How to Pick a Junior Gold Stock

Successful speculation in junior gold stocks has to solve one riddle: How do you anticipate exploration successes before the financial community reacts to them?

The 12-year bear market in gold [prior to the current rally] has given you one leg up. The bear dismantled the research and information infrastructure for precious metals stocks. In the late ‘70s and early ‘80s, big Wall Street firms employed hundreds of brokers who specialised in gold stocks, and dozens of ‘hard money’ newsletters thrived. Since nobody gives medals to yesterday’s heroes, most of those gold experts long ago moved to greener pastures.

Here’s another leg up: a successful speculator builds a diversified portfolio. Placing all your eggs in one basket often breaks your basket. Always prefer a group of intelligently selected speculations to one large bet, no matter how compelling the story. A contrarian, counter cyclical orientation helps as well.

In exploration and speculation, one thing never changes: success favours the trained observer. Luck follows those who use the best tools with consistent discipline. Here are some other tools. The right answers to the following ten questions can help you decide if you even want to bother following, much less buying, a junior gold stock.

Look for Value

Question 1: “What is the current liquidation value of your company versus the market capitalisation?”

Compare the company’s actual value if auctioned off tomorrow against the value the stock market places on all of its shares. If the market cap outweighs the liquidation value, there may be a rat in the feedbag.

Speculation can’t stand on one leg alone. You have to forecast both the upside and the downside. When promoters are trying to sell a junior gold stock, you’ll hear how precious metals will soon soar, how exploration will soon hit the Mother Lode, and how their promotion will boost the stock’s price. That’s all great, but we have to weigh that against our possible downside, and value is the scale we use. Nothing reduces risk like plain, old value. If a mining company is not a viable business, there’s no reason to buy it.

A gold mining company is only worth what it owns…

Add up all the current assets (like cash), subtract the liabilities, and add the liquidation value of all the company’s mineral projects. Liquidation value means what the projects would bring in as is.

What’s the market cap? To calculate it, multiply outstanding shares by the current market price. With 10 million shares outstanding quoted at $2.50 a share, the market capitalisation is $25 million. If this company has $5 million in cash and no debt, its net financial assets are 20% of the market cap.

Assume the company has four gold exploration properties. With a cold and steely eye, assign each of them a value. Now let’s add it up. Net financial assets of $5 million and say, property assets of $12.5 million for a “guesstimate” liquidation value of $17.5 million, versus a market capitalisation of $25 million. If the management can answer other questions, this could be a sensible speculation. More often, however, we find market capitalisations of $100 million and liquidation values of $2 million.

Look for Personnel

Question 2: “Tell me about your management and directors, especially about their past successes in mining and markets.”

Past winners are more likely to be future winners. Whey do we need to understand the track record of the technical team, the directors and the dominant shareholders? Most successful gold mines are made, not found. It takes technical prowess to unlock the deposit’s geology to production. It takes financial prowess to unlock the capital crucial to mining, so the management team must include experienced, proven fund raisers.

Do their skills fit the job? If the team cuts its teeth strip mining oxide gold deposits in Nevada, it may break those teeth on underground silver, lead, and zinc sulfide deposits in Peru. Be particularly leery of exploration teams with little production experience who are out to build and operate a mine rather than to sell the deposit to someone more experienced. The reverse can hold true as well: Mine operators are often poor mine finders. The tasks don’t resemble each other, and what’s successful in one field is often unsuited to the other.

Look at the controlling shareholder’s track record as well. Has he made money for investors in previous deals? Sorry, it’s not enough to make a mine - we want to make money. Be picky here,too. Can the dominant entrepreneur transfer his experience to the project at hand?

Look for the Means

Question 3: “How are you going to make me money on this deal, and when will I make it?”

This is the question the gold stock promoters want you to ask, but make sure you control the conversation so they actually answer it. I once heard a stockbroker explaining a venture capital investment in a technological process. One potential investor asked, “How does the process work?” The broker replied, “It works fine!” Beware of such answers.

Make the promoter explain in detail how the company’s exploration activities will increase both shareholder value and stock price. Why these questions? We want to understand what sequence of events management believes will occur over that time, and how that will affect share prices. We must assign probabilities to the outcomes forecast, and understand their timing and sensitivity. If management doesn’t have a plan outlined, it’s probably too early to buy.

If the company refuses to keep us informed, or if they promise and don’t deliver, we must consider selling the stock. If management doesn’t have a geological theory with a plant to explore and prove it, it’s probably too early to buy. If the results achieved are below what we’ve been led to expect, we should sell the stock.

What are the Goals and Strategies?

Question 4: “What are the company’s goals and how are they going to reach those goals?”

Thousands of public companies specialising in precious metals exploration litter the investment landscape. The vast majority have always failed. Many “penny miners” have, at best, only sketchy goals. Most have none. Small wonder they couldn’t achieve anything - they didn’t set out to!

When a company expresses goals, make them get specific. Ask about intended results on a pershare basis. What do you care if cash flow doubles and issued shares increases tenfold? Will the company’s expressed goals increase share prices? Some entrepreneurs simply seek to increase the assets they’re managing to secure their own cash flow.

Do the company’s goals seem reasonable? Will they raise share prices if they bear fruit? If the answers are “yes,” then ask if the company’s strategy fits its goals. Many companies look like Don Quixote on his battle-mule: Their goals sound grand, but they have no clue how to reach them. Measure their goals against the backdrop of the people. What is their track record for meeting theirgoals? Have they succeeded in similar endeavors? Are their backgrounds suited to their strategies?

Where’s the Money?

Question 5: “How much money do you have, how much money do you need to make me rich, and how are you going to get it?”

Watch the white-leather-shoe boys blanch when you pop this question on them. Mineral exploration is a capital intensive business: no capital, no business!

Start with current assets; cash, treasuries, bank deposits, inventories, prepaid expenses and the like, and deduct current liabilities. This should give you a rough idea of net working capital. Get a detailed description of the monthly “burn rate.” What does it cost for rent, utilities, salaries, promotion, expenses, professional fees, listing expenses, etc.? then superimpose projected exploration expenditures on a monthly basis. If the company has any debt, make sure to add in the interest and principal payments.

This exercise narrows the playing field fast. Many small public exploration companies with less than $1 million in net working capital spend $600,000 annually on non-project overhead, while they need to spend several million on exploration to meet goals (and make us money.)

Finally, where will they get the money they need? Years ago at a gold mining conference, I spoke to an erstwhile promoter who didn’t know my face. I asked him where he would solve his working capital problems and he informed me that a “hot” west coast broker named Rick Rule would raise all the money he needed at much higher share prices. Imagine his surprise when I identified myself and explained the likelihood of his phantom financing!

When companies detail their financial plans, ask what conditions apply to the receipt of funds. Decide for yourself whether the companies will receive the necessary infusion of cash and on what terms. If possible, get the names and the phone numbers of their financing sources, then telephone those sources and verify that the capital is available. See if the preconditions and terms match the company’s own understanding.

Where is the Owner?

Question 6: “Who owns this company? How much did they (or will they) pay for it, and when can they sell it?”

Make the junior gold stock company explain its capitalisation history to you. If there were escrow or founders shares (shares issued for $0.01 to early insiders,) who got them, for what service, and when will they be free to trade them? Determine at what price every financing has taken place. Is the stock fromthose financings already free-trading, or can it hit the market later to depress share prices? How many options and warrants are outstanding? At what price can holders exercise them?

What About Promotion?

Question 7: “Who else will you tell this story to, how will you tell them, and when?”

Promotion often makes the difference between success and failure. Promotion is crucial in capital intensive businesses because it raises subsequent financing with less dilution and increasing liquidity and share prices. Since exploration companies seldom pass out gold watches to thirty-year shareholders, you want increasing share prices.

Make the company (preferably its promoter) detail its promotional plan. Who is the audience? What is the message? Who is the messenger? Do the three mix? What is the promotional budget? Is that sufficient? How will the promoter raise additional capital? At what price and from whom?

Companies must budge at least $150,000 annually for promotion. Sad, but true. At least two management road shows through Melbourne, New York, and London should be scheduled annually and one yearly tour of the company’s focus properties for analysts.

Institutional investors finance exploration but retail investors worldwide provide market liquidity. Promoting to only one constituency is a flawed strategy. Promoting to retail investors should take into account their large numbers. Will a company spend its promotion budget in a market where retail investors have money?

Make sure the promoter knows and complies with federal and state laws. If the promoters are not aware of these regulations and don’t have concrete plans for complying, forget about their stocks.

Where Can it Go Wrong?

Question 8: “What can go wrong, how can I know what is going wrong, and what will you do if it goes wrong?”

If a company management can’t name at leastthree things that could go wrong, they haven’t thought through their enterprise. Make them describe the three worst fears for you as a minority shareholder.

Make the promoter describe specifically how you as a shareholder will get negative information and warnings. Ask what telltale signs you should look for and how you will get information (from the promoter, by fax or e-mail is the best answer) to help you assess these risks day-by-day.

Who is Your Promoter?

Question 9: “Who’s buying the beer?”

If a company has answered these questions in reasonably good form, get to know the promoter personally. No company will answer every question perfectly, but candor and reasonable responses will tell you who to spend more time with. As you build a bond with the promoter, get him to tell you the real story. Because your interrogation took control of the promoter’s spiel, you have helped him order his thoughts about the company. Now let him lapse into “stream of consciousness,” and listen carefully for tidbits of information you would never get from his canned spiel.

Where’s the Dope?

Question 10: “Where can I learn more?”

If you are still interested, this could be a great company. Get their annual and quarterly reports as far back as you can. Read what they hoped to accomplish, and compare that to what they did accomplish. Get newsletter write-ups, securities analyst’s reports, and news releases as far back as you can. One final trick: Summarise your understandings in writing and see if you can get the promoters to accept your memo as true and correct. Hold them to their representations.

Rick Rule
for The Daily Reckoning Australia

Rick Rule is a principal shareholder and senior analyst for Global Resource Investments, Ltd. Rick began his career in the securities business in 1974, and has been involved in natural resource security investments ever since. He is a leading analyst specialising in mining, energy, water, forest products, and agriculture.

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