As Junior Miners Cash in on Soaring Inflation and Growing Global Demand, So Can You

From Money Morning Staff Reports

In the past two years, Toronto's TSX Venture Exchange (CDNX), which is the best way to track the value of junior miners, plunged 80% from its all time highs, essentially wiped out all of its bull market gains from peak to trough since 2002.

But since December 2008, the TSX-Venture Index has already rebounded with a whopping 44% gain.  And in the interim, the mining sector (mostly major companies) has raised over $42 billion, most of it through riskier equity financing rather than lender-secured bonds. To see what we mean, check out the accompanying chart.

There's a message here: Investors clearly anticipate strong returns in the coming years, and are prepared to commit their capital to the natural-resources sector. Some individual companies have already seen their share prices triple and quadruple from their ultimate lows.

But global demand growth and anticipated inflation will be good for commodities. And that means tremendous opportunities remain. So investors looking for serious moon-shot potential need look no further.

The only question, now, is how to identify the very best of the opportunities. All that takes is some very careful scrutiny and an adherence to two simple rules:

  • First, in the short- and medium-term, investors should limit their attention mainly to precious metals.
  • And when it comes to junior-mining stocks, investors need to remember to limit their investments to "best-of-breed" companies - those with superior management, pristine balance sheets and quality assets.

Let's look at both of these rules.

Inflation Wins Out

It's true that there's been an ongoing inflation/deflation debate. But several factors at work have pushed, and will continue to push, junior gold and silver stocks higher.

As Money Morning's Martin Hutchinson has stated in several market analysis columns, with U.S. Federal Reserve Chairman Ben S. Bernanke turbo-charging the printing presses, inflation will win out. Make no mistake: Gold and silver are the antidotes.

According to The Financial Times, China has just admitted that it secretly increased its gold reserves by 75% to 1,054 metric tons since 2003 That makes it the world's fifth-largest holder of bullion, leapfrogging Switzerland, Japan, and The Netherlands.

"Everyone's printing money right now ... gold is the one currency you can't print," Agnico-Eagle Mines Ltd. (NYSE: AEM) Chief Financial Officer David Garofalo said in a recent interview. "In the medium term, it's quite conceivable that gold could be comfortably above $2,000 an ounce."

And he's part of a growing class of mining executives that feel this way.

Rob McEwen, founder of Goldcorp Inc. (NYSE: GG), expects gold will eventually top $5,000 an ounce - due to an exploding money supply.

What's more, the annual worldwide mine production of gold has decreased by nearly 8% since 2001, while its price has tripled.

Agnico's Garofalo - who was named Canada's CFO of the Year by Financial Executives International Canada (FEI Canada), PricewaterhouseCoopers LLP and The Caldwell Partners International - also explained that junior-mining companies are having a rough go at raising money, so the deal flow for potential acquisitions is on the rise

And, he admits, juniors can serve as great turn-key solutions for majors that need to "replace their production and their reserves."

Silver, often referred to as the "poor man's gold," shouldn't be ignored, either.

You see, silver is usually a byproduct of the mining process of various base metals. The global downturn certainly has hit commodity prices hard, meaning some high-dollar projects have been reduced in price and scope - or shelved outright.

Even so, commodity producers have made some impressively quick adjustments in the past seven months. Producers wasted no time before deciding to cut back unprofitable production, suspend new near-term production, and axe capital expenditures and exploration of all sorts.

So with this declining output of base metals, we get the unintended consequence of lower silver production, coupled with rising demand. That's bullish for silver prices.

The Best of the Best

As we noted earlier, the second thing potential junior miner investors should remember is that risk capital should be limited to players with superior management, pristine balance sheets and quality assets. 

Naturally, some of the weaker, beaten-down companies with top-notch assets are attractive as buyout targets.  But if your strategy is to wait for a takeover offer, you could be waiting for some time. The reason: Plenty of stronger companies with great projects and healthy finances are still selling at market caps below their cash balances. 

If you buy a weak company, and the needed buyout n ever materializes, you could end up waiting for a long time for a return on your investment. Even worse, if this downturn turns out to be a lengthy one, weak companies will start to fail. But if you buy a strong player, even if the anticipated takeover or merger never materializes, you can still sit pretty waiting for the eventual recovery in demand.  A strong cash position will help you ride out nearly any storm. In other words, a strong company is still a good investment, even if you're forced to hold it for a long time.

Besides, juniors clearly have a vital place in developing commodity markets.  The majority of larger mining companies simply can't increase reserves enough on their own to meet anticipated growth in worldwide demand. Economic discoveries made by juniors often get sold to a major, creating explosive value for shareholders.

And although it does happen with some regularity, not all juniors end up in the arms of a major.

Some of these small explorers, post-discovery, prefer to make the leap to producer status.  While this entails more risk, the payoff can be tremendous when the transition is successful.

Signs of Encouragement

In addition to a promising outlook on the inflation front (vis-à-vis the upward catalyst the pricing pressures are expected to exert on the price of gold), other factors also bode well for junior miners in the precious-metals arena.

Cutbacks in exploration by the majors will translate into fewer finds, escalating the need to acquire juniors, especially those with proven discoveries.  Also, the smaller-market-cap juniors, by virtue of their smaller size, are easier to buy out.

And for some individual investors, there are attractive incentives in place.  Canadians benefit from "flow-through" shares, allowing those investors write off (against income) all of the acquisition costs in certain Canadian resource exploration shares.  Even institutional investors benefit from committing capital to Canadian junior miners.

Aware of the successful Canadian model, South African Finance Minister Trevor Manuel has introduced a similar - though more restrictive - incentive.  And Peru has had recent success in listing junior mining companies on its Lima Stock Exchange

Not to be outdone, Chile's Mining Minister, Santiago Gonzalez, said he'd like to see junior miners list on the Santiago Stock Exchange too.  Chile, the world's dominant supplier of copper, has just passed a law to aid juniors with proven reserves obtain financing.

Time to Push in Your Chips

True contrarians bide their time as they search for bargains, sifting through countless "suspects" in the hope of finding one or two real "prospects" - preferably those with the strongest fundamentals.

With the sell-off panic of last fall, the countless bailout and stimulus plans that were subsequently enacted, and most recently the widespread direct purchase of government bonds by federal treasury departments around the world, inflation is a given.

If you're looking for a sector that's become bargain-basement cheap and has shown clear signs of revival, look no further.  For now, gold and silver deserve your attention.  Eventually, base metals, energy and agriculture will join the party too.

It's true that junior miners are a riskier asset class.  But the potential of a return that's five, 10 and even 20 times your investment initial is too strong to ignore.

But choose wisely. Don't just commit all your capital to this one mining sub-sector.  And don't forget to do your research: Focus on precious-metals plays, and make sure to spread your investments across a number of promising companies with healthy cash-to-debt ratios.

Remember, it's when your gut says "no" the loudest that you'll often discover to have been the best time to take the plunge.

News and Related Story Links:

  • Chilean Government Officials:
    Santiago Gonzalez