Junior Golds 101

Scott Wright, Zeal LLC
[Adam Hamilton's partner]
February 25, 2005

In the midst of the glorious early stages of the secular gold bull, junior miners (juniors) have become increasingly popular among the investing public. In a market where the flagship HUI unhedged gold stock index has seen its latest, but certainly not last interim top at +614%, the prudent investor is in pursuit of that diamond-in-the-rough, low market-cap, little-known junior that could reap legendary gains.

Though 614% is certainly not chump change, each major HUI upleg consistently produced chatter as to which junior gold stock was rocketing to Mars and blowing the majors out of the water. It is certainly no surprise that the risk factors associated with investing in juniors could reap stellar rewards in uplegs.

Likewise, each major correction produced chatter as to which juniors were getting hammered flat. It is also no surprise that juniors were getting pounded in corrections. Many small-cap stocks, especially junior miners, are very illiquid and have considerably more trouble than larger stocks stabilizing damage control during a sell-off. Therefore it is righteous for the riskier stocks to have more dramatic ups and downs in the flows and ebbs of any cycle.

In riding this gold bull, our primary gold stock analysis at Zeal has centered on discovering the best-of-the-best gold miners for personal investing and recommendation to our clients. Many of the stocks we have favored past or present have been producing mining companies. Companies that are relatively mature and financially stable as well as possessing sound fundamental and technical qualities that position them to launch parabolic as the gold bull picks up steam. So what is it that's so intriguing and alluring about these juniors? 

To get a handle on this question, a few months back I took on the arduous task of looking into the hoopla surrounding juniors. Before we dig into this, I should probably introduce myself. You are probably used to Adam Hamilton's commentary from Zeal each week. As you may have noticed, I am not Adam but a speculator that goes by Scott Wright, a fellow principal with Adam at Zeal. For some time now Adam and I have been tossing around the idea of rolling up our sleeves and really getting to know juniors. As students of the markets we love learning, and we hoped this would lead to superior trades for our clients.

I wanted the 30,000-foot view of where juniors really fall in the whole food chain of the mining industry, as well as to dig deeper into their fundamentals. If the potential for a monstrous reward is worth the risk of speculating in a junior miner, then which ones do I pick and how do I pick them?  After doing much research and wading through the window dressings of hundreds of juniors, it is still difficult to see through the fog, but thankfully the fog really isn't that thick.

The gathering and presentation of useful information for juniors is not as easy and available as it is for majors. Even so, our goal of all this research is to find a basket of juniors we feel are worthy of investment. Juniors that we feel fundamentally comfortable with, considering the information provided, to take that big risk in hopes of reaping legendary rewards. To carve a hole in the fog, we'll take a closer look behind the curtains of these juniors.

In our quest to flesh out the true essence of where juniors fall in the economic cycle of gold mining, we must travel back in time and let history draw us an analogy. In 1848, gold was discovered in California by James Marshall at the sawmill he ran for the ambitious Swiss settler John Sutter. Marshall and Sutter tried to keep the discovery quiet, but rumors quickly spread.

For those looking early on, gold was so easy to find along the American River in Northern California it was like dropping a hooked worm into an industrialized trout pond. As one would guess, word continued to spread eastward not only within America but across the world. The Gold Rush was on!  By 1849 a glut of high-risk entrepreneurs was swarming to the West Coast to get a piece of the action. Since most of them left home and headed for the promised-land that year, they were dubbed the "49ers."

Today's junior miner is a modern-day version of the old-time 49ers. We would consider them gold-seekers, gold-diggers and gold-panners among many informal titles. In reality though, miner is a generous term affixed to this class of entrepreneur. Most "junior miners" do not mine at all. As we will discuss later, there are different paths juniors take depending on their business plans and their capital when it comes to physical mining.

Most, if not all juniors are explorers. They are the industrialized Indiana Jones of today in search of the next great mineable gold deposit. As we will discover, juniors are necessary as gold is not easy to find anymore. It takes more than a pan and a pick. And it sure takes more of a capital investment than throwing your shovel in a covered wagon and heading out West. Junior explorers have various ways of staking their claims and have different strategies for chasing the elusive mother lode.

Solid juniors are of vital importance in today's chain of precious metals production. If we were to rely solely on existing major gold producers to supply future markets with enough gold to come close to meeting demand, woe to the day they run out, yikes!  To provide a macro view of how juniors can survive and thrive, we need to consider the economics of the gold supply chain.

Gold producers are accountable to the markets by their inventories, formally known as measured ore reserves. These reserves are the measured and calculated assets of their claims and mines. The figures are calculated according to the tonnage and grade of gold within their terrain that can be extracted profitably based on current or projected market conditions and technology. Most publicly traded miners publish their geological estimate of reserves and resources at least annually.

With information like this available, we can gather that today's global demand for gold exceeds its supply by greater than 50% each year. With this staggering reality and the fact that the average life of mineable reserves for the major gold producing companies in the world is less than 20 years, we are faced with a serious problem. Using simple economics, this alone is evidence enough for a secular bull market in gold. It's going to take a much higher price per ounce of gold just to bring these supply and demand trends closer together.

If we break it down even further, 20 years appears to be a generous number of mineable reserves for these top mining companies. This is a simple average not weighted to compensate for companies that have low production. The companies with the top five market caps in the HUI and XAU, which happen to be five of the largest gold producers in the world measured by ounces produced each year, have only about 16 years of mineable reserves remaining at their current rates of production.

So unless Armageddon is just around the corner, something needs to be done to supplement the depleting resources that producing mines are facing if gold supplies are ever to meet future demand.

It doesn't take outside observers writing financial commentary for gold producers to figure this out. They are fully aware that in order to continue operations indefinitely, they need to continually add to their reserves. They understand that it not only benefits the lifespan of their company, but their stock price as well. If gold producer XYZ is not able to at least maintain and preferably grow reserves, then over time its mining life will decrease along with its stock price.

All prudent and successful gold miners aggressively attempt to balance this depletion problem by adding to their existing reserves via several different methods. First, most existing gold producers explore just like the juniors. They have teams of geologists staking claims and performing feasibility studies to find their next mineable deposit. They also have existing projects where promising resources have already been discovered, and will take these projects to the next level by investing the appropriate capital to test the economic feasibility of these deposits.     

Another way gold producers can increase their reserves is through acquisitions and joint ventures. This is where juniors may come into play. Since most juniors are not actually mining, these larger producers can gobble juniors up and increase their own potential reserves and mining life assuming the juniors have mineable reserves or otherwise attractive deposits that have good potential to become mineable reserves.

An attractive junior has solid mineral prospects, has put forth the time and capital into exploration and in many cases is receptive to acquisition or joint-venture creation. So as a gold producer looking to add to its pipeline, why not skip much of the exploration process and risk associated with it. What better and faster way to do this than to court the juniors?

We've outlined how juniors are crucial to future global gold production, we've looked through the eyes of the larger gold producers wanting to increase their pipelines, but now we need to think like investors. As investors, how do we anticipate which of the juniors might be a high-potential investment? 

First we'll need to look through the smoke and mirrors to figure out what breed of juniors they truly are. Yes, all juniors are not created equal. There are juniors out there with vastly different missions, visions and goals. After we gather and analyze this information, we can then hopefully make a judgment call as to whether a junior is at the top or the bottom of its class and if its mission lines up positively with that of our current bull market in gold.       

Before we outline the different breeds of juniors out there, it is very important to have a high-level understanding of the process of taking a prospective piece of land from dirt, rocks and shrubs to a producing gold mine. Within this process we'll be able to define what roles various juniors play and what competitive advantages they may have over their fellow juniors.  

As touched on earlier, economically mineable ore reserves are the bread and butter of a miner's lifespan. Reserves aren't just stumbled upon though. It is a tedious and expensive process to bank mineable reserves.   

First a decision needs to be made on where to mine. There are various ways, techniques and technologies available to guide a prospective miner to which land to target. Many times a geologic survey of the land will guide this decision.

If it is private land a purchase or leasing agreement needs to be worked out, and if it is public land a claim and/or a patent needs to be filed and maintained in order to have the rights to mine there. In the United States there is a formal process required to record mining claims on public land with the Bureau of Land Management, and in foreign countries there are similar bureaucratic organizations and mining laws to which a prospective miner must submit.

More common than just discovering a random plot of land in the middle of nowhere, juniors will strategically acquire or claim properties or projects within close geographic distance to existing gold mines that have had good production past and/or present. Another common practice is to peg a location right on top of a shut-down mine that was a past producer.

The reasons for these methods of choosing a plot are crude, yet simple. The first is a half-logical assumption that since there is a gold mine down the road that has an abundant and profitable gold deposit, surely the geology of the earth can't change that much in only this short distance. The plot of land we are on here should have a similar ore grade to that of our neighbor next door, right?  While in some cases this can be true, in many cases it proves absolutely false.

Another reason goes back to economics. Maybe this land was surveyed and/or tested in the past, but the market price of gold was so low it was not as economically feasible to extract as it was for the mine next door. But with the rising price of gold, and because the juniors believe gold prices will continue to rise, this deposit is now feasible or will be in the near future.

For these renewed claims on top of old claims or closed mines, perhaps mining in the past only proved to be economically feasible to skim off the top and tap the low-grade open-pit deposit. But the price of gold now or in the near future will pay for us to dig a little deeper, and we should be able to tap into that rich deep vein system below us.

These reasons are a combination of a modest amount of geological evidence, logical speculation and irrational exuberance. Because of the latest commodities bull there has been somewhat of a mad rush by juniors to stake claims in this fashion. This is readily apparent in Nevada, Alaska and Mexico, just a few of the hot spots around the globe with spectacular past production and great potential going forward.

Now that we have a plot of land, we need to find some gold. Keep in mind the key end result to a successful exploration project is economically mineable reserves. In reality, you can find gold almost anywhere. Traceable gold minerals can be found just about everywhere on the planet, including the ocean. The big question is how much money will it take to recover it and will its sale on the open market pay for the initial capital investments and make a profit going forward.

Now if the actual intent is to discover a gold deposit, whether near a hot spot or not, here is where the operose exploration begins. When starting in this fashion, from ground-down, it is commonly referred to as "grassroots exploration."

If sufficient data cannot be gathered from outcrops, trenches or other underground activity, the next step will likely involve drilling. In order to button down a potential gold deposit, many explorations entail diamond drilling to provide core mineral samples and clues on rock consistencies. The cores can be assayed for gold content and the density of the earth can help estimate the feasibility and cost of building a mine to extract it.

If initial drilling results are promising, and the capital is available, the mining company will try to estimate the mineral resources present at their plot. Resource estimates are gathered through various stages of feasibility studies that geologists and engineers perform leading them to draw opinions based on their results. Similar to a legal brief, these are only estimates stating their opinions based on their findings as to what they think might potentially be in the ground. Resources should not be assumed to be a guarantee that a deposit will ever turn out to contain mineable reserves.

Resources are a loose and thorny word in the mining industry. Measured and indicated resources are a commonly stated way of reporting resources among mining companies globally. Different governing bodies assign this different merit though. Canadian regulations not only require but recognize these terms as a legitimate base for the potential future bankability of ore reserves in their filings, but the Securities and Exchange Commission (SEC) in the United States does not. Because of this you will find that many of the juniors today trade primarily on foreign stock exchanges, where guidelines are less stringent than those of the SEC.      

If initial surveys and feasibility studies are promising, and the capital is available, the mining company will hire a third-party group of highly specialized geologists and engineers to perform a bankable feasibility study. The results of this study will set in course the decision process of whether to develop the land or not. This study will give a good idea of what type of mine needs to be built and how much it will cost per ounce to pull the gold out of the ground. Depending on current market conditions, these newly classified reserves may be attractive for future construction of a mine.

Easy enough right?  Wrong. This brings us to some big dilemmas that present themselves in junior investing. Two major problems that most juniors run into are failure and financing. Grassroots exploration is extremely risky and it's very important for investors to understand this. Project failure happens quite often in this industry. It can be attributed to several reasons, among the most common being the believed deposit turned out not to be economically viable. It would just cost too much money to pull the gold from the ground.

In a secular gold bull, many juniors don't consider this as much of a problem as a private investor would. Maybe a certain project is concluded with a cash cost expense estimated at $700 to produce one ounce of gold. Today this is certainly a loser, but what if three years from now gold is worth $1500 per ounce?  It would sure be worth it then, so we'll sit on this one for awhile and hope the commodities bull keeps us alive.

Failure aside, the largest challenge that presents itself to all juniors and in many cases miners in general is the procurement of capital. In order to extract natural resources, it takes a serious commitment of financial resources. Every step of the process is expensive from exploration, development and construction to even maintenance. Not only can it take several years to bring a mine operational from exploration to production, but it costs tens if not hundreds of millions of dollars to do so depending on the size.

On top of financing, these companies need to obtain environmental and operating permits from various governing bodies in order to proceed. As you can see in addition to development costs, there is also a considerable difficulty factor involved in getting the t's crossed and the i's dotted.

Unlike an internet start-up company that requires a website, a so-called idea and minimal capital, every aspect of converting a naked piece of land into an operational mine is very expensive. Junior miners, unless well funded by venture capitalists or a larger company with deep pockets, are just about forced to have a public stock offering in order to obtain the capital necessary for financing exploration and marketing themselves. Since we are looking for publicly traded juniors in which to invest, we will focus on those that fit this mold.

Now that we have a high-level understanding of the standard process of bringing a gold mine into production, let's look at where various juniors fall within it. As I alluded to before, there are different breeds of junior miners.

The first is the company that has actually been around for awhile, one that has been through the ups, downs and continuing volatility of the commodities markets. This junior has no intentions of ever bringing a mine into production. Their stated goal is to discover gold deposits through various stages of feasibility studies and then either sell them off to a larger miner or establish a joint venture with another mining company that will fund the majority of the future exploration and development costs associated with that specific project.

The way this type of joint venture typically works is junior miner ABC will discover a gold deposit with attractive resources. Miner ABC may not have the funds nor the will to continue the feasibility process. Miner ABC will make this project or themselves as a whole available for acquisition or joint venture.

If not acquired, they will partner up with miner XYZ. Miner XYZ is usually a larger explorer or miner with deeper pockets. What typically happens is an agreement is set up where miner XYZ has an option to gain a certain percentage of ownership rights to this project, say 80%, if it invests a certain amount of money, say $10 million, over a certain amount of time, say three years, to further feasibility studies.  Many times miner XYZ will even have an option in the agreement to obtain or purchase more of a stake in the project than initially was set out.

To this breed of junior, miner ABC, it is beneficial to sell off promising projects or establish partnerships. They are content to have either the cash upfront or to let their partner plow money into the potential mine so it can either pay them off down the road or secure royalties if and when it goes into production. You may find this junior's mission statement clearly justifying this approach solely for the benefit of the stockholder. A little cash now is better than the risk of no cash now and obtaining potentially more cash later.   

Miner ABC is good at grassroots exploration. It has a proven track record and a team of management, geologists and engineers that have excellent resumes. They've discovered gold deposits that have turned into producing mines and are able to recover from projects that have gone awry. This junior usually isn't scrapping to find funding and it does everything it can to avoid dilution of shareholders' capital.

The next breed of junior is the company that not only wants to explore and discover gold deposits, but it wants to develop its mines and bring them into production itself.  It wants to become an actual miner. It doesn't want to be a junior forever. It wants to grow from junior status, to intermediate and eventually to major. Now in order to do this, it needs to obtain some serious financing.

Since developing, constructing and bringing a mine into production is not the cheapest investment, most times a junior will have to establish a joint venture with another company to get its mine up and running. Unlike the first breed, it will go in 50/50 with a partner and take more risk by putting its principals' precious personal capital down to develop this mine into a true producer.

Like the first breed, this junior is good at exploration. Its management, geologists and engineers are also very experienced. Perhaps their president is a former executive from a large producer and is looking for a challenge, as well as a cash cow if he succeeds. Kinross is a prime example of this breed. It went from junior-miner status to becoming a top-ten major global gold producer.

These first two breeds of juniors have staying power. Both still might fail, and both will have to rely on a strong commodities market to keep investors interested as well as come up with creative ways to maintain funding. When there's a bear market in commodities many will not survive, but some will. It's these survivors that are worth a second look. These juniors are still very risky, but if you can pick the good ones the rewards can be bountiful.

Now to the final breed of juniors. In any bull market there are always pretenders. Ambitious go-getters that want to get but have little or nothing to give. These companies try to ride some coattails to get an easy buck.

Remember the often forgotten tech boom/bust of the late 1990s and early 2000?  There was so much blind-faith capital pouring into anything dot-com related it was silly. Companies with a website and a half-baked idea were going public and drawing interest just because they were "tech" related. If I were smarter I would have started the company www.techstockstothemoon.com in 1997 and taken it public. I'd be a billionaire if hindsight was 20/20!

Well, as you can imagine, we are starting to see the likes of these scams in this commodities bull. I have coined a phrase to describe this breed, I call them the dot-juniors. Similar to dot-com start-ups, the depth and breadth of these companies cannot accommodate a rain puddle!  They have no intention of ever becoming a miner, ever putting serious capital into exploration, or ever finding a legitimate gold deposit.

Dot-juniors spend more money on marketing than drilling, and it often works. In the spectacular bull market in gold we've had the past four years and in its anticipated continuance, these dot-juniors may make a few people rich, but will leave the rest dirt poor in the dust. I'm sure you've heard of the popular phrase pump-and-dump. Well, dot-juniors often get involved in such mischief.

Dot-juniors are interesting though. A few of them actually do pan out. As I mentioned earlier, in a commodities bull market junior start-ups rush to the hills to stake their claims. If they get fortuitous and stake their claim next to or on top of a gold deposit that their neighbor discovers, all of the sudden they are legitimate juniors. Also, if their marketers are good enough, and the stock price gets bid up high enough, they may actually execute an additional private placement of shares to secure capital and actually start an exploration project. This is highly unlikely, but possible.

All dot-juniors need to do to look like a real gold-mining company is claim or acquire a portfolio of properties that have potential, buy a shovel or two, maybe a tractor, and if they are really ambitious lease a cheap drill. As I said, you've got to be able to look through the smoke and mirrors to identify these juniors, as they are well masked and tough to uncover. Many times these companies are started by former mining execs that partially know what they are doing, and boy do they know how to put on a good show! 

While screening the universe of junior mining stocks, one key step in my selection criteria was to examine their websites and have a look at their presentation. Most mining companies have pretty decent websites that will provide valuable information. Well, some of these dot-juniors had absolutely gorgeous websites. A first glance at their profile and pretty pictures would make anyone want to buy their stock right away. Thankfully with a little patience and education you'll know to dig a little deeper, what to really look for in a solid junior, then you can see through the smoke and mirrors.

Sometimes it truly is difficult to distinguish between the poorly-marketed good juniors and the well-marketed dot-juniors. Another step in my selection criteria was to make sense of their financial statements. In analyzing these statements, it was apparent that some juniors spent more money on marketing and consulting than anything else.

Now don't throw up the red flag just yet, because there are some accounting loopholes allowing exploration expenses to be deferred, but the statements will always have these broken down in the notes. Do raise that flag though if there are little or no exploration expenses and there are consistently large marketing, consulting and salaries expenses. Could be just another dot-junior launching a pump-and-dump scheme.

Those very first 49ers became rich beyond their wildest dreams, but eight-ounce nuggets scattered along the river banks are only legend now. It's neither easy nor cheap to discover and extract gold these days. Because of this, it's not always a smooth and prosperous road for junior gold miners. Junior mining is a risky business, and it's even riskier offering up your hard-earned personal capital to exposure in these ventures.

Those rare juniors that can do it right, with market timing on their side, can win you legendary gains in a gold bull. A well-played junior miner can be highly leveraged to the price of gold if timed correctly. But a poorly played junior can be demoralizing to your investing future. It is for this reason that junior gold stock investing should be treated like an options play from a risk perspective, only unexpiring. When we recommend junior golds to our subscribers, only risk capital you can easily afford to lose should be deployed.

At Zeal we eagerly await the next major upleg in this young gold bull. In the upcoming March issue of our acclaimed Zeal Intelligence monthly newsletter, we will analyze some of the top fundamental junior gold stocks we uncovered through this multi-month project.

In this newsletter, we will delve into more detail on our selection criteria and Adam will perform a technical comparison and analysis on each of our picks relative to the HUI in preparation to launch actual trades in the near future when appropriate. Please subscribe today!

Through the fascinating process of learning about and studying these juniors, I absorbed a strange energy of excitement for junior miners, but also a keen awareness of the danger that can be present in investing in them.

It is not our goal to find the best past-performing juniors, but to take a look at the present-day fundamental prowess of these stocks and to anticipate which ones are positioned well enough for a potentially glorious run in the future. Please join us today!

Scott Wright
[Adam Hamilton's partner]
February 25, 2005

So how can you profit from this information?  We publish a monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month at www.zealllc.com/subscribe.htm.

Thoughts, comments, or flames?  Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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