more articles by

Doug Dillon


Click to enlarge Click to enlarge

 

Life Lessons: Why Jr Precious Metal Emerging Producers Have Been Underperforming

By Doug Dillon      Printer Friendly Version
Aug 4 2008 2:41PM

montyhigh.typepad.com

On the message boards there have been quite a few frustrated posts by fellow investors wondering why their already undervalued Precious Metal Emerging Producers have been so underperforming the underlying gold and silver metals. A Precious Metal Emerging Producer is a smaller-scale precious metal mining company that is either opening a new mine (either their first or second) or is substantially scaling up the production from existing mines. From my viewpoint, a Jr graduates from an advanced development explorer to an emerging producer when it has all the financing needed to go into production.

I've been wondering the same thing myself, but am not too worried because the ones I'm holding are so undervalued. If the price of gold and silver hold up, they should be producing such good earnings that eventually the market will "get it" and push up their stock prices substantially.

But still, what is the explanation for this underperformance? Here's some explanations I've heard:

  1. Big-Boy Naked Shorting - The "big boys" (hedge funds?) are shorting Jrs (perhaps with illegal Naked Shorts) and going long the precious metals themselves. I've heard this claimed, but have never seen any actual evidence given to back up these claims. I've seen heavy shorting of Minefinders (MFN/MFL.TO) and maybe Golden Star Resources(GSS/GSC.TO), but this does not seem to be an explanation that covers most of my emerging producers. Most of my producers whom have little or no shorting according to the TSX venture exchange. Those stocks where it is happening should get quite a nice short-covering stock pop if they actually execute according to their plan.

  2. Moose Pasture Dilution - this goes something like:

    • Most of the money in the TSX Venture is in the form of index funds which invest in all of the index's stocks (good and bad). I'd love to get some facts and figures and determine how significant TSX Venture index investing is.

    • The TSX Venture has been bloated by a multitude of "moose pasture" exploration companies. They are refered to as moose pasture stocks because they don't have any real mineral resources proved up, just moose pasture that could possibly some day be something. A small fraction of these someday may prove up a resource that is worth money, but until then they don't have much value.

    • As moose pasture stocks are added to the TSX Venture, index funds have to sell part of their holdings of existing stocks to buy the new stocks. This selling reduces the prices of the existing stocks (bad for emerging producers) bringing down the value of the index funds.

    • The addition of these stocks has the net effect of lowering the stock prices of existing stocks (and the index as a whole). The addition of moose pasture stocks is alot like the end of the dot-com bubble where tons of Pets.com and their ilk soaked up the sucker money. In this case it may be the conscious smart-money gaming of the fashionable index investing craze. This is a reminder of how Index investors can suckered by smart money who, when they know where the index investing money has to go, figure out a way to exploit this foreknowledge. Index investing only makes sense in areas where markets are efficient and that implies that there is enough actively managed money to allow index investors to benefit the actively managed money keeping the entire index valued equivalently. I don't think the TSX Venture exchange meets these criteria.

    • When index fund investors see that they are losing money, they flee their current index for another "hotter" index. This results in the index funds selling the stock of all the companies in the index causing the prices of individual stocks and the index as a whole to lose value. This is a positive feed-back cycle and should continue until there is little index money left in the TSX Venture exchange or until a significant wave of new money buys into the exchange's stocks. Falling Nickel, Zinc and Lead base metal prices further depress the index by trashing the associated Venture base metal stocks pulling down the index as a whole. This furthers the flight from the TSX Venture of index fund money.

    • I believe this moose pasture dilution is a significant factor and that the main hope for a Jr escaping it is to either "grow up" to the point where institutional money would consider buying the individual stock for its worth (having achieved mid-tier production levels and having left the Venture exchange for the TSX or the AMEX exchanges) or to have a resource big enough and valuable enough to be a major's takeover target. For production I reckon this to be more than 100K oz gold / year or 5 million oz / silver per year. I reckon 2 million gold oz is a "big enough" resource to be a takeover target. I don't know how big a resource of silver would be necessary to be a takeover target. In any case, its not my opinion that counts, but its the "fund" money that determines what "big enough" is.

  3. The Fear Factor - When the price of precious metals are rising because of fear, money leaves Jr mining stocks of all forms for safety reasons. This makes sense for stocks which still require financing (which may not be available during some kind of systemic upset), but doesn't really make sense for those which don't need financing as their outlook benefits from the rising precious metal prices. But they all get taken down anyway in the flight to safety. Again, there is the momentum effect where once Jrs start falling, they continue to fall as money exits looking for a safer place or at least one that is not down-trending. I believe that this is the case with Jr emerging producers. The antidote of the fear factor is the "Value Factor" which causes the buying of selected Jrs when they are clearly undervalued, supporting their prices. The converse of the fear factor is the "Greed Factor" where Jrs soar when the price of precious metals are rising because of greed not fear. This greed can come from sheer price rise momentum or from inflation driving precious metal prices and Jrs appearing way undervalued. Smart money may be at this point doing value investing, but this fall, as precious metals follow their seaonal rise, I'm expecting to see the Greed Factor kick in.

To summarize, I'm rather dubious of the "Big-Boy Naked Shorting" explanation, but pretty much accept the "Moose Pasture Dilution" and "Fear Factor" explanations.

So, the life lessons I've been getting from Jr precious metal investing are:

  1. Wait for the "greed phase" to invest heavily in Jrs. This year its too late for me to follow this advice because I've been long and strong all year and Jrs are so illiquid you just can't trade in and out with the money I'm swinging.

  2. Only buy Jrs that you expect will "grow up" (see above). I don't care how undervalued a Jr stock seems (well, I guess I have one exception), if it doesn't have a good likelihood of growing up I'm not holding it.

  3. Be on the look out for a genuine end to the precious metal bull market and be ready to exit should that occur. This life lesson comes not from the recent precious metals Jr under performance, but from the collapse of zinc, lead and nickel Jr base metal emerging producers. Its pretty clear that the price of mining stocks (and Jrs in particular) get creamed when the underlying metal price is descending rather than rising. This is the case regardless of how much money the stock may be making (or be poised to make) at anywhere near current prices. This is because there is no telling, once a metal's price starts falling, how far it will fall. A falling metal price provokes a flight for safety even if the stock is set to make big money at the current price. I believe it applies to precious metal mining stocks as well, should an exit should be taken regardless of whether one is above or under water, should there be a clear indication that the precious metal bull market is truly over.

With all of the above in mind, I believe I'm pretty well positioned with the Jr miners I have. I think I know what I'm doing with each one and have good reason to expect success with each. Of course, it all depends on them executing their plans (or something reasonably close to their plans) and the price of gold and silver holding up or, better still, advancing). The payoff should be quite substantial (easy double at least) for each if this turns out to be the case.

Doug Dillon

 

****

You can follow Doug Dillon's learning experience on his blog, World of WallStreet (http://montyhigh.typepad.com/world_of_wallstreet/), on which he frequently posts.