There are inherent challenges in investing in early stage companies. First of all, the lack of revenue and profit keeps the mainstream investors away. Secondly, the regular equity/debt financing activities dilute the shares and constantly pressure the stock price. Thirdly, the immature business model makes consistent operation hard to achieve and thus degrades company's credibility and public image. Therefore, early-stage stocks (or junior stocks) often underperform the general market.
Needless to say investors risk their money in junior stocks for potential exceptional long-term returns. But the question is how to maximize the odds of long-term success while minimizing short-term risks. And here are a few rules I think constitute an answer to this question.
1) Assess the stock's potential based on macroeconomic force, market and the company's position and/or asset.
2) Time the investment to be near the delivery of first revenue.
3) Be contrarian and take position following a bottom formation.
4) Lean on a management team that can deliver.
When I added PACE (
Pacific Asia China Energy,
PCE-V,
PCEEF.PK) to my portfolio recently, I have followed these rules. For rule 1), enough has been said
elsewhere about China's environmental challenges, economic boom, energy demand,
natural gas market, and emerging CBM industry.
PACE's strong position in China is obvious from its two already-acquired PSCs, two pending PSCs, and the unique drilling platform it possesses through its PACE Mitchell Drilling joint venture. On rule 2), I was expecting some initial revenue from potential Dymaxion drilling contracts. On 3), the stock has been in a potential bottom formation since last October. Regarding 4), PACE management has
demonstrated its ability to execute efficiently not only its CBM exploration projects but also its strategy of leveraging with drilling service revenues.
PACE Mitchell Drilling (PMD) recently landed its first
multi-party coalmine degasification contract worth more than AU $10 million, of which PMD's share is 55%. It also has signed an MOU for a second contract in Yunnan Province. PACE president
Mr. Tun Aye Sai revealed to
StockInterview that PMD has three contracts that are close and can have another 10 companies to sign up soon.
With a clear vision, strategy and ability to execute, PACE addressed two of the major problems with junior companies, i.e., lack of revenue and immature/inconsistent operation. Thus the management's credibility and investor confidence are boosted, and the short-term impact from financing activity could also be reduced. Look at PACE's February 20 announcement of a private placement worth CA $5 to $10 million. Share price has actually advanced since (three trading days only though), because investors have focused on the positive news from the drilling contracts.
Ideally, one might also want to add the following rules:
5) Select a company that has a high insider ownership. History has proved that small caps with good insider ownership tend to perform well over time.
6) Make position adjustment wherever it makes sense. A long-term investment does not have to mean buy and hold. One might be able to profit from short-term overbought and oversold conditions, particularly prior to first revenue and when revenue is not significant. The downside of such adjustments is the possibility of missing out on huge runs. So, it makes sense to keep the anticipated revenue and earnings growth in perspective instead of just looking at the revenue or earnings number.
PACE has a good amount of insider ownership. As of this writing, CEO Devinder Randhawa, President Tun Aye Sai, and director Thomas Hogan together directly or indirectly holds almost 13.3 million shares, or about 18% of the shares outstanding before the current ongoing financing. Mr. Hogan reduced his holding by about 8.2% since last May (2006). But his selling activity appears to have stopped for the past month or so, likely because of the anticipated drilling contracts. On the other hand, CEO Mr. Randhawa actually added 180,200 shares to his holding from late June through late September (2006).
For
Far East Energy (
FEEC), I have only applied rules 1) to 3) above. I do see first revenue on the horizon based on company's dewatering period around the Shouyang block's HZ01 well area. Adding to that the company's recent disclosure on dewatering progress I believe the revenue visibility will be getting even better going forward. Regarding rule 4), the management has yet to prove itself. Both operational efficiency and drilling cost have much room for improvement. But it is too hard for me to ignore the company's huge CBM holding in China's largest CBM basin (rule 1). And I'm also drawn to its depressed stock price (rule 3). So hopefully 1) and 3) provide some risk cushion for the lack of 4) and 5). Right, this company does not have significant insider ownership.
It should also be noted that there is an inherent risk investing in any foreign company pursuing CBM exploration and production in China through PSCs with CUCBM. That is, there is no guarantee it can complete significant exploration work within its acreage before the exploration period expires. Fortunately, the exploration period is extendable through mutual agreement with CUCBM, like Far East has recently implemented.
