Should You Join The Next Gold Rush?

Wall Street Journal By Jeff D. Opdyke March 6, 2010

Main Street investors always want in on the ground floor of the next Microsoft or Google, or, in the commodity world, the next gusher or mother lode.

At a time when gold is above $1,100 an ounce and some expect it to go far higher, a lot of investor energy is focused on the so-called junior miners. These are the tiny mining firms that often own little more than a piece of land, some geology studies and dreams of El Dorado. So much cash has flowed into the Toronto Stock Exchange's small-company Venture Exchange—where mining firms in 2009 raised nearly $3 billion Canadian dollars—that its total market capitalization surged by 112% last year.

For too many investors, though, this pursuit of El Dorado ends up as a financial nightmare. Even if you are lucky enough to pick a miner that finds a rich vein of gold, you can arrive so early that your stake crumbles while the miner navigates the hurdles between locating a gold deposit and actually producing it.

Despite the "great sex appeal" of early-stage mining companies, "most just wash out," says Frank Holmes, chief executive of U.S. Global Investors, which runs a gold and natural-resources fund. Those that do find a viable lode often end up hamstrung for years by environmental or governmental delays that erode share prices.

The best way to reduce your risk: Focus on junior miners that are within a year of production. And understand the lifecycle of small mining stocks before you invest.

• Stage 1: Idea and exploration. This is "wing and a prayer" territory, where you are betting an upstart company with no assets in the ground, some cash in the bank and a fistful of geologic analysis will unearth a mountain of gold. Most flame out; some persist for years, perpetually drilling and fund raising, while diluting existing shareholders. These risky crapshoots have little to do with gold prices.

Some firms do find gold, which brings investors running. In 2006, Aurelian Resources announced what some labeled a "bonanza" in Ecuador. Shares that traded earlier that year for 13 cents soared to more than C$3 on the announcement, even as gold prices slumped. The shares eventually went above C$10 a share, even though it was years from production.

• Stage 2: Discovery and feasibility. This marks the period when a miner determines the costs of building a mine and mitigating environmental concerns necessary to secure permits. It is rife with delays and disappointments that undermine share prices.

Consider Aurelian, again. An Ecuadoran decree in April 2008 closed all mining operations, and Aurelian's shares collapsed to less than C$4. (Kinross Gold later bought Aurelian for C$8.20 a share to gain access to the gold deposit.)

Or consider NovaGold Resources, a junior miner that in late 2007 suspended construction of a massive gold and copper mine in Canada because revised cost estimates—some C$3 billion more than projected—made the project uneconomical.

Shares fell more than 50% in a day to less than C$10. Today it hovers near C$6.

• Stage 3: Production. A few companies make it to the point that they are mining gold in quantity. Red Back Mining first started producing gold in its West African mines in the fall of 2005, with the shares then at about C$2. The cash flow provided a floor for the stock price, and the shares have pushed higher as production increased and as Red Back brought another mine into production. Today the stock trades near C$20.

Many juniors in production end up getting acquired. Canada's Wheaton River Minerals for years traded between C$0.50 and C$3, and was producing more than 500,000 ounces of gold annually when, in late 2004, it agreed to an all-stock merger with mining giant Goldcorp. The merger valued the junior miner at C$4.29. Goldcorp's share price has more than doubled since, and that C$4.29 share is now worth about C$10.

The lesson here: Junior miners that haven't reached the production stage aren't really a play on gold. They are a far-out-of-the-money call option that a particular company will be able to navigate all the various regulatory and operational hurdles and actually produce the yellow metal.

If you are going to gamble on the juniors, put the odds in your favor. Focus on those generally within a year of production. They have gold in the ground, they have passed regulatory and financial hurdles and have determined they can build a mine profitably.

For junior-mining investors, that is the true El Dorado.