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The first thing to know about junior resource exploration stocks is that they are volatile. You can make 50% in a day, and you can lose 50% in a day.

This is due largely to the fact that they tend to be thinly traded. Thus, a whiff of good news, or bad, can overwhelm opposing trades. In the absence of a countervailing bid, the stock can move sharply until it reaches the point that someone is willing to step up and take the other side of the trade. If the news is bad and there’s no bid, things get ugly really quickly. Conversely, if the news is good – for example, the recent case of the AuEx (OTC:AUXVF) buy-out – the volume of buyers rushing to get a hold of stock can blow the proverbial doors off.

The chart from AuEx, just below, makes the point in a way that words just can’t.

click to enlarge

Is volatility bad? Not hardly. If you play these stocks intelligently, that volatility can act like a portfolio rocket booster. The alternative: a widely followed stock has little chance of surprising the market on the upside and so can tie up your capital for a long period of time – plodding along while you remain exposed to general market risk with almost no hope of serious appreciation.

By contrast, a junior exploration company punching holes into interesting geology is all about the potential for surprise. If the surprise is good, your stock is headed for the moon. But a poor drill hole is not necessarily a ticket to the basement – not if the company has not overinflated expectations by aggressive promotion and is following a methodical process in its exploration program.

The topic of aggressive promotion brings me to the second thing to know about junior resource stocks – namely, that most of them are borderline frauds. That’s right – the vast majority of the companies involved in the junior resource sector are headed up by management teams that have no special expertise in finding or developing economic deposits. Rather, what they’re good at is telling a really good story based on the loosest of “facts” in order to get investors to pay their overhead and, hopefully, allow them to trade out of their free or low-cost shares at a big profit.

While there are a number of signs you can look for that will give you some sense of the management’s abilities and ethics, one is that the bad apples will tend to shift their stated focus between breakfast and dinner, depending on the flavor of the day. One minute, they are a junior gold company, the next they are on to the world’s hottest lithium find – then sometime after lunch, they morph into being a uranium explorer.

That’s not to say that there aren’t times when competent management teams are faced with the reality that their primary resource target is going to draw a blank, and move on – it happens all the time. The trick is to be able to discern the difference between a strategic retreat and an opportunistic bunny hop into another area where the management has no real expertise or value to bring to the game.

To help our subscribers understand the difference between a competent explorer and a paper tiger, years ago we started the Explorers’ League. In order to be inducted into the league, you have to have been responsible for a minimum of three economic mineral discoveries – but most of our honorees have a lot more than that. This is no small feat when you consider that probably 98% of the folks in the mining business will retire without a single economic discovery to their name.

Ron Parratt was among the first of our Explorers’ League Honorees – the subsequent success he had with AuEx has only once again confirmed the importance of backing winners.

The next thing to focus on is the size, and the general set-up, of the targeted resource. I saw an exploration company advertising on a major financial web site that was breathlessly talking about the 30,000 ounces of gold it had discovered.

While I suspect a borderline or even overt fraud, in the best-case scenario, building expensive advertising campaigns around 30,000 ounces of gold – a truly inconsequential amount – would indicate that management is hopelessly ignorant of the realities of the business. And the reality today is that, depending on a number of variables – location, geology, local politics, metallurgy, infrastructure, etc. – the minimum resource required for a company to have any chance at success is in excess of 1 million ounces of gold. But, really, you should only be focusing on companies with the very real potential to prove up 2 million or more ounces.

In exploration plays, size counts.

And don’t confuse gross metal value with anything remotely resembling reality. In fact, any company that would even mention the gross metal value of its resource is sending you a very strong signal that something fishy is afoot. For those of you new to the game, gross metal value is derived by doing the simple math of multiplying the companies’ ounces (or pounds, depending on the metal) in the ground by the current price of the commodity.

Thus, a company with a market cap of, say, $50 million and a resource in the ground of one million ounces of gold might tout a gross metal value, based on today’s price of $1,250 per ounce, of $1.25 billion. The implication being that the market cap of the company will soon rocket in the direction of the gross metal value… wink, wink, get it while it’s hot and all that.

Now, I don’t have time to list all the ways that the gross metal value gets hammered down to a net that is a fraction of the total… and, more likely than not, even to the point where the deposit is uneconomic. But I’ll give it a quick try anyway.

For starters, there’s the cost of the infrastructure required to actually extract the mineral. While even the cost of building an open pit mine is huge, if the deposit is too deep for that, then you’re talking about going underground, which can be much, much more expensive. Depending on where the resource is located – and most new discoveries are very remote (Congo, anyone?) – and the depth and structure of the mineral resource, building out the mine infrastructure can cost in the hundreds of millions of dollars, and even billions.

Then there are local politics. For instance, how much of the mine will the government want to keep for itself? How high will the taxes and royalties be? Is the area secure? There are projects I’m aware of that, in order to be built, will require essentially maintaining a private army to keep local revolutionaries and thugs at bay.

How’s the metallurgy? Extracting metal from close to surface, oxidized deposits can be relatively easy and effective, with recoveries in the 90% area. But if the target mineral is bound up with all sorts of detrimental minerals, the processing costs will soar and recoveries plummet… often to the point where the overall costs, and the challenges of disposing of the toxic waste, can torpedo even a very large project.

Mining requires a huge amount of power… where’s it going to come from? Can you imagine the cost and hassle of having to build, say, 60 miles of power lines? How about if the deposit is located in a remote corner of the Yukon?

I could go on and on… but you get the idea. There’s a reason that well over 90% of even legitimate resource discoveries never become economic mines. That doesn’t mean you can’t make money off a discovery play – but if it has little chance of becoming a mine, then you need to be clear on why you own it and when it’s time to sell.

The bottom line on how to make serious money as a speculator in anything – the junior resource exploration business merely provides a convenient example – is to identify a volatile, high-risk/high-return investment sector, and then get to know the sector intimately. By doing so, you can eliminate much of the risk, leaving you mostly with the huge upside. And what risk is left is very manageable.

And don’t forget – I’m talking about investing only a relatively small part of your portfolio… 10% to 20%. You can tuck the balance of your portfolio into assets with a much lower risk profile. These days, that might include gold and, for the time being, cash.

Disclosure: No positions

Source: How to Make, Or Lose, A Fortune in Junior Exploration Stocks