Junior gold stocks: how to derisk your investment - Mills
How to derisk the inherently risky business of investing in junior resource companies. The Gold Report interviews Rick Mills for his views.
Author: Sally Lowder Posted: Thursday , 19 Jan 2012
COQUITLAM, BC -
The Gold Report: We have seen some incredible volatility in the market over the last three or four months, with many junior resource stocks on the Toronto Venture Exchange beaten down, even if they have proven resources and substantial cash treasuries. We have also seen some volatility in the price of gold and a disconnect between the price of gold and the price of juniors. In this environment, how should investors approach risk in the junior resource space?
Rick Mills: I agree with Baron Nathan Rothschild who became a legend during the financial crisis right after the Franco-Prussian War. As the story goes, a panic-stricken investor came screaming into his office yelling, "You advise me to buy securities now? Now? The streets of Paris run with blood!" Rothschild replied, "My dear friend, if the streets of Paris were not running with blood, do you think you would be able to buy at the present prices? Buy when there's blood in the streets, even if the blood is your own."
I'm pretty sure things today are not as bad as they were back then, but this market offers contrarian-minded investors an opportunity to take huge advantage of discount share prices and, as you pointed out, many are trading below cash in the bank. Many, many are way undervalued compared to what they have in the ground and what they will have. The thing to do is to even further derisk.
Everything we do has some level of risk, from flying in a plane to walking across the street. All our lives we identify and quantify risk, so it's second nature and part of our makeup. Everyone has his own risk profile, of course. For instance, maybe you won't bungee-jump off a bridge or willingly parachute from an airplane, but you'll happily get crazy driving around on an ATV or a snowmobile. You have a risk profile. You will do this; you won't do that.
TGR: So far, so good. So how do you derisk these stocks?
RM: The way to derisk investments into junior resource companies is to know your risk profile. Then wisely deploy capital into the right management team in the right stage, for you, of company development.
TGR: What steps would investors take to identify companies they're comfortable with? How can they make better-informed choices and thus create less risk?
RM: The most important things are to know yourself and to know that juniors are inherently risky. Understand how much volatility you can handle and how much patience you have to wait while a story plays out. Develop the discipline not to get faked out of your position or chase after hot tips or listen to the cheerleaders. Have a clear and complete understanding of why you're here in the first place. Know the different development stages of a junior, because risk lessens as a company moves a project through drilling and post-discovery resource definition, then into the various mining studies, and finally into raising money, building the mine, and ultimately, mining. You really have to know who you are invested with and the story. Monitor the progress of your management team with its project and make sure they're meeting goals and timelines.
TGR: And when you find companies that suit your risk profile and pass muster in terms of development stage and management performance, you jump in?
RM: You don't want to just walk in and buy all your shares. Develop a plan to buy shares over time . I don't use stops, because these stocks can make huge moves down in a day and you could get knocked out just before they move back up and go on a tear the next day. I'm here long term so short-term moves don't bother me; stops in juniors, for non-traders, create more problems than they solve.
TGR: Could you elaborate a bit on evaluating the various development stages?
RM: The most upside and the greatest risk come with the greenfields, the junior resource companies when they are exploring. It takes a lot of patience with them and with the management teams to let stories play out. Some of these stocks are very thinly traded, so it doesn't take much to make them jump in either direction. Make a discovery, get some good drill assays and they explode in the share price. Get some bad assays and they implode to the downside-make sure they have a back up play, a plan B, already secured and ready to go. They are the riskiest plays by far, but they offer the highest reward.
Next is what I call the post-discovery resource definition stage. A company at this stage already has found something, its share price has exploded and now the company is undertaking a nice drill program. After the price has settled back, decide on an entry point and start to get in. Let the company build an NI 43-101-compliant resource. The risk has been greatly reduced, and of course there's no longer any waiting for a discovery.
The study stage comes next. After the company has its NI 43-101-compliant resource, it gets into scoping, prefeasibility and feasibility studies. Companies at this stage are so much further down the development path that much of the guesswork about grade, size, cost and metallurgy has been taken out of the equation for investors. These companies have done sufficient work to give investors a certain level of confidence that they'll successfully move their projects along.
TGR: Haven't a lot of companies at this stage also been derisked in the sense that their share prices are depressed as well?
RM: Oh, absolutely. A lot of these companies not only have the value, but they continue working and adding to that value every day. It's a fantastic opportunity to buy some companies not only on the path to production but also on the path to some pretty decent cash flows.
Let's look at gold mining. Even though the price of gold has gone up roughly six times, global gold production has been falling since 2001, which tells us that higher gold prices are not bringing on more gold supply. The money being spent on gold exploration is finally starting to climb, but very few big new deposits are being found, so gold miners are adding to their resources by buying them from smaller-cap miners and explorers-the companies making the new discoveries. The majors need them to replace their reserves and depend on them for their upstream flow of new projects for development. That's what juniors do; that's their function in the food chain. So it removes even more risk from the equation for the juniors that are sitting on existing deposits; they are becoming more valuable day by day.
The majors have gone through mergers for much of the last decade, and every round of mergers obviously leaves fewer majors. That said, large Asian miners have been entering the sector. They love not only the gold deposits, but copper-gold porphyries and base metals as well. All of this makes juniors with discernible deposits moving down a path to production all that much more valuable.
TGR: And less risky.
RM: What is the biggest risk all junior companies face-not investors, but the companies themselves?
TGR: Running out of money?
RM: Move to the head of the class because that is the absolute major risk, the most serious risk all the juniors face-remember most do not have cash flow. So if the markets look a little wonky and you think juniors will have a hard time raising money, you can further derisk by looking at companies with treasuries full enough to keep them working-to get by for a couple of years. And you can derisk even more by narrowing these companies down to those that have cash now and that will actually get some cash flow from production in the next little while.
TGR: You've given us a good group of filters for investors to use.
RM: We're doing some pretty serious research here and we have a very strong plan in place. We have directly targeted risk with the objective to lessen it yet leave potential major share price upside.
With careful due diligence and by thoughtfully choosing the development stage of companies we invest in, I think we can make some money.
TGR: Investors certainly will appreciate your explanation of how to lessen their risk as they venture into the junior space. Is there anything you'd like to add before we say goodbye?
RM: Maybe just to emphasize the importance of doing your homework. There's absolutely no way around it. As an investor, you can rely on other people to do some of it-Ahead of the Herd and Streetwise just did by showcasing, for free, several excellent companies to do further due diligence on-but the ultimate decision and the ultimate responsibility for every decision you make rests with you. That's why you need to satisfy yourself that what you put your money into is run by a competent management team.
Know your risk profile. Pick your stock. Plan your entrance, and have the patience and discipline to let a quality management team go to work for you and build value. But be sure to have an exit plan as well; pick the stage at which you get out, because you don't make any money until you sell-stick to your plan.
TGR: Excellent. Thank you, Rick.
RM: Thank you.
Richard (Rick) Mills is the founder, owner and president of Northern Venture Group, which owns aheadoftheherd.com, as well as publisher, editor and host of the website. Focusing on the junior resource sector, Mills has had articles appearing on more than 300 websites, including: The Wall Street Journal, SafeHaven, Market Oracle, USA Today, National Post, Stockhouse, Lewrockwell, Uranium Miner, Casey Research, 24hgold, Vancouver Sun, SilverBearCafe, Infomine, Huffington Post, Mineweb, 321Gold, Kitco, Gold-Eagle, The Gold/Energy Reports, Calgary Herald, Resource Investor, Mining.com, Forbes, FNArena, Uraniumseek, and Financial Sense.
