Mining Companies: Why Smaller Is Better

NEW YORK ( TheStreet) -- Having invested in mining companies for quite a few years now; one of the first lessons I learned was to never touch the large-cap miners. However, before I explain my own reasoning, I want to quote a Bloomberg article from this morning which attempted to cover the same subject:

New Gold Inc. (HGD) Executive Chairman Randall Oliphaunt, who helped build Barrick Gold Corp. into the world's largest producer of the precious metal, says he prefers running a smaller gold miner than a big one.
Companies that produce fewer than 2 million ounces annually have more opportunities to increase output, said Oliphaunt, who was chief executive officer of Toronto-based Barrick from 1999 to 2003 and joined Vancouver-based New Gold six years later. It's "very challenging" to expand a large, established gold company, he said... .

The problem with this Bloomberg article is that while it goes to great lengths to document the fact that large-cap gold miners are gross under-achievers while the junior and mid-cap gold miners have provided very attractive rates of return, it never explains why.

Why do smaller gold miners "have more opportunities to increase output"? Why is it "very challenging" for the senior gold miners to grow? It's very simple: because large-cap gold miners (and large mining companies, in general) have the world's most-idiotic business model.

All large-cap mining companies have a very simple "rule" they live by: they only want to develop/produce large mining projects. Let's assume it is not purely the egos of the suit-stuffers who run these companies which prevents them from getting involved in smaller projects. Why are most large-cap mining companies not interested in developing smaller mining projects -- no matter how high the profit margins will be?

There can only be one answer to this question: They focus purely on larger projects in order to have the greatest total output while managing the fewest number of mines. This, in turn, implies a corresponding belief: The more mines these large-cap miners have to manage, the more things can go wrong.

The rebuttal of shareholders to this attitude should be automatic: "if you can't stand the heat, get out of the kitchen." These companies chose to be large-cap corporations. It's especially easy for mining corporations to spin-off mines -- either through outright sales, or simply setting up independent operations.

When a corporation decides to become very large, this presumes administrative competence. A competent management team should not tremble in fear at the idea of running 20 small, very profitable mines rather than five, huge inefficient ones.

This leads us to yet another question: Why do smaller mining operations tend to be more profitable or efficient? We can answer this question simply by taking a closer look at the development of the mining mega-projects which these large-cap miners covet/demand.