The School of Rock: How to invest in resources stocks right now

Exactly two years ago, I penned a piece providing investors with an education on the School of Rock. 

For those that don't get the reference, the 2003 comedy hit follows a rock n' roll enthusiast posing as a substitute teacher, perfectly portrayed by Jack Black, who goes on to transform a class of misfit students into absolute rockstars. 

It's a classic. And one that I would definitely recommend you watch if you haven't already. 

That said, while I'd love to stumble down the rabbit hole of rock n' roll, there is a different world of rock that I'm sure you, my dear reader, would be far more interested in. 

After all, over the past two years, the S&P/ASX 200 Resources Index (ASX: XJR) has risen around 21%. The S&P/ASX 200, in comparison, is 4.3% in the red. Fortunes have been made investing in the rising stars of the resources sector. Many more have been lost chasing the next big commodity. 

Since identifying winning stocks within this arena requires a unique set of skills few possess, I thought it would be wise to provide a refreshed lesson on how to best invest in resources stocks today. 

Taking this class is Rick Squire, portfolio manager at Acorn Capital. Squire has 25 years of experience in mining exploration and research, having started his career as a geologist. Since 2011, he has specialised in mining investments and finance. 

This lesson will explore the commodities with the most and least upside today, how to navigate a "cost of mining crisis", and what investors should look out for when investing in miners and explorers with projects both locally and abroad. 

We also go deep into the nitty-gritty of the metrics investors should use when analysing resources stocks themselves, as well as three all-star stocks Squire believes are best placed from here (and two that should probably be sent to detention). 

Note: This interview was recorded on Thursday 12 October 2023. 

Acorn Capital's Rick Squire 

Where are we in the cycle? 

Squire and his team believe there has been a breakdown in the traditional commodities cycle, but he still has a positive outlook on clean energy transition metals. 

This includes commodities such as lithium and copper, but also those that have experienced a sharp pullback like rare earth elements, graphite, nickel and cobalt.

"A real divide has opened up between the performance of those metals and their outlook," Squire says. 

"The clean energy transition is still ongoing, there is really strong momentum for it, but the performance of the metals has been quite different and probably reflects the different markets and the supply-demand fundamentals behind them."

Outside of those metals, the outlook for gold, oil and uranium looks positive, he adds. 

"The recent events in Israel and Palestine have put a little bit of momentum into oil. It'll be interesting to see how that plays out because if things deteriorate, prices could be quite strong," he says. 

"In terms of gold, the impact of bonds and interest rates over the next six months could be really interesting. So there's a little bit of caution around these things, but there's still some positive signs for several commodities." 

Commodities with the most upside from here 

Squire believes the best upside exists in stocks exposed to lithium, copper, oil, uranium and gold today. However, he argues that for those commodities that have been heavily sold off, like rare earths for instance, opportunities are emerging in some of the higher-quality assets. 

"You can actually pick out some really good value. It might take 12 or 24 months to really realise that upside, but when it does, you can get great returns," Squire says. 

Commodities that are likely to struggle (and a lesson on why you should be cautious about being too negative) 

Squire invests "across all commodities because you don't know when they're going to turn". Take cobalt, for example, which has seen prices collapse by around 36% since the beginning of 2023. 

"So much cobalt comes out of the Democratic Republic of the Congo and Africa, and all you need is an unexpected event to occur and suddenly the cobalt price can take off," he says. 

You've got to be careful making a really strong negative call on any commodity because external factors can really influence prices.

With this in mind, Squire argues investors should keep a watchful eye on cobalt, as well as rare earths, which have also seen prices plunge in recent months. 

"Rare earths are almost like a leading indicator on the health of the economy - it's often the first one to fall, but it's also the first one to pick up," he explains. 

"Not many projects would be successful at current rare earth prices, but it doesn't take much to move prices. We always keep an eye on quality because they are often the first ones to move and that's where you can actually generate great returns." 

Squire points to Meteoric Resources (ASX: MEI) as an example. 

"I was in Brazil last week, having a look at the project. It's what's called ionic clay and that's a major part of the production in China," he explains. 

"For a long time, it was thought to be largely restricted to China. But there's been a few discoveries recently. Meteoric has made a really exciting discovery - and it's of a far higher grade than its competitors. It also has higher recoveries and therefore the potential to be a large and world-class supply of rare earths." 

While Acorn doesn't focus on ASX 100 companies, and thus, could not talk to Lynas Rare Earths (ASX: LYC), Squire did have some thoughts on Arafura (ASX: ARU).

"We think that is more challenging," he says.

"It's got a very large CapEx thanks to the style of the deposits - and there are limiting synergies in terms of processing. It's also a modest grade. So it's not the type of project that we think is best to invest in." 

The impact of rising costs

Speaking of CapEx, like the rest of the planet, the mining industry has also seen costs explode over the past few years. However, Squire believes there has been a real change over the last 12 months. 

"Today, oil prices are going up and the Australian dollar is weakening. So if you're buying diesel, it's getting more and more expensive," he says. 

Operations that require diesel, like open-cut mines or those in remote areas where they cannot access grid, gas or green power, are likely facing headwinds here. 

"Energy costs can be 30% of a project's cost base and if it's largely diesel, that can really creep up," Squire says. 

Additionally, many junior resources companies have struggled to raise capital in recent months - and thus, are not drilling as much. Because of this, there has been some freeing up of labour within the sector. 

"We're actually seeing, in some cases, relief in the market. An indication of that is a lot of companies were previously waiting three to four months for results from drilling to come back. Now it's down to three or four weeks. So that's actually taking pressure off the cost base," Squire says. 

"Cost impacts are still there. It's still real. But it's impacting some operations more than others.  Investors need to be aware of the nuances there." 

Local versus international exposures

While the bulk of Acorn's portfolio is invested in companies with Australian projects and operations, the team has a "large percentage" of the portfolio invested offshore. 

"We're quite comfortable investing in South America and parts of Africa. But we restrict it so there is not too much exposure in any one country. You need to be very mindful that it's quite a fluid environment in developing countries," he says. 

Basically, investors should look for quality assets in countries that already have large mining companies operating in the region. 

"The education system is set up to produce geologists, mining engineers and even accountants that understand the mining system. You want to invest in bureaucracies that understand mining, so there is less chance of corruption and projects are more likely to have efficient processing, permits and approvals," he explains. 

For example, Chile, which is filled with an abundance of high-quality copper, gold and lithium assets, would seem to be geologically a great opportunity. 

"However, it's very difficult to get projects permitted in Chile and also, one of the great challenges is access to power and water. There is also social tension in terms of the potential for nationalisation," Squire says. 

"So we're not invested there. It's a very high hurdle for us to invest in Chile." 

3 metrics to use when analysing resources stocks 

1. Quality: For investment success in small resources stocks, investors must focus on high quality assets, Squire argues. 

"We don't like small high-grade operations. It has to be something that has scale, be mineable and can get into production for a moderate cost," he says. 

"We really dislike those projects that need a billion or two billion dollars in CapEx. No small company is going to be able to raise that. It has to be done for an achievable price."  

2. Jurisdiction: Jurisdiction is absolutely critical, Squire adds. 

"No matter how good the project is, if it's in Eastern Ukraine, it's never going to get funded," he says. 

"That's one end of the spectrum - it's in the middle of a warzone - but whether its in Africa or Australia, if it's on the edge of a national park or on the outskirts of a city, it's going to be a lot more challenging to get those projects up." 

He recommends investors focus a keen eye on a project's jurisdiction, location, mine life and its ability to get into production. 

3. Permitting and financing risks: Investors also have to understand, not just the technical sides of an investment, but also its related financing and permitting risks, he explains. 

"A delay can lead to an increased need for working capital and that can dilute shares and really reduce the return a project can ultimately achieve," Squire says. 

A deep dive into lithium 

Recently, several brokers - including Morgan Stanley, UBS and JPMorgan - have downgraded their outlook on lithium prices (and related stocks). So how should investors navigate in a sector that is potentially losing momentum? 

While Squire agrees that lithium prices have come off from "absurd" stratospheric highs, he argues that spodumene is still trading at quite high levels. 

"If you take a 10-year view, lithium prices are still very strong today, they have just come back from their highs," he says. 

In this environment, quality projects will be rewarded and poor quality projects will be punished, he says.

"If you look at Liontown (ASX: LTR), Azure Minerals (ASX: AZS) and Patriot Battery Metals (ASX: PMT) - those three, for example, have performed so much better than others," Squire says. 

"I think that reflects the quality of the projects that Liontown, Patriot and Azure have - they're large deposits and they're very mineable. They've got the right metals and they're in quite reasonable locations." 

In comparison, projects that have struggled face a number of technical challenges - such as exploring new technologies and permitting risks. 

"The market is starting to recognise those issues. That's why some stocks are performing, while others are not," Squire adds. 

"Big companies like Albemarle (NYSE: ALB) and SQM (NYSE: SQM) are making big investments in companies like Patriot, Azure, and Liontown. They're still seeing great value in high quality assets. So yes, brokers are downgrading and so they should be, but there is still value in high quality projects." 

Acorn Capital's 3 highest conviction positions

1. Meteoric Resources (ASX: MEI)

Meteoric is Acorn's highest conviction position today. As outlined earlier in this piece, it has an impressive ionic clay rare earths project in Brazil which is "unusually high grade" and similar to projects in Southern China.

"It's six to eight times higher grade than most other projects on the planet. It's also got very high recovery. So that's a perfect combination," Squire says. 

"It's in a state where there is already large iron ore mines - it's the Western Australian equivalent of Brazil. So the bureaucracy is set up, the locals actually understand mining and it's an area largely used for plantations, so poor agriculture use, and very few people around it. So that's our highest conviction stock." 

2. Azure Minerals (ASX: AZS)

Coming in second place on the list, is Azure Minerals - which has recently made a "really exciting lithium discovery in Northern WA" - but was originally focused on gold, copper, silver and zinc projects in Mexico. 

"It's very close to infrastructure zones and if a really high grade. It's got the potential to be one of the best lithium spodumene deposits in the world. So that's really exciting," Squire says. 

3. Auteco Minerals (ASX: AUT)

Auteco is about to close a deal on a small but high grade gold/copper project in Newfoundland in Eastern Canada, and comes in at number three on Squire's top stocks list. 

"The mine went into administration. They're going to leave it on care and maintenance and they're going to drill it to work out the best part of the resource. Then either build a new plant or work out how to scale up the operation to run it at the optimal level," Squire explains. 

"It's a high quality team, a really exciting project, it's in a first world jurisdiction and it's copper, which is really hard to come by on the ASX. So I think that's an exciting project too." 

And 2 crowded companies that investors should be wary of 

There are two popular stocks on the ASX that Squire believes could face challenges from here: Latin Resources (ASX: LRS) and De Grey Mining (ASX: DEG). These companies have seen their share prices rise 170% and 29% respectively over the past 12 months. 

"If you go back to the criteria that I mentioned before - you have a look at Azure, Patriot, and Liontown - they've all got really thick deposits that are high grade," Squire says. 

"Yes, Latin Resources is a reasonably large resource, but it has multiple skinny loads. It will be very difficult to mine and there is a high risk of impurities coming into the concentrate they process." 

Squire believes the market is starting to wake up to these technical challenges, with the stock's share price falling 35% since hitting a high in August. 

"It's starting to fall apart and that's being reflected in the numbers as people start to think about the next stage of production. I think it's got the potential to fall further as we start to see those challenges surface," he says. 

On the other side of the coin, De Grey is a "fantastic discovery" and a "world-class asset that has just raised equity", but is in an "orphan period" as it moves into construction over the next 12 months. 

"It's got a really long build and then they'll come out the end with a style of processing plant that is just not common around the world. So there could be some technical issues," Squire says. 

"It's just not the place to be for probably 18 months. In 10 years, it will be great. But as an investor, I'm trying to make money in the next 30 months to three years and that's not a stock that you will make much money on, if anything, over that timeframe." 

That said, Squire believes investors should take another look at the stock in two years time, once construction timings and costs are clearer. 

"I can't deny that it is a world-class asset, but it's just going to take a long time. The only thing that could save you is a takeover bid," he says. 

"But if I was a big company wanting to take it over, I'd wait until it was probably six months or so from getting into production and that's 18 months or two years from now." 

This article was originally published for Livewire Markets on Tuesday, 17 October 2023.