Junior Mining Stocks In a Long-Term Perspective

Where is the MONEY?

Since the Barron’s Investor Sentiment numbers dipped below 20% (bulls) for the week ended March 6th, the major averages have gone on an absolute TEAR in what must be classified as a “vintage” bear market rally with all sectors starting to kick in as the Shorts and the “Left-Behind Louie’s” are now scrambling to get a “piece” of the action. It might be noted that if this was a “true bottom”, the Barron’s numbers last weekend would have still been mired in the low 20’s but they were above 30% in what I would define as “classic behaviour within a bear market”. I am not a market timer by any stretch but I have used Barron’s Market Lab for over thirty years to get a sense of what the TRUE PSYCHOLOGY of the market actually is. It spoke to me a few weekends ago and it made us some money but that is not the purpose of this report.

Most of us are long some physical bullion in some way, shape, or form but our BIG POSITIONS are in the companies that were SUPPOSED TO BENEFIT from the (correct) overweight in the precious metals SHARES and since we needed the advantage of leverage, we opted for JUNIOR precious metals shares and if we opted for JUNIOR EXPLORATION precious metals shares, we have been largely left out of every rally imaginable and every bullish precious metals move and every discovery or 43-101 or “Resource Estimate Increase” since mid-2007. That was over two years ago.

Why?

The answer to the question, in my humble opinion, is really quite simple. It is all about the MONEY. Between 2002 and 2006, over a billion dollars was raised in the junior mining arena for EXPLORATION and for that amount of money, one might have thought that there would have been a wrath of new BIG discoveries to fuel the fire of speculative interest. Well, there were discoveries but they were either in proven mining camps (Red Lake) (Goldcorp’s takeover of Gold Eagle for $1.5B) or in some remote third world country where the ultimate takeout was about 50% of the stock’s 52-week high. In 2007, the darling of the market was Noront Resources, manned by the superb promoter Richard Nemis, who took a “high-grade pod of copper-nickel-PGM’s” and commanded a $800M market cap by this time last year only to see the promotion evaporate and take mutual and hedge fund BAGHOLDERS to a revised market cap of around $100M. All in all, year over year, that MONEY produced very few new real discoveries.

Then in Q2 2008, with the hedge fund community owning hundreds of individual names in order to “cover the field”, the sudden and catastrophic redemption-led meltdown forced the hedgies to redeem vast amounts of capital and any junior that had a “bid” got hammered. As represented by the TSX Venture Exchange, the carnage was the worst I have ever seen, despite historically high multi-decade pricing for the underlying metals like gold, silver, and copper.

TXS Venture Exchange (Weekly)

Well, the devastation ended near the end of 2008 and the juniors almost caught a “forced desperation bid” last month when the global markets took out the lows and rallied from 678.62 to 937.90 representing a 38% advance from the lows but considering the 80% drop from the Q2 2007 peak, the rally in the TSXV has been anemic.

Why?

The junior mining/exploration sector devoted a great amount of exploration and development capital into refurbishing old projects particularly in the base metals sector. Record high nickel, copper and zinc prices lured the hedge and mutual funds into a “deer-in-the-headlights” mindset that the metals could never correct and bought into the sector with little consideration of the enormous capital expenditures associated with starting or re-starting a mine. When the base metals got taken down with the global contraction and against a difficult credit environment, these developmental juniors were left with advanced projects, zero funding, and in many cases, a skewed feasibility model due to the lower revenue forecasts. These companies unfortunately deserve to be on “Care and Maintenance” until the global downturn shows signs of reversal and since many of these companies were the drivers behind the TSXV move to 3372, it is their inability to recover which has capped the rebound in the TSXV.

However, there are a number of companies in the exploration sector of the TSXV that are being tarred with the same brush as the developmental juniors and herein lies the best opportunity that I have encountered in thirty years in this business.

Let’s take ECU Silver Mining Inc. (ECU.T)(C$.50) as an example of an advanced junior exploration company with one of the largest silver deposits in the world with its Velardena project in Mexico. The rule of thumb for pricing juniors exploration companies is that if they are not yet in production, you can usually buy them safely up to ten percent of “in situ metal value”. If you have ten million tonnes of ore worth one-hundred dollars per tonne, you have a one-billion dollar in-the-ground value. Using discounted net present value modeling and accounting for both mining costs and capital costs, you can arrive at various valuations depending on term and rate of interest and capital cost payback period but the rule to which I adhere is that I can pay up to ten percent of a billion dollars or one hundred million because the major mining companies, when they take an interest, will pay between twenty and thirty percent of in situ metal value. My “lift” is therefore two to three times my cost base.

In the case of ECU, I take the January 26th report authored by Bill Lewis of Micon (an independent) who states that there exists between 569 and 930 million “silver equivalent ounces” present at Velardena. This would imply an in situ metal value or “in ground” value of (assuming U.S.$10/oz. silver) of between $5.6B and $9.3B. Using my rule, I am therefore “safe” in buying ECU for a valuation of between $569-930M (10% of in situ metal value) or after dividing by the undiluted shares issued of 242M, between U.S.$2.35 and $3.64 per ECU share. With the shares quoted on 3/17/09 and U.S.$.38, I submit that it is this type of severe discounting that is hampering the TSXV’s rebound while at the same time.

Here is another example. New gold discoveries in proven favourable mining jurisdictions like the Canadian provinces of Ontario and Quebec, specifically the Abitibi-Greenstone Belt which has produced 180M ounces of gold and 145M tonnes of Zn-Cu ore over the past one-hundred years, have historically been priced in the $50M-100 range of market capitalization. Last year, Goldcorp took over Gold Eagle for $1.5B in stock and cash for a gold discovery below one-thousand feet in depth. Other comparables included Rubicon Minerals (RMX.V) capped at over $250M for a gold discovery in the Red Lake Camp where the most noteworthy drill result was 2.5 m of 173 gms/t (8’ of 5.0 ounces/t). I draw to your attention Explor Resources Inc. (EXS.V) (U.S.$.18) whose discovery in the heart of the Abitibi-Greenstone Belt was reported last July at 12.2 m of 16.6 gms (40’ of .496 opt) and who recently reported 3.0 m of 142 gms./t (10’ of 4.15 opt) at their Eastford Lake Gold property. EXS.V is capped at C$13.2M compared to RMX.V at $250M.

The valuation gap that we are now experiencing in the junior exploration arena is reminiscent of the late 70’s, a period of stagflation not unlike today’s environment (only it was a lot better back then because the banks weren’t technically insolvent) during which the TSXV (then the old Vancouver Stock Exchange) was muddling along with investor interesting suffering after the horrendous 1973-74 bear market and that remained in place until gold prices finally broke out above the $300 market. Within months into late ’79, the gold price rocketed north of $500 ultimately peaking in January 1980 at intra-day $857 per ounce. In the move AFTER the gold breakout in 1978, the old VSE took off an ascent that saw many juniors advance between 1,000 – 5,000% as the public finally came down with a severe case of gold fever and since gold was relatively expensive and offered little in the way of leverage, the GO-TO investment became the juniors. The U.S.$1,000 level for bullion in 2009 is to the juniors today what the $300 level was to the juniors back in 1978.

As for the TSXV, the chart below shows the severity of the discount in the junior sector by way of the correlation to gold bullion. The “$CDNX:$GOLD” chart proves in spades that a picture is worth a thousand words.

I believe that these juniors represent excellent risk-reward opportunities.Those looking to take advantage of in situ metal valuation adjustment should look to ECU Silver Mining Inc. (ECU.T) and those looking for an exploration discovery valuation adjustment should consider Explor Resources Inc. (EXS.V) where such adjustments could be in the order of 800-1,600% over the intermediate term as these junior markets experience normalization and a return to sanity. It “feels” like the ‘70’s and very few remember how many fortunes were made in a very short window – but I do. It was wondrous.