While some investors favour precious metals, as they tend to have more utility, there is a wide range of juniors involved in searching, staking, proving up and even developing projects in every mineral category, but the road from discovery to mine is fraught with dangers for companies and investors alike.

Being on the small side, these companies could offer greater growth potential but this also comes at greater risk. With gold’s plunge this year, some wary investors have steered clear, while others see huge opportunity.

Few junior gold miners have delivered strong performances over the past year, but their depressed prices could represent more attractive entry points for interested investors, albeit at extreme risk, owing to many of these being in dangerous penny-stock territory – below $5 apiece.

Gold stocks – particularly those of juniors – have been undervalued for longer than many investors thought possible. But, as in all things, most believe that the undervaluation cycle will eventually have to be broken.

Mickey Fulp, author of the Mercenary Geologist website, tells Mining Weekly that, for successful junior investment, considering four criteria is essential. These are to look at the company’s share structure, the people, the project (which is most important) and the company’s capital-raising ability.

He points to the fact that a multitude of junior companies are teetering on the brink of failure, having burned through their capital and now not meeting the minimum listing requirements of stock exchanges.

From the start of the year to August, about 85, or 5%, of the 1 673 mining companies listed on Canada’s TSX and TSX-V failed, compared with about 6% in the oil and gas industry.

These do not include companies taken off the exchanges owing to merger and acquisition (M&A) activity, going-private transactions or those companies that have graduated to bigger exchanges.

Fulp says it takes a lot of time to “wash out the bad” companies and many are, by now, merely hanging on, creating more danger for the unsuspecting investor.

He warns that dilution is the bane of juniors, and while there is a range of alternative financing options available to smaller companies, not all of them are accessible at this time, necessitating some juniors having to undertake highly dilutive share placements to survive.

With anecdotal evidence pointing to a sharp increase in the number of insolvencies in the mining sphere in the last two years, market signals are pointing to things getting a lot worse before getting better, John Sandrelli, a partner at law firm Dentons Vancouver, says.

He tells Mining Weekly that, given the “very challenging” current market conditions – characterised by slumping commodity prices, rising costs and a lack of access to capital, especially for the small and medium-sized miners – he has not seen much change for the better in recent months.

“We believe this will be a drawn-out market cycle, different to what we have seen before, and we believe the lull will last at least until the first quarter of 2014.”

Sandrelli underlines the need for businesses to navigate this difficult time by planning proactively andby making deliberate changes to company structures, before it is too late to avert disaster.

Incessant Due Diligence

Seasoned Vancouver-based investment banker and exploration junior Newstrike Capital director, president and CEO Richard Whittall believes that nowadays it is part of the junior business model to be acquired in the long run, which could potentially create significant value for investors.

“It’s a question of whether a junior can discover a deposit, how much of a mineral it can discover and at what cost the discovery comes,” he explains in an interview with Mining Weekly.

He points out that the normal investment rules for any business also apply to investing in the junior minerals sphere, which means taking a critical look at the margin at which the company would be, or is, producing goods.

“When assessing a junior for potential investment, the mantra ‘Have they got the likelihood of constructing a low-cost operation for low-cost capital expenditure?’ applies. Investors look for a rate of return,” Whittall says.

Among questions investors should be able to answer about any specific junior, before making an investment decision, are ‘can this be a low-cost mine?’; ‘what are the infrastructure requirements, such as roads, rail and electricity?’; ‘how stable and mining-favourable is the jurisdiction in which the project is located?’ and ‘can the company transform the discovery into an economical deposit with compelling enough character-istics to attract financing?’.

He says these are the boxes juniors have to tick in order to raise capital through equity raises, which are, in general, the life force juniors need to survive.

In general, when a commodity price is high, one can afford to pursue a low-grade project, but when prices are low, high-grade projects tend to be the only saving grace.

Equally important to having a strong asset is to have the right management team in place. Investors should look to see whether the company has the expertise to bring a discovery into commercial production.

“You need ‘cradle-to-grave’ people in the management team. They need to have certain skills sets, such as the ability to raise cash, credibility and a proven track record and the ability to bring a discovery all the way through to production,” Whittall notes.

This is especially true in the face of the volatile commodity prices in recent months, underlining the need to have staying power in the team, which only comes with experience. Management needs to have been through several cycles to be able to know what to expect.

Dentons Vancouver partner Alan Hutchinson believes the management team is the most important element to look at when considering junior investment. He also advocates a thorough mix of senior management and young blood coming through the ranks.

“One would need an experienced team to know when not to panic in cyclical down markets. There also needs to be a changing of the guard as more senior staff step back. I believe a new generation of managers will lead the recovery phase, not assets,” he says.

House Mountain Partners founder and co-author of Morning Notes Chris Berry tells Mining Weekly his thinking on what the most important elements of junior investment are has evolved somewhat.

He says those companies with the strongest balance sheets and with no debt offer the best opportunities to survive the current market environment. Cash flow is what investors want and those companies generating positive cash flow stand to weather “this current malaise” the best.

“But survival isn’t why we invest in these companies. Currently, I think a more important factor involves understanding the supply and demand dynamic and the supply chain for a specific commodity.

“With historically high growth rates having fallen in recent months in emerging market economies such as China, it behoves investors to pay closer attention to specific commodities with looming supply and demand imbalances, rather than just assuming that all commodity prices can rebound in tandem – which I do not think they can,” he says.

Berry is currently particularly focused on the potential for supply shocks in specific commodities manifesting themselves through resource nationalism, weather events or geologic exhaustion.

Further, a company management’s experience in the exploration or production of a given metal and its cash management capabilities are critical indicators of success, he says.

“I see compelling evidence of deflationary forces in the global economy and, as investors cannot control these forces, focusing on some of these factors and having patience are keys to success.”

In for the Long Haul

One thing is certain: the markets are not about to change abruptly and investors navigating the current bear marketplace have to be brave and work on the assumption that commodity prices, if not all at once, will rebound.

“If one wants to invest in the current climate, your investment horizon has to be longer than a year– perhaps even significantly longer,” Whittall says.

Fulp adds that there is significant risk aversion in the market at present. He notes that many countries seem to be racing to devalue their currencies, and since the junior sector is in the riskiest investment quartile, recovery in the junior market is not expected soon.

He believes that a significant catalyst for a recovery in the junior sector would be a stronger gold price, pointing out that the TSX-V is mainly driven by the price of the yellow metal.

Critically, the midlevel and major gold miners also need to become successful again and reward their shareholders with satisfying returns on their investments. He reminds investors that mining is a value industry, not a growth industry.

However, not all the blame rests with the majors, as the junior industry is rife with so-called ‘lifestyle companies’, where management harvests the stock exchanges before liquidating these companies and then disappearing.

Newstrike’s Whittall points to the recent Denver Gold Forum, in Colorado, where the unremitting message sounded through one presentation after the other was that the gold mining industry was only now waking up to securing a decent return on the initial capital.

“It’s as if the gold miners are now waking up from their mea culpa, and many are trying to make up for their sins of the past. The industry has finally figured out what the margin of production is – one of the basic principles of business economics,” he says.

This realisation was spurred in large part by the World Gold Council’s new all-in cost standard, which has helped companies and investors take into consideration the overall costs of everything in a company’s portfolio and its relationship to the bottom line.

Whittall says only about 20% of mid- to senior companies are currently in good enough shape to do M&A transactions, driven mainly by the need to replace depleted ounces.

However, these companies will first need a few good quarters before they would be willing to once more engage in M&A activity.

“Juniors are the lifeblood of the mining industry, and despite their larger peers not currently being in the market for M&A, they will buy later. It will probably take a maverick CEO to break rank in the intermediate $500-million to $1-billion market to change the sideways market,” Whittall says.

Despite most commodity prices being high on a historical basis, such as copper and silver, they have fallen in recent months while cost inflation has ravaged the industry.

“This margin compression needs to reverse either through a rebound in commodity prices or optimal cost management on the part of the companies,” Berry comments.

He agrees that majors will likely need to continue writing off assets and regain investor trust before they can aggressively start looking for smaller M&A candidates.

Berry adds that he believes a sustained economic recovery in the US and in the eurozone will serve as a significant catalyst for recovery in the junior sector.

“These economies are growing, but substantially below their potential, which means that higher commodity prices may be some way off. Compounding this is the fact that many emerging markets, which have served as the catalyst for higher prices in recent years, have substantially slower gross domestic product growth rates.

“I do believe we are at the bottom of the cycle, but I have not seen compelling evidence of a turn yet,” he says.

Fulp warns that this is a time when speculators should be diligent. “This bear market presents the best opportunity to position oneself to make a considerable amount of money in the future,” he says.