Junior Gold Stocks 3

Scott Wright March 28, 2008 2836 Words

“Junior gold stocks” is a three-word expression that for some breeds dismay, trepidation, and anger. But for others it illuminates excitement, opportunity, and profits. Regardless of which camp an investor resides, one thing is for certain. During this fantastic 7-year-running secular gold bull, the junior gold stock realm has been host to a highly-volatile range of sentimental extremes.

Sometimes investors who speculate in the junior market are burned. And being burned on a junior gold stock can certainly be harmful to one’s capital. This is just one of many reasons for the lack of investor loyalty toward juniors. When this group is underperforming, traders are quick to capitulate and it doesn’t take long for this tiny sector to become the pariah of the markets.

But the reason investors do speculate in juniors lies on the other side of their inherent riskiness, their high-reward potential. When the juniors are in favor they can quickly return legendary gains. Rapid and robust gains always attract traders to a sector regardless of the risk.

And the rewards for speculating in the future hopefuls of the gold mining industry have proven to be colossal. Though there is no junior gold stock index that I know of to measure their gains as a whole, we can look to the producers to give us a baseline of some of the gains thus far. The HUI gold-stock index is the premier index for gold stocks, comprised of elite producers, and has seen an incredible 1331% bull-to-date gain.

But throughout the course of this gold bull the majority of the best-performing gold stocks have been the juniors. The premier juniors have seen gains actually far exceed the HUI’s. When a small-market-cap low-volume junior makes a discovery and/or banks resources, its stock can launch parabolic on very short notice.

These fast ascents are possible because juniors usually start out with nothing. And without a project that hosts high-potential gold mineralization, it should be assumed that a junior has nothing. In reality odds are highly stacked against juniors. It takes a lot of skill and capital mixed with a little luck to discover, explore, and develop a deposit that may or may not turn out to be economically feasible. In reality most juniors will fail.

So when a junior does have a successful exploration campaign its exposure and market capitalization should grow. From a fundamental perspective this makes absolute sense. In the process of going from nothing to something a junior is transformed from a company with hopes and dreams tied up in a plot of land to a company with actual assets, and valuable ones at that.

But while juniors continue to do what they do best, explore for gold, these stocks haven’t seemed to reflect the recent run up in the price of the metal they seek. Since August 2007 when gold began its march higher from the mid-$600s, junior gold stocks have been treated like the bald-headed step children of the gold-stock sector. And the fact that many juniors trade at the same levels today as they were trading at $300 ago on gold has not sat well with folks.

To take this underperformance even further, gold stocks in general have had a sluggish feeling about them throughout the course of this latest upleg. And the root of this seemingly perpetual unlove comes from generally rotten industry-wide sentiment. Even though the HUI had risen from 300 in August to its recent high of 515, an impressive 72% gain, those deployed in gold stocks haven’t been feeling the love.

Now in each and every upleg there is indeed a circus of sentimental extremes. Even in massive uplegs 2, 4, and 6 that averaged gains of 136% over about 9 months, investors had to constantly climb a wall of worries to get to the top. While constants do hold in each upleg, does current upleg 8 have a different look and feel than the rest?

The main thing that has bothered gold stock investors lately is decreasing leverage. Over the course of this bull gold stocks, as measured by the HUI, have exhibited positive leverage to gold of 4.6 to 1. While this positive leverage is fantastic and has made investors a lot of money, it is to be expected.

Gold mining is an inherently risky business. Not only are mining companies slave to gold’s volatility, but they must also deal with risks on the geological, operational, geopolitical, and managerial fronts. Gold stocks bear much more risk than their underlying commodity. Therefore their gains should rightly augment gold’s gains or else there would be no reason to own them. And this risk/reward tradeoff should be amplified even more for the junior gold explorers.

With gold rising 54% over the same time span as the HUI’s rise of only 72%, this perception of sub-standard leverage is in fact tangible. In this upleg gold stocks are averaging less than 1.5 to 1 leverage to gold. Because of this the multitude of gold-stock traders is perhaps righteous in feeling they haven’t been adequately rewarded for bearing the risks of owning these mining companies.

At Zeal we’ve closely monitored the HUI’s leverage to gold since this bull began. We’ve written several essays on this topic and update a chart each week in the subscriber section of our website that monitors this leverage model. And in our most recent thread of research my business partner Adam Hamilton penned a revealing essay that isolated leverage within each individual upleg.

While it is apparent that leverage has been declining over the course of this bull, Adam found that there is no need for alarm yet in the current upleg. Within any upleg the HUI’s leverage to gold greatly varies at any given time. And historically it isn’t until the final third of an upleg that the truly big gains happen.

Interestingly in past uplegs about half of an entire upleg’s gains are realized in this final third. And it is these massive late-upleg gains that typically give gold stocks the positive leverage that investors expect. This final third is also where the unloved juniors come into play.

Since most juniors are too small for institutional investors and fund managers to trade, and individual investors aren’t as exuberant early on in an upleg, they typically don’t get very much early attention. So while gold stocks indeed rise with gold, the juniors often suffer a lagging effect.

But since it is the individual investors that typically drive the fortunes of the juniors, when they get excited the juniors take off. And as we know from previous uplegs, it isn’t until the end of an upleg when the majority of individuals captures this excitement. So naturally with large increases in capital chasing the small-market-cap low-volume juniors, the environment becomes ripe for rapid ascents of these stocks.

Ultimately while at times it is very frustrating owning junior gold stocks, it should not be a surprise that the performance of this group is inadequate in the first part of an upleg. Trader sentiment gradually improves as an upleg progresses, and when greed waxes extreme individual traders inevitably pile in to the juniors and fuel colossal gains. Juniors are the greatest beneficiaries of euphoric spikes.

Aside from the general malaise juniors experience outside of the sentiment spikes, some people believe another hindrance might be holding them down. And this surrounds the major problems in the global credit markets mixed with general stock market volatility to the downside.

Since the majority of juniors has no cash flows they rely solely on equity and debt financing. Therefore today’s prevailing economic conditions may have an impact on a junior’s ability to raise the necessary capital to fund operations. And a weak stock market doesn’t help either. It makes it all the more difficult to not only sell shares but price them high enough to raise sufficient capital.

While these economic dilemmas certainly create valid concerns, I have yet to see financings grind to a halt for the juniors. And considering the gold environment today this is not likely to happen any time in the near future.

Unfortunately all these leverage and economic fears often cause folks to discount the critical role juniors play in the gold mining cycle. Thus sometimes it is important to step back and rethink the vitality of these companies. And their role becomes apparent when you take a strategic look at the health of the greater gold mining industry.

Interestingly after 7 years of rising gold prices, global mined gold production continues to fall as miners are finding it increasingly difficult to extract this precious metal from the earth. Since the industry’s supply peak in 2001, gold production has been on a downward trend. In fact 2008 is on pace to make it a four-year running decline in global production.

And looking forward the miners’ ability to supply the market isn’t going to get any easier. With the demand for this yellow metal continuing to grow there is no slack for the producers. They must renew reserves and grow production in order for this industry to maintain some semblance of balance.

This means on the exploration side of the gold cycle that economically feasible gold mineralization needs to continually be discovered and developed to replace aging and depleting mines. But even after 7 years the gold mining industry still seems to be behind in procuring its inventory for the future.

This is in large part due to the lack of exploration in the second half of the last secular gold bear. The price of gold was so low in the 1990s that there was very little capital available to fund gold exploration. So with financing options dried up, gold companies got behind in procuring the appropriate inventory to replace future production.

Also hindering this replacement issue is the lack of major discoveries in the last couple decades. The discoveries of multi-million ounce deposits are becoming fewer and farther between. And outside of the effects of a gold bear another reason for this is major gold-producing and geopolitically-safe countries have been pretty well scraped over. This is forcing gold miners to look elsewhere for gold, in regions that tend to be geographically challenging and geopolitically hostile.

So where do the gold juniors come into play? Well even though the existing gold producers of the world perform active exploration internally, many are not able to renew their resources fast enough to replace production. In order for the gold industry to survive, and grow, the next-generation gold producers and primary exploration companies play a vital role in supplementing the existing producers’ shortcomings.

Whether it is juniors being acquired by the producers or turning into gold miners themselves, their role is crucial. And the juniors understand the opportunities available to them. With the price of gold soaring and many producers unable to ramp up supply, the doors are opened for these eager entrepreneurs to get a piece of the gold pie.

And though the underlying mission of a junior gold explorer is to actually find gold, today’s juniors come in a variety of flavors. They range from the shameless promotional outfits that have no idea what to do with their randomly staked land holdings to experienced industry veterans that are proficient at exploration and discovery. Regardless of where a junior falls in this continuum one thing is for certain, there are a lot of them.

Today’s hefty population of juniors is a stark contrast to just a short time ago. At the turn of the century the business of gold mining was abhorred. As gold fell to its bear low near $250 only a handful of junior gold explorers could be found. Today as the fortunes for gold have changed there are now hundreds of juniors. And new ones seem to be hitting the markets every week.

While a junior’s role in the gold cycle has not changed, choosing the juniors in which to speculate is now much more complex than it was in 2000. Like separating the chaff from the wheat, it takes prudent analysis to separate the duds from the promising juniors.

But with gold stocks disliked and juniors loathed today, is it even worth the time to thresh out the most promising juniors? Yes! In fact usually when the juniors are downtrodden and rejected, intra-upleg, it is the best time to buy. When gold stocks return to favor and euphoria runs rampant, the juniors will be the best-performing stocks in the gold stock sector. And based on our studies at Zeal, we believe probabilities still favor a soon-to-unfold final-third run in our current upleg.

So once you muster up the courage to trade in the junior realm, the next major task is to identify the stocks that have the highest probability for success. And the best way to discover these high-potential juniors is through diligent research and analysis.

Investors must peel away the layers of each company that piques their interest in order to understand their core fundamentals. Due diligence is imperative before you trust your hard-earned capital to the fate of a junior gold explorer.

When folks come to me and want to know how to research a junior I usually highlight some key areas of focus that are essential to understand. In a series of essays I wrote a little over a year ago I detailed what to look for in some of these areas.

From a high level, first it is important to understand the qualifications and history of the management team. In junior gold exploration it is usually nice for the management team to have a strong technical background. If this area is lacking they need to surround themselves with an experienced team of geologists and mining engineers.

From here you’ll want to take a look at the quality of projects and the strength of the resources that may already be identified. In the process of doing all this it is also important to consider the geopolitics of the countries in which the projects are located. Then of course you cannot overlook the financials. Examining the balance sheet and understanding the impact of previous financing decisions can be very telling.

I encourage you to peruse these previous essays for more details in each of these areas of focus. When all these research areas are considered in aggregate, you can then formulate an opinion on whether you like a junior or how it may compare to the others.

Ultimately with the hundreds of junior gold stocks to choose from today, it can be quite an undertaking to sift out the winners. This is why deep fundamental research is more important now than ever before. And this is why even our own research team has had to dedicate a lot more time and effort into the stock research the feeds our newsletter trades.

When we do stock research at Zeal we do it one sector at a time as comparables force out the winners and losers. Our latest project took a look at nearly 300 junior gold stocks! And after analyzing each stock we pared down the group to come up with our favorite dozen that we believe have the highest probabilities for success.

These stocks range from small juniors with no resources yet to some of the biggest and best that are either prime buyout candidates or the gold miners of the future. These companies have projects that either host or have the potential to host quality gold resources. And ultimately we favor these stocks because they have the potential to make an impact on the gold mining industry and can greatly reward their shareholders in the process.

Well since we can’t fit all the fascinating fundamental information for each stock in our newsletters and since not all stock traders have the bandwidth to spend time researching stocks, Zeal’s stock research has been in high demand. It is for this reason that in the last couple years we’ve been formalizing our research into a report format.

Our last research report published in November on Zeal’s favorite gold-producing stocks was exceedingly popular. But it also led to countless requests for us to take a look at the other side of the gold stock spectrum, the juniors. Well we listened and our brand new hot-off-the-presses report on junior gold stocks profiles our favorite 12. If you would like each of these detailed profiles at your fingertips, then please purchase this report today.

The bottom line is junior gold stocks, whether loathed or loved, offer gold stock speculators fast and furious gains if timed right and chosen prudently. These high-flying explorers are indeed the riskiest stocks of this sector, but they can also be the most rewarding.

Currently the juniors seem to be universally hated by all traders. But these stocks will again have their day in the sun. When investors finally get excited about gold stocks, as they should with $900 gold, this sector will again gather momentum. And those well-positioned juniors ought to be the top performers.

Scott Wright March 28, 2008 Subscribe