The junior gold and silver mining sector is going through an extremely tough period. Investors are facing an equally tough challenge in their investment decisions. There is a reason why resource investing is known for having the highest volatility of all sectors.
Where are we in the bear cycle? Is the bottom in or could it get worse? In trying to answer those questions, we rely on the latest data from Casey Research plus a very interesting discussion between precious metals expert David Morgan and talented mining builder Amir Adnani.
The sector (GDX) in general is beaten up, but especially the junior miners (GDXJ). The following data show the evolution over the past year in bullion vs senior and junior miners (courtesy Casey Research). The junior gold and silver miners are down year on year with an amazing 30%, making them the worst performers in and outside the precious metals sector.
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As counterintuitive as it seems, it is only in times like these where seeds are being planted for once-in-a-decade future profits. This is how David Morgan looks at the sector:
It is an individual choice to hold only physical or a combination with mining shares. There is more opportunity to build wealth in the mining sector than in physical bullion. There is an incredible opportunity in the junior mining sector right now.
Strategically chosen stocks are the underlying condition. Well managed, well thought through and well financed junior companies are in the position to acquire bullion in the ground, either through economically viable properties or through acquisitions. Morgan rightfully says that it is not the case for many of the junior miners. He also refers to trusted analysts who point out that half of the companies in the TSX-V could not exist in two years.
It is really a separation period of those companies that have good management, projects and assets vs companies that are hoping for that. This separation process will probably continue for a while like that.
The following chart by Casey Research illustrates Morgan's point. It shows the number of new IPOs on the TSX-V vs the stocks that are withdrawn. The number of withdrawals from the exchange is for the first time higher than new IPOs. It indicates that the process of cleaning is raging at full speed.
Additionally, Rick Rule, a very respected resource investor who became a billionaire in the sector, said that only an absolute minority will be among the winners (source). That minority is already bottoming.
We are going back to 1991, a period in time that was characterized by frequent delisting of junior companies. That movement will likely start in the first quarter of 2013. The best 5% to 15% of the juniors and explorers have probably already bottomed although the bottoming process may take an additional period of six to 12 months. Occasionally, however, we will witness pretty dramatic escalations, comparable to the best-in-class juniors in 2012.
When Rick Rule refers to "pretty dramatic," he really talks about ten-baggers. That is the potential out there for investors willing to spend enough time picking truly the best junior miners. In the meantime, miners need to spend more on exploration as the discoveries are decreasing year on year. It has become very tough to find economically viable properties. The number of gold deposits that are 3 million ounces or more have become much smaller than some years ago. Mining costs are rising as well.
The latter point was also detailed by Casey Research in the following quote and graph:
This tells us in simple terms that the average exploration-stage company, after deducting their liabilities, has very little cash to continue funding their operations. After they pay off all their liabilities, they have only 0.2 cents per share to spend on drilling, for example. By these numbers, a company with, say, 50 million shares outstanding would have only US$100,000 left after its total liabilities are deducted from cash.
A testimonial comes from Amir Adnani, president of junior gold miner Brazil Resources (BRIZF.OB) and part of the most talented mining builders in Casey's Next 10. In his interview with David Morgan, he says that nowadays only long terms trends matter. The time has gone in which excellent news moved a stock. His company is building competitive advantage via acquisitions, asset creation, capital structure, and people. Brazil Resources did more acquisitions in the last two years than the years before, given these tough market conditions. No wonder that since the IPO in May 2011 the company's share price has almost doubled, while the rest of the junior sector has been beaten down between 30% and 50%.
Morgan adds to it that investors on the outlook for tomorrow's winners should pick out junior miners that are strong in all areas of their business. Those companies are scarce.
In closing, it is fair to quote Rick Rule who was spot on to point to the big fallacy of investors:
If you are not doing the work to segregate the wheat from the chaff then get out of the sector. People wanted to be in the sector in 2010 at the market top, and they don't want to be in the sector three years later with the prices 70% off. It is like someone walked in the street and ignored every store that a 'for sale' sign and went to the only store that had the 'full price, no discounts ever' sign. Now is the time to time to buy as we are in a bear market. We sell high in a bull market; we buy low in a bear market.
Note: David Morgan discloses he owns shares of the two companies of Amir Adnani.