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Junior Gold Cleansing

June 28, 2013

There’s not much arguing against gold stocks being the most hated sector in the markets these days. And with such a loathing, you can only imagine the visceral disdain towards the more risky juniors.

Provocatively it wasn’t too long ago that the junior subsector was a speculators’ paradise that offered legendary gains. These small companies are of course a vital component of the gold ecosystem. And the quality ones that made solid discoveries while skillfully advancing their projects towards development would righteously see their stocks soar.

Junior gold stocks do have a strong dependency though. Their ultimate success is heavily influenced by the fate of gold, and to some extent the sector bellwethers. Gold has of course been trapped in a major rut since its 2011 high. And the larger gold stocks have leveraged gold’s losses to the downside as investors have run for the hills.

Unfortunately with gold selling off hard and the larger mining stocks getting crushed, the juniors don’t stand a chance. And indeed junior gold stocks have been annihilated amidst a sentiment superstorm that has left no prisoners. The carnage in this subsector has made it the vilest of pariahs.

Any investor who has a position in juniors has no doubt felt the pain. And to show how bad it’s been, we need look no farther than the performance of the GDXJ Junior Gold Miners ETF. This ETF (managed by Van Eck Global) is the most popular and liquid of its kind, and offers a good pulse of the subsector it represents.

In addition to the price action of GDXJ (blue), I included that of gold (red). Gold of course had a mighty run to its 2011 high. And for the most part the juniors followed suit. When gold rose higher, so did the juniors. And when gold pulled back, the juniors did the same.

There was somewhat of a disconnect however when 2011 rolled around. In 2011 gold easily surpassed its previous year’s high to carve out a series of new all-time highs. But while GDXJ would share gold’s directionality on most days, it would never eclipse the all-time high it achieved in late 2010.

Even big brother GDX (Van Eck’s Gold Miners ETF, the world’s largest gold-stock ETF that is comprised of the world’s largest gold-mining stocks) was able to achieve an all-time high in 2011. Unfortunately much to the chagrin of junior investors, GDXJ spent most of 2011 in a sideways high consolidation band.

This disconnect was a big-time head scratcher for the junior crowd, the same traders that enjoyed a trough-to-peak GDXJ gain of 100% in 2010, over which time gold and GDX were only up 34% and 59% respectively. As is the nature of most junior investors/speculators though, it’s all about “what have you done for me lately”. And this fickle group was all too quick to jump ship.

From gold’s high this chart proceeds to display a whole bunch of ugly. This selling was righteous initially given the overbought state that followed gold’s anomalously-strong summer upleg. And it’s certainly not unexpected that gold stocks would follow suit, with the juniors naturally leveraging to the downside.

And leverage they did, with the juniors getting creamed in the latter months of 2011 amidst gold’s wild downside volatility. From gold’s August apex, GDXJ was down a gut-wrenching 33% by the end of that year. Investors were beside themselves, running around like their heads had been chopped off.

2012 ended up being somewhat of a schizophrenic year for gold. It sported two decent-sized uplegs that were chased by corresponding selloffs that took back most of the gains. And when all was said and done, gold ended up with a 7% gain on the year. Certainly not great, but all in all not too bad given the negative sentiment starting to pierce this shiny-yellow metal.

With gold positive on the year juniors should definitely have been up, right? In fact, based on historic precedent they should have exhibited positive leverage, multiplying gold’s gains. Sadly this wasn’t the case. Not only did GDXJ not leverage gold’s gains, it didn’t even pace them. In fact, it was down 20% on the year!

With GDX also down (-10%), gold-stock investors and speculators experienced a miserable 2012. It was a year of frustration, and of wonderment. What the heck was going on with gold stocks? Why wasn’t this sector performing as it ought to be?

Surely 2013 would be a much better year for the juniors. These beaten-down stocks were due for a glorious awakening. If gold and the big producer stocks caught a bid, the juniors would be off to the races. Unfortunately as is glaringly obvious, the juniors have been subject to far more carnage.

Going into this year sentiment towards the juniors was already rotten. And sentiment shifting even more negative was virtually unimaginable. But given what’s been going on with precious metals, the unimaginable has occurred. There’s no sugar-coating it, gold has had a disastrous year. And this has naturally spilled over into the stocks that seek to wrest it from the earth.

From melting-up stock markets taking away the allure of alternative investments to an ultra-rare futures panic, gold has taken it on the chin. And it has plummeted to lows not thought possible amidst its long bull run. In 2013 alone gold is down 27%, to levels not seen since 2010. And this has of course permeated into the stock arena, with GDXJ’s 58% loss leveraging well to the downside.

It’s hard to believe, but GDXJ is down a staggering 81% from its 2010 high. And a decline of this magnitude has seemingly sounded the death knell for this sector. In their heart of hearts most investors are convinced that gold’s bull is over. And if this is the case then gold stocks’ best days are certainly behind them, with most juniors destined for the graveyard.

Indeed from a layman’s view things are looking quite ominous. The mainstream media remains overtly bearish on the metal. And this bearishness, coupled with a $400+ plunge so far this year, has been none-to-kind to the producers. Simple math tells you there’s some serious margin compression going on.

We’re also seeing major producers that have already taken or are preparing to take large write-downs on the carrying values of some of their assets (production and/or reserves are proving uneconomic at these lower gold prices). Exploration and development is being throttled back at nearly all levels (from junior to major). And it is getting harder and harder to raise capital. If you didn’t know any better, you’d think we are spiraling into a deep dark secular bear.

Thankfully it doesn’t take but a smidgeon of objectiveness and rationality to realize that we are far from shifting into secular-bear territory. Yes, this is a brutal spell that’s done a lot of damage to the sector. But gold’s structural fundamentals are just too strong for it to give up its ghost.

Gold’s decline has been purely technically- and sentimentally-based, not fundamentally-based. Demand remains high. And it is expected to rise in the years to come as more and more investors embrace gold as a viable hedge to their fiat-based portfolios.

And provocatively we’re likely going to see a new fundamental boost as an aftereffect of this carnage. As mentioned the lower prices have forced producers to throttle back production, developers to delay and/or shelve development, and explorers to dramatically reduce exploration. All this easing, even if it’s temporary, will no doubt put the mining industry behind the curve on reserve renewal.

What this will lead to is next-generation mines not coming online fast enough to keep up with depletion, as well as a thinning of the development pipeline. How is this positive for fundamentals? It will eventually lead to a widening economic imbalance. Supply will fall well short of meeting demand.

And lower output, the threat of lower output, and/or the inability to keep up with rising demand will eventually force prices higher. If this imbalance is to moderate, the miners need an incentive to cooperate. And they will only cooperate if it makes financial sense.

Circling back around to the juniors, assuming gold’s bull is intact and that prices will rise down the road, juniors will once again thrive. Unfortunately these high-risk little companies have and will feel the brunt of this ongoing carnage. And they’re in the midst of a cleansing period that is radically changing the junior landscape.

The fact is many juniors will not survive the rough stretch that’s obliterated their sector. They’ll be washed out. And this washout will occur due to their inability to fund operations. Unfortunately a large portion of juniors already have financial statuses that put their going concern in doubt.

In our latest survey of junior gold explorers we drew from a universe of 600+ that trade in the US and Canada. And based on their market capitalizations alone, it’s apparent that this sector is due for a cleansing. Amazingly over 60% of these stocks had market caps of less than $10m, with nearly 50% sporting market caps under $5m!

To make matters worse, this breakdown was based on inputs from mid-March. GDXJ, which is actually conservative as a measure of juniors since it includes producers, is off over 40% since then. Assuming an average loss of this magnitude, we can now expect that over 70% of junior golds have market caps under $10m.

This bottom three-quarters or so of juniors also have an average share price of only about $0.05. Now, knowing that the only way these juniors can raise capital to fund operations is by selling shares, explain to me how on earth a sub-$10m nickel-stock-price company is going to survive in this environment.

There are of course exceptions, but the vast majority won’t. Most probably couldn’t overcome the primary hurdle of finding investors to buy their shares. And if by some miracle they did, they wouldn’t be able to muster up enough capital to perform any semblance of exploration without diluting the snot out of their existing shareholders.

Mineral exploration is expensive. General surface prospecting can be costly, especially when it comes to assaying samples, performing advanced surveys, and mapping. Drilling then jacks up costs even more. And we can’t forget about paying the geologists and making property payments.

I’ve seen the balance sheets of many of these small juniors. And they are dismal, with very little working capital. And if they don’t have working capital now, they are pretty much hosed in this environment. They just won’t be able to operate.

Unfortunately things don’t necessarily get better as the market caps climb. The financing environment has been so bad for so long that most juniors have blown through their treasuries without being able to replenish. There are juniors in the $25m, $50m, and even $100m+ range that have insufficient working capital to operate. These larger companies may have higher-quality and/or more advanced assets, but if they don’t have money, there’s not much they can do with them.

It’s going to take consistently cooperating markets and then some time for investors to come back to the juniors. And sadly many will not be able to hold out until things improve. This cleansing will mostly get rid of impurities, but some good companies will be forced to shut down or sell out at fire-sale prices.

Fortunately not all hope is lost for the juniors. As mentioned these ambitious little companies are indispensable components of the gold ecosystem. Make no mistake, when gold makes a comeback, the juniors will follow. And those brave contrarian investors who partake in this sector at these bargain-basement prices ought to make fortunes.

Partaking in this sector of course requires extreme discretion. The last thing you want to do is buy into a junior’s story only to have it caught up in the cleansing. Investors should target companies that not only have quality assets, but a solid support structure that will get them through this carnage.

This support comes in the form of solid financials and a well-thought-out plan that’ll be executed by a top-shelf management team. And believe it or not, there are still companies out there that fit this mold.

June 28, 2013

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