The secret to making money in junior resource stocks

Many investors think junior exploration companies are high-risk investments that are fraught with challenges, with little chance of success. While it is true that the odds are against a company finding a mine (less than one in 10,000, by some estimates), you don’t have to pick one of those few, successful stocks to make enormous profits in the junior resource sector.

Most junior resource companies are engaged in early stage, “greenfield” exploration where risks are high, but where good drill results can send the share price rocketing. Greenfields have huge upside potential, and investors who recognize how and when to invest can profit from the tremendous price fluctuations that occur in these stocks, without having to predetermine which few companies will find an economic deposit. Since no one knows what is hidden underground, junior resource stock speculators should not focus on geology, but instead on understanding the stock.

The big secret about investing in greenfield sites is that there are no secrets or special insight required to profit from them. The only requirements are due diligence and patience. The key is to gather all relevant background information, and follow strict guidelines that improve the probabilities of trading more winners.

The primary considerations for investing in junior resource stocks are management, structure and timing. Amazingly, all of this information is available for free from www.sedar.com (press releases and financial statements), www.sedi.ca (insider trading reports) and www.bigcharts.com (stock charts).

Management

The management team is critical to the success of a junior resource company and its stock. Management must find projects, develop them in a timely manner, control share structure and complete financings at progressively higher share prices.

First, the management team must include members with the technical ability to find and explore attractive projects. However, that skill alone is not sufficient to ensure a stock’s success. There must also be members who are skilled in the boardroom so that they can make deals for projects and raise the money needed for acquisitions and exploration. Finally, each company needs “promoters” who can assume the role of public face (usually the CEO). They must be able to promote their company to the public and relate to investment advisors who can, in turn, create buying interest from their clients. Today many juniors are struggling to raise working capital, and only those with strong management are likely to survive. Detailed management profiles can be found in the management information circulars all companies file on www.sedar.com.

After completing a qualitative assessment of management’s skills, investors must determine how motivated management is to have the stock move materially higher.

Ideally, management should have a large vested interest in the stock and primarily depend on the success of the stock for compensation rather than salary. Promoters often have several companies in their stable, so examine each one to ensure that the combined compensation is low enough to keep them hungry. These figures are in the management information circular and audited annual financial statements on www.sedar.com.

Naturally, all exploration companies would like to find a mine. However, their promoters know the chances are remote. To improve their chances of making money regardless of discovery, promoters position themselves through stock options and direct investment in the stock at strategic points. In doing so, the promoters tend to follow predictable patterns that can help guide investors’ actions.

Researching the following criteria can help investors recognize these patterns, and find opportunities to buy shares at lower prices than management has paid.

Stock option plan: Insiders may signal it is time to buy when they award themselves significant quantities of stock options when the stock price is low, or in advance of news flow. Most Canadian exchanges set a minimum price for insider options at 10¢ per share. Look for stocks that are trading below the lowest exercise price of most insider options so that you can amass a large profit before insiders make money on their options. It is a good idea to create a spreadsheet to track the exercise price, expiry date and quantity of options issued. Be wary of the expiry date on out-of-the-money options, as expiring options may be replaced with new ones at a lower price. This information can be found on www.sedi.ca.

Insider trading and holdings: Promoters should have a significant vested interest in the stock. Investors should look for cases where the promoters have recently made a material personal investment into the stock by buying in the open market. Investors should be attracted to stocks that are trading below the price where insiders recently bought. In Canada, insiders are required to report trades on www.sedi.ca within five days.

Scrutinizing management for ability and vested interest can also include calling them, meeting them at investment conventions or attending dog-and-pony presentations. Investors should consider consulting a well-informed investment advisor who may have knowledge of the promoters. Investors should maintain a checklist and ensure that all of the criteria are met.

Share structure

The share structure of a company is important, and can yield insight into the stock’s key price points. By studying the price points where future sellers may materialize, investors can determine entry and exit targets, and calculate the price level to take profits.

Share dilution is often an issue for junior resource stocks, so several factors that can increase the number of shares outstanding need to be considered when gauging price points.

Previous share issues: After an initial public offering, juniors tend to raise capital through private placements, which restrict investors from selling their shares for four months. Rising stocks may face downward pressure if the private-placement participants sell after this period. It may be prudent to anticipate this decline and sell in advance of the four-month anniversary date. If the private placement contained flow-through shares, investors should calculate the after-tax cost of these shares (about 40% below issue), and use that value as a target price for the stock. Shares issued for property acquisitions or to satisfy debt should also be considered as a source of supply. Details of previous share issues are filed in press releases on www.sedar.com, and on company websites.

Ongoing financing: Sometimes, a junior will announce impressive early exploration results. Its stock prices may move sharply higher on frenzied trading for several days following this good news. This is referred to as a “breakout.” The company will likely require additional capital to carry out the next phase of exploration, and since it is easier to raise money when the stock is rising and actively trading, it is common for a new financing to be arranged shortly after announcing exciting results. This may be done at a discount and take some time to complete. Usually, the upward momentum of the stock will stall, and the price will decline when the financing is announced. Investors must ensure that they sell the stock at the peak of the run-up phase — just before the financing is announced and the momentum dies.

Outstanding warrants: New share offerings often feature one- to two-year warrants that allow the holder to purchase more shares at a fixed price. Shareholders who receive warrants attached to a new share issue often sell the shares at or above the issue price, and retain the warrant for no cost. As the expiry date approaches, holders will normally exercise and sell the stock, and this selling often depress
es the share price. A stock will have difficulty going far above the warrant’s exercise price without a lot of new buying to absorb the selling from the warrant holders. Similarly, a stock may appreciate just after warrants expire, as the potential overhang no longer exists. Investors should carefully note the exercise price, exercise dates and expiry dates of all outstanding warrants.

Other shareholders: The study of long-term stock charts (see www.bigcharts.com) can determine where shareholders have bought previously, and predict at what levels they may sell. Many shareholders who bought at higher levels will become sellers if the stock approaches their break-even price. Investors should note those prices and strategically place sell orders just below them. When buying, look for stocks that are trading infrequently and at low prices. This is usually a signal that few sellers remain and that most of them are selling for tax losses, or to put unpleasant memories behind them. Some companies with these characteristics will never recover. However, this is when the smartest investors accumulate shares. Investors can lower the risk of buying duds by following their checklists.

Flow-through funds: Resource companies frequently turn to flow-through investors, such as limited partnerships for exploration financing. Promoters often approach these investors to minimize the time and effort required to raise capital. Later — as the partnership is redeemed by its unit holders, and forced to raise cash — the stock may be mercilessly pounded into oblivion. Most often the timing of this aggressive selling is influenced by partnership redemptions, and may not coincide with corporate developments in the stock. Determining when this supply of stock will be sold is a challenge, so investors must be cautious when investing in stocks that have flow-through limited partnerships as significant investors. Press releases sometimes show which limited partnerships have bought.

Buying into the right company in the earliest stages is fundamental to investor success. The optimum structure for a junior resource stock is tight enough so that incremental buying results in stock-price appreciation when milestones are met. This allows the company to raise money at consecutively higher prices. Study the levels at which stock may be released into the market and enter sell orders accordingly. Maintaining a checklist can help you organize your strategy well before the stock moves.

Timing

Timing, the third and final critical component, measures the ebb and flow of money into the company’s treasury and into the stock. One feature of the evolutionary cycle associated with greenfields is a long dormant phase, followed by a gradual upward movement as money is raised, surveying and sampling is completed and exploration starts. Then, if exciting results are announced, the buying frenzy drives prices into the stratosphere. From that point, since most discoveries don’t pan out, the stock painfully ratchets its way back down to dormancy near the lows, and the cycle begins again.

Proper timing can make the difference between profit and loss. A long-term, fundamental buy-and-hold philosophy should not be applied to junior stocks. Instead, predetermining the correct time to enter and exit the stock is critical.

There are a number of key points to assist investors with timing.

Timing to avoid dilution: Perhaps the greatest challenge of investing in junior resource companies is the ever-present risk of dilution. As most juniors do not have earnings or cash flow, they must issue new shares to raise the capital needed for exploration. Each time they do so, existing shareholders suffer dilution. Further, without successful exploration results, eventually there will be too many shares outstanding to complete new financings. At that stage, management will be forced to consolidate the shares and start over. Existing shareholders will have a reduced percentage in the company and a low chance of recovering their investment. To evaluate the possibility of a share consolidation, investors need to look at the number of fully diluted shares a company has. As a rule of thumb, investors should look for companies with less than 50 million shares and market capitalizations of less than $5 million, as these usually do not undergo share consolidations.  Avoid stocks that have recently consolidated, as there may be a long wait before the stock moves again while the promoters rebuild their shareholding.

Trading the dormant phase: For many investors, investing during the dormant phase, which can last for up to two decades, will prove to be the most challenging and most rewarding tactic. This is the time for investors to accumulate and trade shares to reduce the cost of any remaining shares to zero. Within a dormant phase, stocks tend to fluctuate dramatically within a certain trading range. This oscillation pattern helps investors trade the stock, realize profits and use profits to accumulate more stock in anticipation of the dormant phase ending and a breakout occurring. It may be best to trade within a registered retirement savings plan or tax-free savings account so that tax concerns will not interfere with any decision to sell.

Trading the breakout phase: Most of the time, junior resource stocks drift around within the high and low parameters of the dormant zone. But occasionally, good news flows at the right time and the stock breaks into new territory on extreme volume. Investors who have already traded out of the stock just below the breakout price should immediately buy back in. This new position should be sold within days, as investors may anticipate a financing to be announced.

Money in the treasury: For a company, having money in the treasury is considered akin to having gas in the tank of a car: it is viewed as a requirement for movement. Many investors restrict themselves to investing in junior stocks that already have enough capital to finance a near-term exploration program, believing there is less uncertainty in such stocks. However, that belief is ubiquitous and largely discounted in the market, rarely coinciding with buying near a low. It is possible to make money at this stage, but the returns will generally not be as high. By the time sufficient funds have been raised, the price action on the stock becomes dependent on drill-hole assays. Investors at this level must compete with other like-minded shareholders for trading profits. At this point, the stock will be near the upper limit of its dormant-phase trading range, and astute investors should have already recovered their initial investment. Instead, investors should focus on who is investing rather than how much has been raised. Promoters will normally position themselves well in advance of raising exploration funds. It is best to mimic what the promoters do.

Investors often try to time their buying to coincide with a bottom or anticipated near-term price movement. But successful junior resource stock speculation is contrarian investing in the purest form. It is critical that investors do not follow a conventional approach. Instead, first determine if the proper timing conditions have been met. Then, confirm by watching what the promoters are doing. A checklist will lower the chance of letting emotions interfere with timing decisions.

Trading

After qualifying a stock based on management, structure and timing, investors can improve returns with a few simple trading techniques. Junior resource stock investors must use unconventional trading strategies that do not depend on the long-term success of the company. Instead, the strategies should be based upon the typical evolutionary cycle unique to junior resource stocks.

Greenfields spend most of their time in a dormant phase, where they exhibit tremendous volatility and opportunity for trading profits. Investors should look for stocks that fluctuate 400% or more between the low and high ends of th
eir dormant phase. Rather than trying to find the bottom, investors should buy into a stock through three purchases. After confirming using the timing checklist, invest only one-third of the total amount intended. Only buy additional shares if the price falls another 30%, then invest a second third. If the price declines 50%, invest a final third. This technique will position the investor to sell, as the stock oscillates back up to the high of its dormant-phase range.

When selling, investors should sell in two steps. First, recover all invested capital by selling one-third at 300% above cost. The final two-thirds can be sold just below the upper-range limit of the dormant phase. Some investors may retain some shares for the long-term in case a mine is discovered. If the stock breaks out, reinvest for a few days using only the profits.  The buy-and-sell points within a dormant phase are illustrated in the MacDonald Mines Exploration (BMK-V) chart. In 2005, this stock met all the criteria. The stock traded between 6¢ and 30¢ over four years and investors could have tripled their money twice. In the end, there was an opportunity for huge gains when the stock broke out and blasted off to $1.32, before drifting back down into dormancy.

— Peter Besler is an investment advisor with MGI Securities Inc. in Toronto (www.mgisecurities.com). He can be reached at tel. (416) 594-2257, or pbesler@mgisecurities.com. This article originally appeared on www.miningmarkets.ca.