Junior
Gold Stocks 3
Scott Wright
"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
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