Gold Series Part III – Gold Rush!

We began this series with an attempt to cut through media spin and answer the question what is gold? Next we laid out a fundamental strategy for owning gold in a balanced portfolio. This proper mix of assets included physical metal, large mining firms, junior mining firms and finally exploration companies. The latter is by far the most exhilarating of all gold related asset classes. As we focus in on this exciting sector one question remains; how do we protect and preserve capital while participating in this gold rush?

Many investors dream of having the opportunity to tell a cocktail party story about their stock pick that began as a $0.50 share traded on the pink sheets and ended in a $50 takeover. The desire to fulfill this dream is one of the most dangerous of all human instincts and ironically can cause even a competent investor to ignore nearly every sign of peril. Some investors will recklessly shift capital in and out of thinly traded stocks searching desperately for their winner. In the end, debilitating losses typically triumph and instead of an objective look at the facts blame is placed on the market.

The problem with this portion of the market is that there are real tangible success stories. Some companies do set out to explore a prospective claim and end up making a discovery that produces returns in the range of several 1,000% for early shareholders. In order to capture gains produced in this gold rush we need to focus on proper capital placement using the facts, not emotion, to guide our decisions.

The Business

Exploring is fairly simple and begins with determining a target area. Once this area has been identified the newly formed company must raise capital. Debt will not be available because the company’s only asset is hope. $10,000,000-30,000,000 in initial capital is typically sufficient depending on variables unique to each project. 5% of this capital is immediately paid to investment bankers for handling the equity offering. The remainder will fund salaries, expenses, drilling activities, core sample analysis and the acquisition of additional nearby claims if necessary. Success in this business will follow this timeline:

Initial claim analysis and soil sampling
Round 1 of shallow drilling based on initial sampling
Analysis of drill results produces next year’s target area
Round 2 of deep drilling in targeted area
Analysis of drill results forms basis for 43-101 compliant resource estimate
Additional fill-in drilling provides data needed for preliminary economic assessment
Further sampling and drilling conducted to produce a bankable feasibility study
Project is sold to a major mining firm who will develop the mine

Over 4,000 companies claim to be in this business today. More than 85% will fail, generating capital losses for shareholders. While 15% will experience some degree of success only a very small percentage of these will properly reward us for the risk associated with our share purchases. In order to be successful we must use the following filters to sort out the trash.

Project

The location of a company’s target project acts as our first filter and encompasses two parts. Everything can line up perfectly but if there is no gold in the ground we are destined for a capital loss. Geological considerations form the first layer of this filter. If there have been mineral discoveries in the past on adjacent properties or in the general region we can assume a realistic chance of success. What we want to avoid is speculating in an area with either no history or a long track record of failure.

Part two of this filter takes into account the geopolitical environment. We want to speculate in regions that are mining friendly. Some governments have a history of terminating mining rights or seizing companies all together. If we have taken all of the many risks involved in financing this venture we want to be reasonably certain that we will be able to experience the rewards associated with a large discovery.

People

As a company progresses through the sample timeline we listed above an executive makes each decision along the way. Where to drill, when to drill, how to finance, who to hire and when to sell are only some of the critical decision that must be made in order for a company to stand a chance at survival. These companies are burning cash by the minute and it is your cash that they are spending.

The mining business is fairly incestuous and we can use that to our advantage. Most executives have an accessible track record. If someone is asking us to finance these activities and they have run eight mining firms into bankruptcy we have something to be concerned about. Conversely, if an executive has had several projects that progressed through development and ended in a sale creating shareholder value we can assume that they know what to look for when taking on a new project. We can also look back to see who else worked on those successful projects. This search will often tip us off to other new firms that deserve our attention.

Just like investing in any other business we want to stick with the winners. As they say, 80% of the value is created by 20% of an industry. It requires the same amount of capital to purchase shares in a mediocre firm as it does a possible winner.

Share Structure

In this early stage debt is almost completely unavailable. Companies are forced to access financing in the equity markets. We need to pay careful attention to what we are buying as share structures can differ drastically from company to company.

Typically initial financing occurs in the form of a small private placement offering. This event is only accessible to accredited investors who are somehow connected to the executives who have identified a target project. Once some certainty has been established, an initial public offering will be structured. Canada is currently the most financially friendly jurisdiction for mining firms and a large majority of them have chosen to be headquartered there. Shares are often issued on the Toronto Venture Exchange and Americans can purchase equivalent tracking shares on the pink sheets. Some brokers offer direct access to the Canadian exchange and this is ideal as more robust volume creates better trading conditions.

Once shares are freely trading we want to be sure that management has a clear financial direction. They must be using capital to progress along a reasonable timeline. Some firms continuously issue press releases in an effort to artificially pump up stock prices. This is often an effort to facilitate constant additional share issuance. Staying focused on the fundamentals of the business will keep you from being lured in by this seductive scheme.

Finally and perhaps most importantly, we are looking for a very tight share structure. If management owns very few shares and public filings show a pattern of incentive shares being rewarded and then immediately sold we can assume a lack of commitment. No one knows the potential of a project like the people calling the shots. We want to see them putting their own money where they are asking us to put ours. There is nothing wrong with management using our capital to advance a worthy project. If they are successful the returns will be significant for all parties involved.

The intention of this series has been to help investors understand what is driving the bull market in gold. Once this has been accomplished careful attention should be paid to the individual phases that exist during the bull market. Initially bullion, or physical metal, preforms best. The second phase is characterized by constant surprises in quarterly earnings statements as large mining firms begin experiencing the effects of higher output prices. Finally, a speculative mania takes hold as investors seem to be overwhelmed by the potential windfall that accompanies a gold discovery. Many market participants will race to purchase any potential gold explorer in the hopes that they can be the next one to tell of fantastic profits.

Sticking to a fundamental due diligence process built around a solid understanding of the mining business will help investors pick good exploration stage companies. If this sector is kept to a maximum of 25% of overall gold exposure in a balanced portfolio the chances of profitably participating in the bull market will be greatly increased.

By Edwin B. Tucker