Junior Base Metals Stocks

Scott Wright January 2, 2010 2525 Words

If you peel away the layers of what the mainstreamers classify as materials stocks, you will find the base metals stocks. And it is this group of stocks that represents the mining companies responsible for the supply side of the non-ferrous metals trade.

Such metals as copper, aluminum, zinc, nickel, lead, molybdenum, and cobalt have seen huge increases in demand in recent years. And with supply not able to keep up, this has naturally sent these metals’ prices through the roof. This has allowed the mining companies to generate staggering profits, thus greatly rewarding their shareholders.

The base metals stocks have been among the best performers in the entire markets since the bulls for their respective metals took shape in and around 2003. And with these bulls still in their early- to mid-stages, these stocks should continue to outperform for years to come. The miners that operate low-cost and long-life operations while continually renewing their reserves will thrive.

A few months ago our research team sifted through the entire universe of North American-listed base metals stocks and identified what we believe to be the best of the best. And when all was said and done we selected our favorite dozen and published detailed fundamental profiles on each. The elite miners profiled in this September report are operating and/or developing world-class projects, and offer investors a widely-diversified selection of base metals stocks.

But while this report was well-received, the feedback I’ve heard from folks has shown that there is a craving for even more, especially on the speculative front. And the base-metals-stock sector indeed offers plenty of speculative opportunities. If you keep digging down you’ll eventually find an enterprising group of stocks that reside in a speculators’ playground, the juniors.

In a classic sense, junior mining stocks are non-producing explorers. While these companies can vary in maturity within the discovery, exploration, and development stages they do have one common goal, to strike it rich. Juniors embody the entrepreneurial spirit, most being startups with a small amount of seed capital. And while most will fail in their ultimate quest to profitably mine a mineral deposit, those that do succeed can score their shareholders legendary fortunes.

Though tiny as measured by market capitalization, juniors play a big role in the commodities lifecycle. Whether they are absorbed into the larger mining companies or bring mines to life themselves, junior explorers provide the next generation of base metals mines. But for speculators looking to make their fortunes in the junior markets, caveat emptor. For every success story there are vastly more failures.

Considering the inherent risks associated with investing and speculating in juniors, our previous base-metals-stocks report was mostly comprised of companies in the producer class. There are a few larger and more advanced juniors profiled in this report, but the majority are miners (ranging from small-sized to some of the largest in the world) that actually deliver a product to the marketplace.

In order to shift our focus exclusively to juniors, the research parameters needed to be redefined. And this is exactly what we did for our brand-new Favorite Junior Base Metals Stocks research report. Since we already performed an initial scrub of the universe of base metals stocks for use in our previous report, it was pretty straightforward to modify the parameters and target the non-producers.

And based on population alone this ended up being quite the undertaking. If one thing is for certain in the junior sector, a bull market brings a whole lot of contenders out of the woodwork. With several junior stock exchanges around the world that serve to funnel venture capital into public companies, all one needs is a catchy name, a piece of land, and some encouraging rock samples to list a mineral-resource stock. Junior base metals stocks that trade in the US and Canada alone number nearly 300!

These juniors represent the Wild West of the resource-stock world. And it was no easy task finding the cowboys among a large group of bandits. It is inevitable that schemers, pumpers, and low-quality projects try to steal some of the capital flooding into this sector. With so many pretenders, investors must be very discerning when researching these companies.

On top of the quality, quantity, and stage of project(s), it is imperative to consider company history, management experience, geopolitics, and financials among the many attributes that make for a solid junior explorer. And in order to be confident that our picks have the highest probability for success, the entire pool must be surveyed. Over the course of our research we made a number of fascinating observations.

Now it is not news that the entire junior resource sector has been struggling in the last few years. These juniors have been entrenched in a serious crisis of confidence on the investment front, caught in a sentiment storm that began well before the stock panic gripped the markets last autumn. All you have to do is look at the activity on the world’s premier junior stock exchange, the TSX Venture exchange, to understand this junior turmoil.

Measured by the CDNX, the juniors have really underperformed the rest of the commodities sector. And this is alarming considering the risk/reward tradeoff associated with this class of stocks. In order to entice investors, this high risk must be rewarded with outsized gains. But this has not been the case of recent. Retail investment, which drives these markets, has largely abandoned the juniors.

The stock panic of course made the situation a lot worse, but provocatively its aftermath has proven quite helpful in our research. Warren Buffett’s clever adage “only when the tide goes out do you discover who’s been swimming naked” is very applicable to the junior sector. Prior to the panic a large contingent of juniors claimed to be on the fast-track to producerdom. But with market and capital conditions radically changing as a result of the panic, these companies’ true colors emerged.

The panic really tested which juniors, regardless of where they were in advancing their projects, had moxie. In only a short period of time the junior markets went from a period when it was relatively easy to access capital to a period where capital flows had all but dried up. From the juniors that were in the early stages of resource delineation to those that were performing advanced engineering and economic studies, capital conservation became the modus operandi.

This state of financial disarray really exposed those juniors that were poorly managed and had weak portfolios. The poorly-managed juniors quickly seized on the financial front. They ran out of capital, couldn’t fulfill their liability obligations, and based on the declining value of their shares are finding it very difficult to raise meaningful capital to fund operations.

Most of the juniors unable to raise sufficient capital have also been exposed to have weak project portfolios. Since the panic bottom investors have slowly made their way back to the junior markets. And both new investors and those brave enough to return are naturally going to be more selective when entrusting their hard-earned capital to the fate of a junior explorer. A lot more due diligence is performed, and only those juniors with top-shelf projects have been able to attract post-panic capital.

What has also helped in our junior research is our ability to categorize them. With a collection of fundamental data for each stock at our fingertips, we are able to sort and arrange to our heart’s content. And when sorting by market capitalization we are able to segregate these stocks into distinct categories. The larger and more advanced juniors reside in the small-cap category. Though this structure seems oxymoronic, the universal criterion for a stock to fall in this category is for it to have a market cap in the $300m to $2000m range.

While this small-cap category is typically considered too speculative for most mainstream investors, when it comes to base metals juniors the small-caps are the biggest of the bunch. Within this mature group of juniors you’ll typically find companies with well-advanced projects, an exceptionally-large deposit, or a combination of the two. But with only about 2% of base metals juniors residing in this category, it is only a small representation of the greater community.

The next category down is the micro-cap stocks, juniors with market caps in the $50m to $300m range. But with this group housing only 14% of the total junior population, it also represents only a small faction of stocks. Provocatively the majority of juniors have market caps under $50m. These lightweights are called nano-caps and represent 84% of all base metals juniors. And with the average market cap in this category at only about $11m, you can see how small these juniors truly are.

In prior junior analysis, specifically for our latest Favorite Junior Gold Stocks report that was published in March 2009, I broke these categories down and performed capital-volume analysis. Using share price and volume data it was apparent, at least for the junior gold stocks, that this equity class was still out of favor and would continue to have difficulty raising capital.

Well this is pretty much the same story for the base metals juniors today. Share prices and volumes are low, especially for the nano-caps, which paints an ugly capital-volume picture. This of course does not bode well for attracting the exposure and trading activity that is necessary to raise capital via equity financings. Instead of taking this capital-volume approach for the base metals juniors, I went a different direction to help refine the search and discover where opportunities lay.

And what better way to do this than straight-up performance analysis. From early October when we started this project to the middle of last week when I updated the numbers, the bellwether S&P 500 had a strong 9% rally. Commodities also performed well over this span of time with the Continuous Commodity Index (CCI) rising 14%. So how did the performance of the base metals juniors compare?

Excluding a small fraction of outperformers and underperformers that had anomalous gains/losses during this exact span of time, I calculated the simple average gains for each category. The small-caps performed well, with average gains of 10%. But while these gains paced the S&P 500, they lagged the CCI. These are nowhere near the gains you’d expect in return for the small-cap risk. Why not just invest directly in the CCI?

Moving down a level, the micro-caps performed much better. On average these stocks well-outperformed both the S&P 500 and CCI, with average gains of 19%. This 2.1x leverage to the S&P 500 gives investors a nice risk premium, but some would say not enough for the risk. But since this is just an average leverage, there are obviously stocks on the high side of this category with incredible gains over this 2.5 month period. There are definitely opportunities here and this is where skillful stock picking comes into play.

Not surprisingly the micro-caps are the best of breed. The nano-caps, those higher-risk juniors that should be returning higher gains, barely beat the small-caps with average gains of 11%. And to take it a step further, those juniors with market caps under $10m did even worse, sporting average gains of only 7%. This sub-$10m contingent couldn’t even beat the S&P 500 when commodities were on the rise. This is noteworthy because over half of all base metals juniors reside in this group.

This simple performance analysis is very telling. The first thing it tells me is that the micro-cap category is the sweet spot of the junior sector. It also tells me that the nano-caps are still well out of favor. Even though there will be outperformers in each group, on balance investors are still staying away from the highly-speculative low-market-cap juniors. And this is concerning considering where we are in these bull markets. As outlined in my prior CDNX analysis, there is an ongoing structural problem with the junior markets that is unfortunately taking its sweet-old time to correct.

Additional fundamental data that we captured in our research confirms this junior malaise. In our first pass researching each of these companies we peruse their financials. And it is shocking to see the large number of juniors that have very little, zero, or even negative working capital (current liabilities are greater than current assets). Barring successful capital-raising efforts, these financial woes make for unsustainable operations.

And in my observations most of these companies continue to find little success tapping the markets for capital. Since equity financings are typically the only source of capital for these juniors, their low stock prices mixed with a general lack of enthusiasm from the retail investor is a deadly combination that will ultimately kill the fundamentally-weak companies.

But alas, all hope is not yet lost in the junior sector. In fact, incredible investment and speculation opportunities abound even today. It is true that there are a lot of junk stocks out there, which makes quality research even more valuable, but juniors will never relinquish their role as vital constituents of the base metals trade. And if you can identify those juniors that fit the shoe and get in while it’s early, extraordinary gains can be made.

In our hot-off-the-presses new report that includes comprehensive profiles on our favorite base metals juniors, it so happens that 10 of the 12 stocks fall within the sweet spot of the micro-cap category. These fascinating companies range from early-stage explorers to emerging producers. And their portfolios consist of rich mineral deposits that host such metals as copper, cobalt, nickel, and more.

These juniors own some of the world’s biggest and best undeveloped deposits, and their high-quality projects are scattered around the globe in geopolitically-safer countries. And with each company employing highly-experienced and competent managerial and technical teams, they have the tools to continue to make further discoveries, grow resources, and eventually bring profitable mines into production.

Investors have the opportunity to grow with these companies. Some of these juniors will eventually graduate to producerdom on their own. Some will establish joint ventures to assist with financing and operations. And some will be prey for the larger miners that are once again on the M&A prowl. In any of these scenarios shareholders would be greatly rewarded. Buy your report today to have the fascinating profiles of all 12 of our favorite junior base metals stocks at your fingertips!

The bottom line is base metals stocks will continue to be great beneficiaries of the ongoing commodities bull. The world’s developing economies will prop base metals demand at a high level for years to come. And the mining companies responsible for feeding the supply chain will leverage the resulting high prices, greatly rewarding their shareholders.

Investors who seek highly-leveraged exposure to the fortunes of the base metals can find some gems in the currently neglected but indispensable and due-for-a-pop junior sector. Even though this sector is going through a restructuring of sorts, there are still juniors with incredible potential that should fly on their path to producerdom. But only well-informed investors that are able to skillfully research this muddled pool will find the winners.

Scott Wright January 2, 2010 Subscribe