We all know that commodities are hot and have been so for the last few years due to investors wanting protection from inflation and strong growth from emerging markets. The greatest gains have not been made in the commodities themselves but instead junior exploration stocks. These little companies are the workhorses of the mining industry. They scour the globe and try to find natural resources and often present high-risk high-reward investments to investors. These may be risky, but they offer investors the possibility of achieving 1000%+ returns which makes them irresistible to the speculatively inclined. In this article I am going to present some tips to help investors participate in this interesting sector without making some of the mistakes that doom most speculators.
1. Approx. 95% of all junior resource companies will go bankrupt and are not worthy of an investment. This is according to legendary resources investor Rick Rule of Global Resource Investments who has 40 plus years of experience.
2. The reason for the high failure rate is that the majority of these little companies have uneconomical deposits. Investors must really do their due diligence when it comes to evaluating these type stocks. All of them have fancy websites with copious amounts of PR which always presents them in a favorable light. They all claim to represent a "great opportunity" for investors. Furthermore these companies often pay research firms to publish "investment research" which gives specious projections and price targets. Don't fall for this trick.
3. Because these stocks are risky, investors need a substantial margin of safety along with a high potential reward before investing. This usually means you need to avoid companies with small deposits or are exploring in areas that are not likely yield a large find. This requires a rudimentary knowledge of geology which is usually outside most investor's ability, but it is necessary if you are to put yourself in a position to win. You only want to be investing in exploration companies that have the opportunity to discover large find (e.g 8-10 million ounces of gold, 100 million barrels of oil, etc).
4. Diversify--no amount of knowledge will make you infallible when it comes to investing. The exploration business is tough even with the most advanced technology and capable management. In the end you never know if a company is going to find a deposit or whether it will be commercially viable. To guard against the inevitable mistakes you need to diversify your portfolio and never bet the farm on some stock with good prospects. In fact the allocation you have to junior resource stocks should be relatively small with perhaps 20% as the absolute limit. Why? Because the majority of you companies will likely go to zero after they fail to find any meaningful deposit. In this business your winning stocks will be few and far between but when you hit you will get a huge return. Also allocate no more than 1-3% in any individual stock to prevent against blow ups and somewhat help to buffer the expected volatility.
5. People--People matter when it comes to companies and this is especially true for resource stocks. Investors need to carefully evaluate a company's management to determine whether they are winners or simply losers. Consider the experience of management--what is their background (geology or finance), have they run companies before and what was the result, and finally have they every themselves made a geological find. The idea being that if you find management who has already built a company before from scratch then they have the necessary skill set to do it again.
6. Major Investors-- For me this is a big one. Its great that you think a particular company is worthwhile and a good investment but what do other more experienced investors think. Always take a look at the major owners of a prospective investment. Are there any standouts like Rick Rule, Ross Beaty, etc. Ideally you want to have strong backers because it shows that this company is for real and has a good chance (not guarantee) of success. After all, it has been vetted by very fastidious investors and passed their criteria. Checking up on a company's ownership can give you great leads and helps you avoid duds.
7. Finally do not try to trade these stocks as you would ordinary stocks. The volatility is often hard to stomach (30-50% moves for no reason) and it is very hard to get in and out at the appropriate time because these stocks are very sensitive to company announcements. Major news includes recent drill results, capital raising, purchase of prospective land, etc. Most of the time you will not know the exact time of the news release and could miss out on substantial moves (i have seen stocks double or fall 70% in one day at the open). So it is usually best to just sit tight once you have made up your mind and hold regardless of the volatility.
Black Swan Insights