From its lofty peak of over 2400 in March 2011, the TSX Venture Composite Index has dropped more than 70%. That’s a steep decline by any standards. As dismal as that number may be, it does not reveal the catastrophic impact the near collapse of numerous juniors have had on investors, both institutional and retail.

In the hallway outside Baja Mining’s Extraordinary General Meeting a few years ago, I met three shareholders who in the space of a few weeks had seen $30 million of their investment wiped out by the drastic plunge in the share price.
They had travelled all the way to Vancouver from London, Ontario. Just a few months earlier, they had paid in cash for the Baja shares at $1.10 each in a private placement.

The stock was holding up nicely at that level. And then came news of a major cost overrun.

By the time that meeting was held, the stock had dropped to less than 20 cents.
They were visibly angry – and agitated.

That’s an extreme example from the retail side. Looking at things from the other side, many insiders have lost millions as well.

Aside from the mistaken belief that the downturn was short-lived, or the need to project confidence in their companies, why are insiders delinquent at protecting their fortune?

There are many reasons for it, but here’s a major one: peer pressure not to sell.
On Wall Street, there’s even a term for it: blood oath. It refers to the expectation among insiders not to sell their stock while they are still involved in the venture.
Here in a gentler and kinder Canada, I am not sure if this phrase even exists, but nonetheless, the concept is the same.

Picture this: A group of people get together to start a venture. There’s a leader and his followers. They position themselves with cheap founder shares. They acquire control of a shell and then do a private placement. The game plan is to have tightly held stock, do a bit of promotion, have favourable exploration results, do more promotion to get the stock higher so they can do more financings at increasingly higher prices.

The aim is to ultimately sell their company to a major and make anywhere from three to ten times their initial investment.

Everyone has some skin in the game. There’s a role for everyone. Although it’s not spelled out anywhere or overtly mentioned, no one is supposed to sell without tacit permission from key members of the network or a very strong compelling reason for doing so.

Looking at the management structure of a junior, at its visible web of relationships, what you see is often a small fraction of what exists. Like the dark matter that glues the universe together, the shadowy, invisible part is often more important than the visible part. This shadow web includes, but is not limited to investors, brokers, friends and relatives.

We are living in an age of increasing transparency. (Think SEDAR and SEDI and the proliferation of websites and firms dedicated to tracking insiders’ holdings.) Occasionally when someone does sell a bit of his holdings for whatever reason, his motive for doing so is often speculated – and at times denounced – by bystanders and shareholders on stock message boards.

Over time, he gets the message that to fit in, he must resist the temptation to take profits.

And so, unless there’s a very strong financial need to sell, insiders often don’t sell.

Independent Thinking – Difficult, but Crucial to Wealth Preservation
Is it worth it to fit in and in the process get trampled by a stampeding herd of bears?

In the investment business, a rule of thumb is that if you have made three times your money, you have done really well.

In many of these cases, at the peak of the market when it looked as though China’s growth would keep increasing forever, many insiders’ original investments had already gone up more than three to five times their original cost.

Yet they hung on.

Looking back, perhaps they were just as infected by the euphoria virus – what the former Federal Reserve chairman Alan Greenspan would call irrational exuberance – as the investing masses.

How different the trajectory would have been if John Doe (whose story was told in part 1) had been more prudent. He could have sold some or all of his shares in an orderly manner prior to and after the peak of the market. If he sold everything, he would have netted about $6 million. His associates probably would not like that, but there was not much they could do about it.

That would have been a great success story. After all, people spend years of their lives identifying and scheming to get their hands on a great asset and then many more years advancing it, hoping to get rich from it one day.

Now we know that company is struggling for survival. With that cash, he would be in position to save them.

Instead, he finds himself trapped in a leaky ship with the rest of his colleagues.

The ship is in a rickety state – and is listing badly. A sudden squall may just sink it for good.

In the end, his investment including time, money and efforts will likely amount to nothing if and when the company declares bankruptcy. Either that or the stock will be so badly diluted that this man will be lucky to recover 10% of his original capital.

“Be Fearful When Others Are Greedy”

Not everyone is like that, however. Institutional investors have no qualms about taking profits. If their investment has been a dog, they may curse management, but sell they will.

There are shady players whose lives revolve around pump-and-dump schemes. Others have a legitimate asset and are astute at getting out at the peak. Perhaps the latter are students of Warren Buffett who reportedly said, “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”

Years ago, a friend of mine, a geologist cum mining engineer turned promoter complained that Ken Doe (not real name of course), the guy that he did the deal with was quick to sell. My friend had vended a mining asset into a publicly listed shell controlled by Doe, an ex-broker.

When the shares became free-trading, this man sold and sold, driving the stock lower, while my friend hung on to his shares which became worth less and less as time went by.

The inference was that this Ken Doe was not a team player and someone who has no loyalty.

Back then, that’s what I thought. But now I am not so sure anymore.

Why would anyone hang on to a stock that is considered overvalued? Promoting an overvalued stock and making it even more overvalued is unethical. Eventually, its value is unsustainable and it will crash under its own weight. In the process, many innocent participants will get hurt.

This ex-broker probably acquired a trading instinct along the way. He would certainly know how to use sell-stops to protect his positions, whereas my friend coming from the geology side of the industry, was probably an amateur in the ways thing work on Howe Street.

By the way, this man has gone on to become a very successful promoter with at least a couple of homeruns to his credit. He is now a very wealthy and respected man in the industry, whereas my friend is now languishing in obscurity.

You have to give this ex-broker credit for the market savvy – and the thick skin to resist peer pressure. He certainly knows when to walk away. Perhaps he knows the Gambler’s lyrics by heart:

“If you’re gonna play the game, boy, you gotta learn to play it right.
You got to know when to hold ‘em, know when to fold ‘em
Know when to walk away and know when to run.
You never count your money when you’re sittin’ at the table.
There’ll be time enough for countin’ when the dealing’s done.”

(Part I of this post can be found at Sattva Capital will be exhibiting at PDAC’s Investor Exchange. If you are there, come by our booth (#2601) for a chat.)