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Junior Gold Stocks 5Scott Wright Nearly a decade into gold’s secular bull the mining industry continues to exhibit struggles. And this is best characterized by an ongoing 6-year downtrend in global mine production. For this reason, and the fact that gold is up 373% since 2001, those miners that are able to find success have the ability to greatly profit in this bull. And it is this profit potential that has attracted investors to gold stocks. The gold-stock sector has been one of the best-performing in all the markets over the last decade, winning investors legendary returns. And these investors are always in search of the next great gold stock. Like any other sector, the larger bellwethers have limited upside thanks to their size and predictability. But also like any other sector, there is a contingent of smaller-cap stocks that hold enormous potential. These smaller-cap stocks breathe excitement into the markets and invigorate those speculators willing to accept higher risk for the opportunity for huge gains. In the mainstream markets you see a lot of hubbub surrounding biotech stocks. And indeed it is quite a speculative rush owning a stock that successfully engineers and subsequently gets the next great drug approved. On the gold front this rush is realized when you correctly choose the right junior explorer, a company that finds and delivers the next great gold mine. But provocatively like most small biotechs, the small gold explorers have no sources of revenue. These companies don’t yet have a saleable product, and thus the profitability achieved by their more mature peers is not yet in reach. And herein lies the major risk investing in these junior-level companies. But the antithesis to this risk is the potential for immense rewards. There is a lot of money to be made in the gold-mining industry. And in a market where this metal’s price continues to trend upward, there is huge incentive to jump onboard. And it actually doesn’t take all that much to go for the gold. Anybody with an entrepreneurial tilt can build a gold company. All it takes is landing mineral rights in a prospective region and getting a geologist on your payroll. As a result of this ease there are now hundreds of juniors trying to take advantage of this gold rush. But though anybody can form a gold company, not anybody can find gold. And when gold is found, even less actually know what to do with it. As investors our challenge, and excitement, is found in sifting through the throngs of juniors to find that next-generation gold miner. And those who are diligent in their research can be greatly rewarded. At Zeal we seek to find the rising stars before they get out of reach. Every year we set out to scrub the growing universe of junior gold stocks and publish our favorites in our popular reports. And after embarking on the latest round of research a few months ago, I’ve observed a radical change in the junior-gold landscape since my previous effort. Looking back, the infamous bond and stock panics made for a dreadful 2008 across all markets. And the juniors were hammered particularly hard. The S&P/TSX Venture Composite Index (CDNX), which is a common proxy for junior resource stocks, saw a staggering 70% decline on the year. This far outpaced the general markets, demonstrating extreme investor malaise toward owning these risky juniors. And the gold explorers were not immune to this CDNX carnage. But the smart investors knew that this anomalous panic-driven event was utter nonsense, and that great buying opportunities abounded. With gold bottoming in November 2008 and the CDNX finally bottoming a month later, buyers slowly returned to the junior scene. And the quality juniors that were trading at highly-depressed valuations were snatched up at once-in-a-lifetime bargains. It was around this bottom that I started another chapter of junior-gold research. And as chronicled in the prior version of this essay series a year ago, I quickly found that their states of affairs were appalling. With stock prices insanely low, investors not willing to buy cheap shares, and non-existent credit markets, many juniors were in big financial trouble. Only those with quality projects and fiscal discipline would thrive in 2009. And in March 2009 we published an updated report profiling our favorites, 12 gold juniors we believed would lead the pack in the recovery. And judging by the results so far, our diligent research is paying off. From the very day this March 2009 report was published to this week, these 12 stocks have an average gain of 130%. Over this exact same span of time the venerable HUI gold-stock index, which tracks the 16 biggest and best gold miners, was up only 39%. High-quality juniors have the ability to greatly outperform their much-larger counterparts! Over the course of 2009 not only did gold recover from its panic-driven lows, but it crushed its all-time high. And along with confidence, capital found its way back into the gold-stock realm. This capital infusion is measurable to some degree thanks to a fascinating research report recently put out by RBC Capital Markets. For several years RBC has tracked capital raisings (equity financings) among North-American-listed gold stocks, and 2009 was an epic year on this front. Last year RBC tracked 151 separate transactions that raised nearly $19b, a whopping 500%+ increase over 2008. Now as mentioned above 2008 was an anomalous year. Investors wanted little to do with gold stocks, regardless of size. As a result 2008 actually saw less than half the capital raised than in 2007, and the lowest total since 2005. RBC suspects the capital raised in 2009 was the most ever the gold industry has seen over a single 12-month period. In its analysis RBC did a fine job parsing out transaction size. And with the top 10 transactions being performed by the world’s mega miners, covering about two-thirds of the total, RBC focused on digesting the $6.4b raised by the smaller-cap gold companies. And it is important here to place juniors in proper context under the classic market definition of “small-cap”. In most financial-market dictionaries you’ll find “small-caps” defined as stocks with market capitalizations between $300m and $2.0b. Now in most sectors small-cap can be synonymous with junior. But when it comes to gold stocks this is not the case at all. In actuality only a handful of the largest juniors fall within this range. In the gold-stock world the most common companies falling in this range are the small and low-end mid-tier producers. So as per this RBC analysis, small cap is not synonymous with junior. And since our focus is on junior explorers, it is important to break down RBC’s data to get a better idea of where the juniors fall into this record 2009. The next tier of capital raisings included those transactions in excess of $100m. And RBC logged 21 of them that totaled over $3.0b. Since only a small handful of the largest juniors are capable of raising this kind of capital, I don’t believe these transactions are representative of the junior class. Though some of these 21 were performed by a couple of large advanced-stage juniors in the process of building their mines, I’m inclined to believe the lion’s share of these financings were done by producer companies. This leaves about $3.0b that might be attributable to the greater junior contingent. But thankfully RBC reveals even greater detail in its analysis. Of all the small-cap transactions, 58% raised gross proceeds of less than $25m. And this equates to only 13% of the total small-cap funds raised. Based on my research, this sub-$25m-transaction group is where you will find the majority of junior gold explorers. Allow me to explain. With prospecting for gold now back in vogue, there are more juniors on the scene than ever before. My database is now comprised of over 400 publicly-traded junior gold stocks. But even with this ongoing population growth, the average junior is still pretty small in size. If I remove the 10 largest and 10 smallest, the average market cap of this pool is only about $42m. And it is only this high thanks to an undersized group of supersized juniors. Interestingly if I use $50m as a cutoff, only 21% of junior gold stocks have market caps on the high side. And of those on the low side, 85% have market caps under $25m. This clearly demonstrates that the great majority of juniors simply don’t have the capital structure to raise over $25m in a single equity financing. In fact, very few juniors with market caps over $100m (12% of the total population) can pull off equity financings this large without beating their investors bloody with the dilution stick. To be conservative, if every transaction that RBC tracked under $25m was performed by a junior, this would amount to about $825m. And this represents only about 4% of the total equity financings for all of 2009. You see, no matter how you measure the junior-gold sector, it is a very small piece of the gold-industry pie. One more interesting tidbit from this RBC thread is its “use of proceeds” tracking. Again focused on the $6.4b of small-cap financings, exploration took the cake as measured by number of transactions. This was followed by construction, feasibility work, acquisition costs, debt payback, and then investment. But what I found even more interesting is how different the picture looked as measured by dollars. Construction was by far the largest category, more than double exploration. Of the $6.4b raised 44% went toward construction (new mines and expansion of existing), 19% to exploration, 15% to acquisition, 10% to feasibility work, and the balance to debt-payoff/investment. This 19% tagged for exploration represents $1.2b, and I’m sure a material portion of these financings were performed by the producers. Exploration is a junior gold company’s bread-and-butter. These companies live by the drill and die by the drill. And with what I would bet to be well less than $1.0b raised specifically for junior exploration in 2009, this sector has yet to flex its muscles. Interestingly when I did my initial scrub of the 400 or so juniors in our pool, I looked at the financials for each company and logged pertinent data I thought would be useful. And one of these fields is working capital. When I remove the 10 largest and 10 smallest (which were in the negative) WC totals, the average junior only had about $3.3m to fund its exploration programs. Now when I pulled this data in late December it came from Q3 2009 financial statements. And based simply on observation, Q4 was a very active month for junior financings. With the HUI briefly eclipsing 500 once again, there was a lot of excitement for gold stocks. I think it’s fair to say that Q4 saw more transactions than any other quarter in 2009. Just for kicks and grins, let’s say the $1.0b that may have specifically been raised for junior exploration is spread evenly across 400 companies ($2.5m for each). And just for fun let’s also assume all this financing activity happened in Q4, subsequent to my WC calculations. If we add this $2.5m to the WC balance for each company, the average junior would have ended the year with $6.0m. Though many of the smaller juniors would be thrilled to have $6.0m in working capital, considering how expensive it is to explore for gold this isn’t very impressive. I suspect the juniors will easily surpass 2009’s capital-raising efforts if they want to make more of an impact on the gold-mining industry. And this typically translates to investors buying more shares and thus driving up prices. Speaking of exploration, my latest round of research afforded a look at where in the world the juniors are spinning their drills these days. With gold quickly depleting in the world’s historically-reliable mining districts, explorers are forced to look far and wide for the next gold lode. And thanks to a field in our massive database that shows the locale of each junior’s projects, we can gather a collective picture of where they are looking. Naturally most juniors, especially those with limited capital, are going to stay close to home. It is more expensive and risky to set up shop in an unfamiliar region. And with most of the gold juniors we look at headquartered in the US or Canada, North America is a very popular spot. And why not! The US and Canada are both top-10 global gold producers, and Mexico is knocking on the door. Of all the companies we looked at, 67% had at least one project in North America. And Canada was by far the most popular country, with 40% of all juniors owning a project there. Canada has an incredibly-rich gold history and very favorable mining laws. And as the world’s second-largest country by total area, there are still a lot of places to look. Next is the US, with 23% of the junior populace owning projects in our country. And this is of course followed by Mexico at 13%. The next most popular region to look for gold is South America, with 16% of all junior explorers owning projects there. Many of the world’s largest operating mines and undeveloped gold deposits line the mineral-rich Andean mountain range on the west side of the continent. And such mining-friendly countries as Peru, Chile, and Argentina naturally attract the most interest. Brazil is also a growingly popular destination to the east. And we are even starting to see more juniors venture into some of the more unstable, and untapped, countries of Colombia, Bolivia, and Ecuador. Next is Africa, but only 8% of the total junior population owns projects in this destitute part of the world. Many of the countries in Africa have simply amazing mineral potential. But the barriers to entry and elevated geopolitical risks really make Africa a turnoff for most juniors. Those that are finding success are doing so in such countries as Ghana, Burkina Faso, Mauritania, and Tanzania. Asia is next behind Africa at 6%, and juniors struggle with the same types of problems in this part of the world too. Of the small group of juniors exploring in Asia, we are seeing varying degrees of success in China, Russia, and the Philippines. To round out our whirlwind tour you’ll find a small contingent of junior explorers in Australia, Europe, Central America, and the Caribbean Islands (combined 8%). And considering the gold that comes out of Australia (the world’s 3rd largest producer), it is surprising to see so few juniors going down under. I suspect many of the juniors exploring there are locally-based and have their primary stock listings on the ASX. This short junior geography lesson tells us two things. First is that some juniors are spreading their wings and venturing into parts of the world where foreign, and modern, mining companies don’t have much of a presence. The risk is greater, but vast mineral riches can be found. Second is that gold prices are not yet high enough for many juniors to leave their comfort zones. And you can hardly blame them for playing it safe. But as gold demand continues to rise and it becomes harder to find it in these comfort zones, the explorers will be forced to take on more environmental risk. In our brand-new hot-off-the-presses report we profile our current favorite advanced-stage junior gold stocks. And these elite companies embody a truly global diversification. With so many gold juniors today, and quality ones at that, we decided to expand our research by segregating the junior sector into more distinct categories. Junior gold stocks not only have a wide range of sizes as measured by market cap, but they vary widely in where they are in advancing their projects. This variance prompted us to divide these companies into 2 major categories, early-stage and advanced-stage gold juniors. There is no definitive line that separates these 2 categories, as there are wide-ranging market caps in both. But simply put the advanced-stage juniors are closer to producing gold than the early-stagers. And this is why we decided to profile the advanced-stagers first, as they won’t be juniors for long. Among the stocks in this advanced-stage category are emerging producers, those juniors in the process of constructing quality mines. You’ll also find pre-development companies that have performed positive economic studies based on current market conditions. These juniors are on the cusp of mine development and have their sights set on bringing mines to life. Of the 12 stocks profiled in this March 2010 report, 1 will be a producer by the end of 2010, 3 are on track to commission their mines in 2011, 5 are anticipating production in 2012, and 3 hope to be mining gold by early 2013. In the brand-new April edition of our acclaimed Zeal Intelligence monthly newsletter, we recommend one of these favorites to our subscribers. This company operates in a small South American country and is working to bring a 4.0m+ ounce gold deposit to life. Subscribe today! We believe these advanced-stagers to be the best-of-the-best next-generation gold miners. If you would like all 12 deep fundamental profiles at your fingertips, buy this report today! And of course stay tuned for our follow-up report in the coming months. The elite early-stagers are the next next-generation gold miners, and own deposits that every junior investor should know about. The bottom line is 2009 had seen a revival in terms of capital finding its way back into the gold-stock sector. And though most of the qualified transactions were performed by the producer companies, the juniors also took part in this renewed sector interest. Armed with fresh capital, the legions of juniors have taken to the hills in search of the next great gold deposit. But with more juniors now than ever before, the competition is fierce to become a standout. And with such a large pool at hand, our job as investors has become much more difficult. Diligent research is proving invaluable in this explorers’ realm. Only a very small fraction of gold juniors will be successful and actually find that next-generation gold mine. But if you can discover this minority, legendary gains can be won. ### Apr 2, 2010
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