As this gold bull market continues in its secular uptrend, gold stocks have become increasingly popular as their gains are greatly leveraging those of their underlying metal. And within this hottest-of-the-markets stock sector, a sub-sector has emerged that investors have embraced and adored.

 

Junior gold stocks tend to thrive in gold bulls, and as this particular bull heats up, more and more investors are looking for a venue in which to entrust their speculative capital. Junior golds lie in an adrenaline- and risk-laden sub-sector that can sure take investors on a wild ride. And picking winners in these small-market-cap stocks can yield monstrous gains.

But unless you have countless hours of free time to research the junior golds, it is often difficult for the average investor to know where to start to discover some high-probability-for-success winners. Among the hundreds of junior golds out there it is indeed difficult to thresh out the good from the bad.

Over the last few months I've spent quite a bit of time researching junior gold stocks in order to discover some potential winners. In addition to a recently published research report identifying our favorite junior gold stocks, I found that there are some very useful areas of research that all investors should consider before they speculate in this gold-mining class.

I have refined these important areas of research into five major sections. Each of these sections can reveal a wealth of information that should help guide the decision-making process of which juniors in which to invest. With a little diligence, any motivated investor can use these threads of research and apply them to any junior gold stock they choose.

In the first part of this commentary published last week, I dove into the importance of looking into a junior's history/management, exploration and resources. Strength in each of these areas is vital for the success of a junior gold stock as are these next couple sections that focus on the importance of geopolitics and financing/funding.

Geopolitics: Geopolitics are always a key component to consider before investing in any resources company. This is especially important for gold due to the growing scarcity of historically safe gold-mining venues. Today more than ever gold miners are forced to scour the far corners of the planet in order to discover the gold deposits of the future.

Unfortunately a sizeable portion of the untapped global gold resources grace some not-so-popular regions of the world. And in order to supply the future demand for the Ancient Metal of Kings, the gold industry must increasingly deal with corrupt governments, cultural challenges and logistical nightmares.

In first-world free-market gold-producing countries such as Canada, Australia and the US as well as Marxist-led gold-rich South Africa, it has become increasingly difficult for junior explorers to stake fresh and exciting claims. Because of this, many juniors are forced to venture into relatively untapped countries that host varying degrees of geopolitical sensitivities.

Of the twenty junior gold stocks that populate my recently published report, only seven center their operations in the countries mentioned above. Some of the best junior gold companies are finding gold in the countries of war-torn central Africa, socialist-swinging Latin America and previously-untouchable Asia including China, Mongolia and the former Soviet Union republics.

And depending on the primary country of operation, geopolitical-risk discounts must be considered for many junior gold stocks. With the strength of our current gold bull and the push for global discovery, this discount has somewhat increased in recent years.

Regardless of the political state of a country, governments are not blind to the fact that the world economy is in the midst of a major commodities bull market. Fortunately many countries recognize that they cannot exploit and profit from their natural resources without the injection of foreign capital and expertise, thus they're respecting free markets and opening their arms to foreign investment.

But on the flip-side of this coin, there are those governments that are repulsed by the thought of foreigners profiting within their borders. As seen in recent years, many countries have taken to over-taxing and in some cases nationalizing resources that foreign companies are developing or mining.

And then there are those countries that are under-governed with the federal bodies having little control over the affairs within their borders. As a libertarian this style of government is appealing, but in non-first-world countries this usually equates to safety hazards. The threat of violence, war and terror supports further discounts to junior golds operating within countries plagued with this risk.

Most of the junior golds we look at are North America-based companies, hence their trading locale. And those juniors doing business in geopolitically-unstable countries are sometimes finding it very difficult to garner local support and/or obtain governmental permitting for a project that would likely greatly help the respective economy. Geopolitical risks can sometimes bear heavy costs to cash-strapped juniors.

When researching any junior gold stock it is imperative to weigh geopolitical risk. The country of operation needs to be strategically examined and its history and reputation with foreign business and its dealings with resource-specific companies should be considered. Sometimes the high-risk projects are valued accordingly but sometimes they are well undervalued and speculative opportunities may be available.

There are excellent junior golds that are trying to operate in such geopolitically-risky countries as Venezuela, China and the Congo that have projects valued at just a tenth of what they would be if they were operating in a safe domicile. If these projects move forward and garner support, obtain the necessary permitting and eventually pour gold, it could mean vast riches for those investors who believed in their stories and accepted their geopolitical risks.

But it is of utmost importance to remember that geopolitical risk is usually out of the control of the juniors. These juniors can indeed greatly reward you if all turns out as planned, but it is important to stay aware of any threatening situations. A project can just as easily turn for the worse as it can for the better.

Financing/Funding: All junior gold stocks typically have one thing in common, the constant challenge of financing. The continuous struggle of obtaining, retaining and maintaining working capital for operations weighs heavily on the success of a junior gold. Unlike producers that are able to generate cash flows from the sale of their metals, pure explorers do not have a recurring source of revenue to draw upon.

The primary source of capital for junior golds in the exploration stage comes from equity financing. And equity financing is a fascinating fixture within the junior gold world. But this form of financing is wrapped with intricacies that are important for a prospective investor to understand, because depending on how these financings are structured, they could eventually make or break a junior.

Now in order to maximize capital from both initial offerings and subsequent stock sales, a junior needs to build on a strong foundation that effectively tells its story. Juniors need to have the same mentality as a televangelist. The more believers a televangelist can convert the better his cash flow to support future ministries. Juniors need to gain believers in their story too in order to obtain enough capital to keep them functioning.

This is why the marketing and promotional games commonly associated with the juniors are so important. But there is a fine line these companies walk in order to balance the strength of a story and their need for capital. When researching juniors it is important to look past the smoke and mirrors that their first-look facades may present.

The reason investors need to err on the side of caution when it comes to financing is due to the unfortunate and pestilent presence of serial promoters. Some juniors may be guilty of over-promoting their assets while others are guilty of misleading investors by telling a story that is downright false in order to inflate their stock prices.

Researching this thread serves a dual purpose. First, it forces you to utilize other aspects of research that include history/management, exploration, resources and geopolitics to determine the strength and legitimacy of the story a junior is trying to tell.

The second lies on the other side of the line where you may come across a junior that is poorly marketed and not spreading its story well enough. In this case diligent research could prove to present a great buying opportunity. Regardless of its promotional prowess, the interest in and demand for a junior gold stock ultimately contributes to the amount of capital it will receive through equity financing.

It is also important to keep an eye on the structure and volume of any private placement(s) a junior may be party to. A typical junior-level private placement of shares, especially from the release of shelved shares after the company is public, consists of a consortium of investors that subscribe to shares and/or warrants at a fixed price.

In many cases some of the investors in a private placement are indeed the firms or individuals tasked to market and promote the stock. This is acceptable, but be leery of aggressive marketing campaigns that might correspond with the timing of the unlocking of restricted shares. Don't buy on hype, but on unbiased and intelligent research.

Once financing is procured it is then prudent to find out where the money is going. A good junior should be using the lion's share of its financing for exploration with a small and reasonable balance for other expenses such as compensation and marketing. This information is easily obtainable within the public filings of their financial statements.

Another thing to look at for the capital-challenged juniors falls in the project funding game. If a junior is strong enough so its equity financings can take it all the way to the final feasibility phase of a gold project, then it must begin to consider obtaining the funds to actually construct a gold mine.

The small minority of juniors that actually make it to this point find that the capital costs required to construct a gold mine usually dwarf the costs of exploration. This is one reason why many juniors that get to this phase will either joint venture their projects to a senior partner that can manage the funding or just outright sell them to the highest bidders. In reality, very few juniors actually construct and operate a gold mine.

Constructing a gold mine can cost from the tens of millions on the low end up to well over a billion dollars on the high end. With most junior gold stocks having market caps well under $1 billion with very limited working capital, equity financings are often not enough. So if positive feasibility tests give the green light for mine construction, these juniors need to muster up some serious capital to move forward. This capital usually comes in the form of debt financing.

For those mature juniors that are taking the path toward gold production, project funding is an area that needs to be closely examined. Once the tedious technical studies and environmental permitting are complete, large international banks are usually called upon to provide debt facilities that allow the juniors to construct a mine.

And because these banks are lending money to small companies with no collateral that do their business in a sector that is highly volatile and at the mercy of the markets, a lot of intricacies are packaged into the loan requirements.

Quite unfortunate for the junior gold explorers but in most cases necessary through the eyes of the bankers to partially protect their money, some variant of hedging is likely to find its way into the loan requirements. There are different ways a hedging facility can be structured, but the most common is in the form of forward sales. Forward sales are exactly what they sound like, selling forward a portion of future gold production at a fixed price.

It is very difficult to find an early-stage gold producer that is not slave to hedging. In a bear market hedging was the smart bet for many miners, but in a bull market hedging can really hurt profits for many years until the obligation is either met or restructured. Imagine being locked in to selling gold for $400 per ounce while the open market is paying hundreds of dollars per ounce higher, ouch! So though hedging seems like a necessary evil for some of these small companies to bootstrap their way to future success, it is still prudent to examine the details of any hedging arrangement.

When examining a hedging structure, a heavy hedge can indeed be a show stopper in the speculation decision. I like to look at junior hedging arrangements as a portion of their total gold reserves. If too high of a percentage of gold is sold forward, then it is not worth risking your capital in a company where a bull market would eat it alive. But if the hedge appears like it will not be too heavy a burden in the future and rests on a minority of the gold reserves, the junior might be worth the risk. Each situation should be examined independently.

Conclusion: History/management, exploration, resources, geopolitics and financing/funding should all be viewed objectively. Each of these areas of research can be weighted differently depending on the junior gold stock in question. Depending on the size and stage of a junior some of these areas may not be applicable.

And believe it or not junior gold risk usually scales with size. Though not always the case, the larger the junior the less risky it should be. In my eyes there are four different levels juniors can fall into. The largest and most mature juniors are on the verge of becoming gold producers. These juniors have completed advanced studies on their gold projects and are about to or have started construction of a gold mine. For these strong juniors gold production is imminent within the next 24 or so months.

The next level junior hovers around the mid-tier level. This company has resources through preliminary positive technical studies and has a defined drilling program to advance its project(s). Within the next 12 to 24 months this company expects to make an economic viability decision on its flagship project.

The next level junior a good friend of mine has coined as the "nano-junior". This junior is on the very small side of the scale as far as valuation goes yet has promise looking forward. This company could be just getting started in the resource development game and has land holdings that are "promising" with very early testing showing encouraging results.

And the last level junior I have dubbed the "dot-junior". This junior, like some of the infamous dot-commers of the tech bubble, is a trend chaser, a serial promoter or a schemer. It typically spends more money on marketing, promotion and salaries than it does on exploration. And its sole purpose is to exploit the gold bull and shamelessly suck in some of the capital that junior gold stocks command. The dot-junior has no desire to ever become a gold miner yet can be stealthily disguised with a pretty website and fancy "market speak". Beware of the dot-juniors.

Are the juniors you are looking at poised to blossom in this gold bull market? A company doomed for failure may have good initial momentum as it follows the industry trend, but when it's revealed that it has poor assets without a legitimate business plan it will swallow investor capital so fast there is no chance of recovery.

At Zeal we perform independent commodities-stock research and reveal it incrementally to our newsletter subscribers as market conditions warrant as well as through the detailed profiling of our favorite stocks in a given sector in our research reports. If you are interested in cutting-edge commodities-market analysis and stock picks, please subscribe to our monthly Zeal Intelligence newsletter today. And if you would like our latest junior-gold research report at your fingertips, it is available now.

The bottom line is due diligence is essential for successful stock picking. And for the junior golds it is even more important as this riskiest class of mining stocks has very little coverage outside of juniors' self-directed marketing and promotional campaigns. Any investor though can use the research tools I highlighted above and apply them to any junior.

As this secular gold bull matures and continues to gain more popularity, a larger pool of capital from mainstream investors should greatly bid up the gold stocks. And among the gold stocks, the juniors should really thrive as their exploration projects stand to greatly influence the future of the gold industry.

Scott Wright

January 5, 2007

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