With most speculations, when things go wrong, they go spectacularly wrong. The exploration or research project fails to deliver. The mine or factory is nationalized. The market changes, and a once-robust business model is no longer viable. The list of fatal outcomes is endless.
But there’s a stealth fatality, a sort of chronic wasting disease that’s not as obvious as a company visibly imploding. We call it “the death of 1,000 financial cuts.” Less poetically, it’s what happens when a company never really achieves its goals, but the hope that it will remains. Management keeps raising more money year after year, and shareholders get diluted down to essentially nothing along the way.
Let’s say that Moose Pasture Exploration has an exciting gold prospect hidden under the mossy swamps of northern Quebec. It’s a new company with only 10 million shares issued. These are tightly held and the CEO is famous for past success, so they trade at $1.
They need to drill the Moose Pasture project to look for gold and add value for shareholders. So they offer a private placement (PP) to the public to raise the funds needed. Given the high regard for management, the company is able to raise $5 million at $1, with no warrant and no discount. The number of shares issued increases to 15 million. Suppose I liked the story and bought $1 million of the PP. I’d own 1/15, or 6.67% of the company.
Now the death of 1,000 financial cuts begins…
- The $5 million doesn’t all go into exploration, of course. Gotta keep the lights on, pay salaries, hire consultants to promote the story, build a base camp, maybe build roads too, and spend a lot of time peeling back the moose moss looking for places to drill.
- But our famous CEO is actually as good as his reputation. He gets all this done as well as the government permits needed, and a first round of drilling kicks off within a year. Mother Nature is rarely cooperative, so this work results in some encouraging results but nothing we could really call an important discovery.
- Nothing has changed much, for better or worse. It’s unreasonable to expect to hit the mother lode on the first try. Still, Mr. Market isn’t known for his patience either, and share prices are down to $0.75.
- But Moose Pasture Exploration needs more money to give it another go. So they raise another $5 million, and this time investors need more persuasion to buy in. The PP is offered via 7.143 million “units” comprised of one share at $0.70, with a full warrant at $1.00, good for 12 months. On closing, the company will have 22.143 million shares issued. There’s another 7.143 potential shares hanging over the share price, if the warrants get exercised.
- To maintain my ownership of the company, I’d have to more than double my position. The results don’t warrant that, so I hold with what I have. I now own 4.52% of Moose Pasture.
- The next exploration season, the company has less prep work to do, so more of the money goes into drilling. Most of the holes are dead as a doornail, but one hole hits a bonanza-grade interval toward the bottom of the hole. Let’s say it’s 10 meters of 100 grams per tonne (g/t) gold, starting 500 meters down the hole. That’s very rich—a significant discovery—but of unknown value. The stock leaps when the exciting headline hits the wires. Then cooler heads prevail, as people realize that the rest of the drilling disappointed. The stock ends the day flat, and then starts sliding over the coming months, as there’s no chance of more answers before the next drilling season.
- Of course, Moose Pasture needs more money again. Unfortunately, gold is down at the time, and the stock is trading at $0.50. Worse, management realizes that their best shot is to follow up on the high-grade hit at depth, and that will require more deep holes—which cost more money. So they offer a new PP, with units at $0.45, including a share and a full warrant good for 24 months at $0.55. On closing, this will instantly double the number of shares the company has issued and outstanding, adding 22.22 million new shares. There’s an equal number of warrants that can be exercised for new shares at almost half of the price I paid for mine. This will make it harder for the share price to climb back up to my entry price.
- With that exciting bonanza-grade hit, I don’t want to sell. But the discovery is not obviously a mine in the making either. I again decide to hold with what I have. I now own 2.3% of Moose Pasture’s 43.37 million shares issues and outstanding.
- I’m sure you can see where I’m going with this, but let’s say the next season delivers a string of high-grade hits. The stock shoots up to $0.80. I’m still in the red, but things are looking up. However, this price triggers an acceleration clause on the second batch of warrants and they are exercised. (The first batch expired unexercised.) My ownership is reduced to 1.52%.
- At the end of the season, the results are compiled, and it becomes evident that there’s more gold on the Moose Pasture property, but it’s not all in one easy-to-mine place. It’s deep, and it’s complicated. And it’s going to take a lot more money to drill…
With that, we’ll leave our intrepid Moose Pasture explorers to their dream. Note that the company hasn’t failed yet, but it’s not clear that it’s going to deliver in the end either. This can go on for years and years. If I put more money in, I’m exposed to greater and greater risk should they fail in the end. If I don’t, I get diluted down to a smaller and smaller stake.
But what if I sell and the company finally delivers a world-class deposit after I exit?
That’s the question that leads to the death of 1,000 financial cuts.
And it’s the wrong question to ask.
The right question is: where is my money most likely to deliver the gains I’m after?
As much as I hate taking a loss, holding a position because of that emotion is a mistake. It’s not about what I like or don’t like. It’s about where the odds—the math, not my feelings—says my money is most likely to do the most good.
If I know of a stock I think has a much higher chance of delivering a big win, and I don’t have cash burning a hole in my pocket, the right thing for me to do is to take my lumps and redeploy.
If there’s nothing I like better on my radar, I may hold Moose Pasture for a while longer. But I do so knowing that the more shares a company has out, the faster the dilution is for existing shareholders when it raises more money. At some point, even if it succeeds, I can be so diluted that the stock shooting up 1,000% wouldn’t even get me out of the red ink I’m in.
Speculation is risky. I can’t let myself get married to any particular stock. They’re like race cars. I can try them out. I drive them as far and as fast as they’ll go. But I don’t imagine that any one car will always win. And I know it won’t take the punishment forever. I have to always be willing to switch out and upgrade my portfolio as I go.
The willingness to redeploy capital in pursuit of the best odds is the essential defense against the death of 1,000 financial cuts.
