one or more steps removed from realistic predictability. This conspicuous absence of standardized quantitative data, answered by high levels of subjectivity to fill the empty spaces, significantly widens the range of outcomes across analysts. The number of companies listed on the Venture (with meaningful annual turnover) compounds the lack of standardized quantitative data, leaving the field open to poor performance in the category of due diligence. As a result, poor predictability relegates the Venture Exchange outside of consideration for a wide majority of investors, both retail and institutional.
Analysis and motivation: Analysis at the institutional level is internal, and thereby not subject to assessment or comment here. This commentary is restricted to analysis available for a fee or for free and available to the general public. Some analysis is conducted as part of a subscriber service, or on free web sites. Analyst/writers conduct analysis across a span of companies. Some charge subscribers for this service. It is generally believed that many if not most of these analysts are also compensated in some way by the companies they cover, in turn compromising the independence (and reliability) of their work. At the same time, these analysts (and their followers) face the dilemma of separating the analysis from personal investment in covered companies. Specifically, if an analyst invests in a covered company, is the assessment tainted by this personal involvement? On the other hand, if an analyst does not personally invest in a covered and recommended company, is the assessment unconvincing?
Analysis by investment bankers is questionable at best, as it exists, too often, as an adjunct to the financing proposal. Firms are naturally reluctant to portray client companies in a negative light.
Analysis by most newsletter writers is seen (in large part and fairly) as advertorial, a cross between paid advertising and journalistic content. As such, it represents little more than prostitution of the press, and offers little to nothing of substantive value.
In the end, individual investors are, for the most part, left to their own resources, and by sheer volume of the task, restricted to a very small number of companies under consideration. Warren Buffett cautions against investing in more than six companies. He argues that one person can not know more than six companies adequately to robustly support the investment decision. The challenge, of course, is in identifying those six companies.
The opportunity: Aside from conflicts of interest, the motivation to conduct thorough analysis within this junior resource market is severely hampered by the three structural limitations cited above:
- lack of standardization in analysis
- absence of quantitative data
- size of the market
The Venture represents an underdeveloped marketplace for a number of reasons, including: poor liquidity; self-regulation (lack of oversight); and the risky nature of exploration. At the same time, success in addressing the listed structural limitations for analytic work does represent a significant opportunity.
To date, the study of 1500 companies (with as much as 10% in annual turnover) has proven too great for any existing models of analysis. There are too many bases to cover, so analysts cover what they can, what they want, or what they must. Pressures from employers, from clients, from subject companies, or from peer writer/analysts bring some companies into focus and leave others unnoticed. There appears to be no scientific method of selection. Such a ‘hit and miss’ selection exercise cries out to be replaced. Moreover, once a company is selected for study, the analytic process lacks rigour and is fraught with subjectivity, personal bias, and conflict of interest.
Success in addressing this opportunity will necessarily involve:
- the timely collection of large masses of accurate and relevant data
- a capacity for organizing and managing volume of data in a standardized and quantitative database
- an algorithm by which to perform early (and regular) filters against 1500 subject companies
- a feedback loop by which to continually test and refine the process
These components are presented graphically below:
The graphic, above, represents the first two stages in the one below. Inner rings depict subsequent layers of more detailed review and analysis on a progressively reducing number of companies:
Aside from analyst coverage by those in related businesses (e.g.: financing deals), the selection process appears ad hoc, to be generous. Covered companies are those who make repeated contact with analysts, or who come to attention by word of mouth. The lack of a comprehensive methodology in the selection of companies restricts most work to stages 5 and 6, above, with only modest entry back at stage 4 of this framework.
There is no practitioner (known to me) of anything close to the depicted model against the Venture market, pointing to the significant opportunity for a successful new entrant to eclipse the current offering by multiple orders of magnitude.
The greatest tasks for pursuit of this model will be in the design of a standardized, quantitative database, and the implementation of an effective and efficient process for the timely collection of large volumes of accurate and relevant data.
Data in hand, the creation and continual refinement of an algorithm by which to eliminate the majority of subject companies from consideration will be a straightforward exercise.
The new front-end stages in this model will necessarily change all that follows in subsequent layers of analysis. Not only does this model start by including all companies in the market. It also derives from both a completely new framework of thinking and a motivation for comprehensive study not now readily visible in the marketplace.
Motivation, rigour of methodology, and scale, therefore, differentiate this model from anything currently available. If successful, this undertaking bears the potential to transform the entire landscape of the Venture Exchange and to render nervous a significant contingent of the cast who currently dominate the field.
Sounds like fun to me…
Thoughts?
Kevin Graham