Description
Endeavour Mining Capital (TSE:EDV OTC:EDVMF) trades at approximately a 36% discount to the net asset value of its junior mining investment portfolio. EDV’s unusual merchant banking business model adds considerable value compared to open market purchases of securities and EDV should provide a very high return during a precious metals bull market.
INVESTMENT STRATEGY
EDV acquires investments through private placements by junior mining companies. These may be in the form of equity, bridge loans, secured loans, unsecured loans, convertible debentures, warrants and options, royalties, net profit interests and other hybrid instruments. In exchange for these high risk capital commitments, EDV receives very favorable pricing. EDV especially likes situations where new capital is critical to a transformation such as arrival of a new management team or a significant corporate development (e.g. acquisition/development of a major new asset). EDV seeks to obtain a 30% or better internal rate of return on transactions, based on reasonable projections.
EDV normally holds about 20-25 small positions. EDV’s objective is to continually realize gains and recycle capital into new favorably priced private placements. If the original investment thesis was correct then the investee company should have some clear benefit from use of the capital and the market for its public securities should improve allowing EDV to distribute its equity at a profit. Obviously there will be a great variation in individual returns with some investees thriving while others fail completely.
The exceptional success of some early investments allowed the portfolio to evolve with a second component of “core merchant banking investments.” EDV holds larger longer-term investments in these companies and seeks representation on the Board of Directors. An experienced Endeavour executive can provide critical guidance to small companies with high potential. It also ensures that Endeavour has a deep familiarity with the fundamental value of each investment.
PERFORMANCE
The results have been excellent. In the past two years the NAV (after all fees and expenses) has risen from C$2.31 at 9/30/02 to C$4.75 at 9/30/04 and far outpaced the 46% gain in the XAU index over the same period. During the weak market for precious metal stocks earlier this year the peak to trough fall in EDV’s NAV (calculated monthly) was 21%. In comparison the peak to trough drop in the month-end XAU was 22%.
EDV says “management does not view the Issuer’s business as cyclical, the value of its assets in the mining sector may fluctuate with the market for securities in that sector and the demand for precious and base metals.” Returns will always reflect a mixture of 1) the merchant banking profit earned as a provider of high risk capital and 2) the general market price of mining stocks. EDV should earn a modest return during a flat market. During a strong bull market EDV should earn exceptional returns from the warrants attached to many transactions and from increased speculative enthusiasm for junior companies.
PORTOLIO COMPOSITION, NAV, and DISCOUNT
EDV explains its policy of very limited disclosure about individual investments: “Endeavour operates in a highly competitive financial marketplace that demands the utmost discretion and confidentiality. Accordingly, our practice is to not disclose sensitive details regarding individual transactions. This practice has been carefully considered with the primary objective of maximizing our potential returns by limiting the possibility of adverse market impacts caused by inopportune disclosure.”
This policy tries to accommodate the importance of maintaining a close relationship with issuers with the need to realize gains, recycle capital and manage risk. The annual report cited these companies as providing the largest contribution to last year’s returns:
Bema Gold (BGO.TO) – has an Endeavour director
Bolivar Gold (BGC.TO)
Glencairn Gold (GGG.TO) – has an Endeavour director
Northern Orion Resources (NNO.TO) – has an Endeavour director
Oxus Mining (OXS.L) – has an Endeavour director
Wheaton River Minerals (WRM.TO) – Endeavour directors recently resigned because of an advisory conflict of interest
As of 5/31 EDV disclosed that US$35mm (44% of assets) was invested in companies with an EDV director. While the composition of the “core merchant banking portfolio” is not formally disclosed, it’s basically the names above.
EDV publishes a monthly NAV update on its website. NAV at 9/30/04 was C$4.75 per share and the market close on that date was C$3.00, a discount of 36.8%. For the past six months the change in month-end NAV has roughly tracked the average change of the six companies shown above. I use this as a guideline for daily NAV. The average return of those six stocks in October is +1.0% so my rough guess is that NAV on 10/22 is C$4.80. EDV closed Friday at C$3.05 so the discount is now approximately 36.5%.
EDV provides some useful breakdown of the composition of its assets. At 5/31:
Loans and debentures 8%
Equities 77%
Warrants 15%
EDV has not borrowed money to leverage returns. And looking through the place of incorporation to identify the location of operating assets shows:
North America 25%
South America 38%
Europe & Asia 28%
Africa 5%
Oceania 4%
NAV has risen 106% since 9/30/02, but EDV’s share price has risen only 30%. The market has failed to understand the nature of the EDV’s business and the value it generates. Even this year the discount to NAV has grown from 13.6% in February to the current 36.8%. EDV management understands the need to deliver the company’s value to shareholders. Earlier this year EDV began publishing the monthly NAV in the expectation that increased transparency would encourage buyers. EDV began paying a semi-annual dividend of C$0.035 so that shareholders can receive at least a money-market yield. EDV believes that it can attract some analyst coverage following release of its audited year-end results in a few months. If a discount persists then the Board of Directors will take additional (unspecified) steps to try to ensure that shareholders can receive a fair value for their investment. The discount has varied widely and I believe the current high level signals a good buying opportunity rather than a chronic problem. On the downside the high discount provides a significant margin of safety to the current share price.
What is a fair price relative to NAV? I don’t know of a good comp for EDV’s unique mix of merchant banking and portfolio income. A gold/mining conference typically has 100+ little companies. Each has maps, a mass of geology data, and a story, but which people can you trust, which data has value, and which stories could have a happy ending? I think most investors would be better off buying EDV at a small premium than trying to assemble their own portfolio of junior miners. EDV provides diversification, excellent management, and access to the preferred pricing of private placements. When EDV is at a discount I think it should be attractive even for specialized mining portfolios (US Global Investors and Front Street Capital are the largest institutional holders).
MANAGEMENT
Endeavour Financial (Endeavour) is a boutique mining advisory firm that created EDV in 2002 to take advantage of investment opportunities generated through the existing client advisory business. The management team includes many years of senior executive experience in the financial and mining industries. EDV pays Endeavour a management fee at an annual rate of 2% of the first C$50mm in net assets, 1.5% of the next C$50mm, and 1% of assets over C$100mm. In addition, the advisor receives an annual incentive fee equal to 20% of net income above a 15% ROE. These fees are high, but not unreasonable for a highly specialized portfolio of public and private investments.
TAXATION and REGULATION
EDV is incorporated in the Cayman Islands. It is not supervised by any financial services regulatory body. There is presently no taxation imposed by the Government of the Cayman Islands on income or capital gains. If any form of taxation were to be enacted, the Corporation has been granted an exemption therefrom until August 6, 2022. The Corporation is subject to foreign withholding taxes on dividend and interest income.
Taxable US Investors: EDV believes that the IRS would consider it a “Passive Foreign Investment Corporation” (PFIC) and EDV prepares the information that US shareholders need if they are going to report EDV as a Qualified Electing Fund (QEF).
CORPORATE GOVERNANCE
The close relationships between EDV, Endeavour Financial, and investee companies are the strength of EDV’s business model, however there are very significant potential conflicts of interest. So far these close relationships have worked to EDV's benefit.
Endeavour Financial does not manage any investment funds that compete with EDV for allocation of assets. Endeavour manages a couple of funds for Canadian investors that buy only “flow-through” shares that have a particular Canadian tax advantage. EDV is not a Canadian taxpayer and never buys flow-through shares. Endeavour’s Investment Committee has given EDV first priority (ahead of Endeavour employees) in allocation of any deals with limited supply and EDV can “black out” all other Endeavour parties when it wants to trade a position.
Director relationships do not prevent EDV from selling shares in “core merchant banking holdings” to take advantage of exceptional price performance or to manage risk (by preventing a particular holding from becoming too large a portion of the portfolio). For example, I would not be surprised to discover that Endeavour reduced its large holding of Wheaton River Minerals (last reported in a WRM filing as 4.4mm shares and 1.5mm warrants).
In October 2003 EDV issued a secondary offering at C$3.45 per share, a substantial discount to the NAV at that time of C$4.10. An offering like that increases the asset base and potential income of the manager, but dilutes the interests of existing shareholders. However, Endeavour felt that existing shareholders would receive two significant benefits: 1) EDV felt that its existing capital base was too small to accommodate the number and size of available transactions and that more capital would result in increased profitability per share, and 2) the larger company size was accompanied by a move from the TSX-Venture exchange to the TSX main board. Now EDV has no plans for any additional stock offerings and EDV believes that its current capital is sufficient for its available transactions.
PORTFOLIO VALUATION
EDV publishes a monthly NAV (with quarterly external audit). Publicly traded securities are valued at the last traded price. Private securities are: “recorded at cost unless an upward adjustment is considered appropriate and supported by persuasive and objective evidence such as a significant subsequent equity financing by an unrelated, professional investor at a transaction price higher than the Corporation’s carrying value. Downward adjustments to carrying value are made when there is evidence of a decline in value as indicated by the assessment of the financial condition of the investment based on operational results, forecasts, financing and other developments since acquisition.
Options and warrants for public companies which are not listed or traded on a national exchange are valued at the difference between the exercise price and the quoted market price of the underlying shares, plus an adjustment for time value. Options and warrants for private companies are valued at the difference between the exercise price and the carrying value of the underlying shares.
WHY GOLD?
There’s plenty of information available about the bullish thesis for gold and bearish thesis for the US dollar. Instead of repeating that information, I just want to focus on one factor that has not been sufficiently appreciated in the market. A lot of gold is produced in countries with strong currencies. As these currencies appreciate, the operating margin of mines in those countries deteriorates and discourages marginal production.
South Africa accounted for 17% of world gold production in 2003. Since 12/31/01, the US dollar price of gold has rallied 53% from US$278 per ounce to US$424, however the price in Rand has fallen 21% from R3312 to R2618. Earlier this year a survey showed that 40% of South Africa’s gold mines were losing money and another third were earning returns of less than 10%. Gold has risen about 10%in ZAR since the survey, but South African managers remain focused on minimizing investment and shutting marginal production.
Canada accounted for 5% of world gold production in 2003. Since 12/31/01, the US dollar price of gold has rallied 53% from US$278 per ounce to US$424, however the price in Canadian dollars has risen only 18% from C$442 to C$524. Some analysts forecast that Canada’s trade surplus, budget surplus and rising interest rates will result in appreciation of the CanD to parity with the US dollar. If that happens then a Canadian gold mine would need a US$ gold price of $524 per ounce just to maintain current operating margins.
Australia accounted for 11% of world gold production in 2003. Since 12/31/01, the US dollar price of gold has rallied 53% from US$278 per ounce to US$424, however the price in Australian dollars has risen only 5% from A$543 to A$572.
Only mines located in countries with weak and dollar-linked currencies will realize significant increase in profitability from a falling dollar and rising gold price. I think EDV’s heavy weighting towards Latin America and other emerging markets is perfect.
TIMING and POTENTIAL RETURN
If you studied GRZ, AZS, and other small mining stocks then you can see that many of the fundamental stories have improved during 2004 as reserves increased, companies made progress towards production, and commodity prices increased, yet share prices are below the peaks reached around December-January. Gold and gold stocks have been overlooked with all the focus on energy. Junior and intermediate gold stocks are unusually cheap right now and EDV is an unusually cheap way to invest in junior and intermediate gold stocks. I believe it would be reasonable for gold to rally 10% over the next year, the XAU index could rally 20%, EDV’s portfolio could rally 50% and EDV share price could rise to NAV. That would put the share price at C$7.12, 133% above the current level.
ADDITIONAL INFORMATION
Websites:
Endeavour Mining Capital: http://www.endeavourminingcapital.com/
Endeavour Financial: http://www.endeavourfinancial.com/
Vanguard Shareholder Solutions (useful archive of media coverage): http://www.vanguardsolutions.ca/s/OurClients-EDV.asp
United States Current Account Balance: http://research.stlouisfed.org/fred2/series/BOPBCA/125/Max
Investor Relations:
Vanguard Shareholder Solutions: 866-801-0779 or (604) 608-0824
Endeavour CFO: Bill Koutsouras: 345-946-7603
Some Investee Companies:
Bema: http://www.bema.com/
Glencairn: http://www.glencairngold.com/
Northern Orion: http://www.northernorion.com/
Oxus: http://www.oxusminingplc.com/
Wheaton River: http://www.wheatonriver.com/
Fortress: http://www.fortressminerals.com/
Catalyst
1) Falling dollar/Rising Gold price
2) Increased valuation of portfolio companies
3) Reduction in discount to NAV