Today, I want do describe my investing style and how it works which will give you insights into how I reach satisfying investment returns with a margin of safety.
I’ll use Nevsun Resources (NYSE: NSU) as an example as it has been one of my largest portfolio positions over the last year.
Nevsun Resources is a Canadian mining company with a copper zinc mine in Eritrea and a copper gold project in Serbia. I was bullish on both zinc and copper which made Nevsun a perfect sector play. Further, Nevsun has no debt and had a cash balance of over $400 million which fell to around $150 million after the company acquired Reservoir and the Timok project in Serbia.
The cash balance, no debt, cash flow positive mine in Eritrea, and extremely high ore body grades in Serbia gave the company a margin of safety as, sooner or later, that value had to emerge. However, there has been plenty of bad news and this shows how we have to take advantage of Wall Street’s short term orientation and myopic view.
This is what happened:
- In 2015 and in January of 2016, the company was hit by lower commodity prices which is exactly when my interest in NSU increased as the stock price fell from above $4 to $2.20.
- Then in 2016, Nevsun didn’t manage to smoothly shift from mining the secondary copper-rich ore to mining the primary zinc-rich ore. Zinc and copper recoveries were much lower than expected and the company slashed its dividend to have better funding options for the Timok project, but that really hurt the stock price and problems in Eritrea led to it trading close to $2 in the first months of 2018.
- There was also a delay in releasing the pre-feasibility study for Timok and the company shortened the expected life of its Eritrean mine from 8 years to 4 years alongside a hefty impairment.
However, after the new management cleaned house, finally good news started to arrive. Zinc and copper recoveries increased, the net present value of the Timok project increased, Eritrea again became a cash machine, and all was finalized two days ago with the announcement that Nevsun rejected Lundin’s $1.16 billion takeover offer.
So, we had a sequence of bad news and now finally good news, but what I want to share is how I invested in NSU.
How Sven Invested In NSU
First, I took a long term approach which is the best advantage we do-it-yourself investors have over Wall Street.
For me it was simple. The cash on Nevsun’s balance sheet, and the huge net present value of the Timok project—which is now at $1.8 billion thanks to the extremely high grades and returns the project offers—was enough to know that the likelihood of losing money was extremely small, especially at prices below $2.5.
Short term problems like low zinc recoveries which were never a risk for the company as the cash flows remained profitable, and the dividend cut that lowered the stock price from $3 to $2.3 were actually buying opportunities. As always, when others sell in panic, it is time to buy.
The point is that when you find value—and the value with Nevsun is the metal in the ground and the cash on the balance sheet,—you can’t really lose in the long term and therefore, the smartest thing do to is to expect volatility related to news and increase the position when appropriate. Let me explain this more in depth.
Nevsun paid about $500 million for Timok which gives it a minimum value of $1.7 per share. When you add the $0.5 in cash, there was a margin of safety at a price of $2.3. Further, this doesn’t even include the cash producing Eritrean asset and further exploration potential which was just a bonus. Another thing to add was that cash flows from Timok are expected to be above $1.5 per share in the first 4 years of production by 2022, which increased the value of the project as the net present value of it is $1.8 billion, or $6 per share.
When the market doesn’t want to recognize value, competitors will. That is why Lundin and Euro Sun made an offer to acquire Nevsun for about $3.7 billion, which was rejected by Nevsun as the value of the company is much higher according to the management. Nevertheless, this shows what a margin of safety is in investing. I expect negotiations to follow, with perhaps another player, but this isn’t an asset play anymore but rather a merger arbitrage play now.
What To Do Now
If you’ve followed me and invested in Nevsun, you might wonder what to do now.
Well, the higher the price, the higher the risk is as the metal in the ground is the metal in the ground. It’s logical that the management rejected the offer as Lundin is still interested which means we might see higher offers. It also means that there might be other interested players.
However, if Lundin calls it quits, the stock might fall significantly. If negotiations last a long time and copper prices fall, bad things could happen. On the other hand, the offer puts a downside limit to NSU’s price as it shows that the value is at least $3.7 billion, but this is now merger arbitrage investing and not margin of safety bargain investing.
I have personally already trimmed my positions due to portfolio risk allocations, and will slowly manage the remaining part depending on the news. The point is that I made the bulk of my profits on this one as the bulk of my purchases have been done between $2 and $2.3, and I’m not going to risk my large profits for the potential of another 20% or similar jump.
My goal with NSU was to get to a 20% yearly return up to the Timok ramp-up in 2022, which is something that I have already achieved now thanks to Lundin. However, take advantage of the merger arbitrage traders who will seek short term returns if this fits your risk reward.
So, I thank Nevsun, and I hope you enjoyed the ride with me. Here are the learning points I wish to share that have helped me through my investment in Nevsun:
- Find value with a margin of safety, the rest will come.
- Never buy a full position immediately. Wait for better entry points which always come in volatile sectors like commodities and especially mining.
- Have an investment strategy set up beforehand, and look at all that can go wrong. Think ahead at what would you do – this will allow you to take advantage of dividend cuts, etc.
- Never fall in love with a stock and listen to the market – love and stocks are not good together.
- Research is the key to low risk high return investments.
- Always rebalance around the intrinsic value of a stock.