US Markets The risk of punting on junior resources December 1, 2008 Scott Wright, Zeal Research
Junior resources stocks reside in a realm that has long been considered the Wild West of the equity markets. And investors who speculate on the junior circuit are the consummate gamblers. Risks and rewards are realized in extreme fashion as juniors can either make you rich or rob you blind.
The allure of juniors will always captivate investors. It’s exciting to own a portion of a company that is in effect a modern day treasure hunter. Whether it is searching for precious metals or petroleum, if a junior scores a find the owners of the company will be greatly rewarded. Speculating in juniors allows desk jockeys to become prospectors.
In the same fashion that investors long for the thrill of the hunt of the next big gold deposit or oil field, juniors long for the speculative capital investors bring to the table. For most juniors the only way to procure capital for their exploration endeavors is to offer up shares of their companies.
Well if you are at all attuned to the markets these days, you are likely aware of the across-the-board carnage of virtually every asset class. And commodities and commodities stocks have not been excluded from the pain. The juniors in particular have been absolutely crushed.
Investors who have been riding the storm have seen their junior speculations simply obliterated.
Going into May 2007 all was fine and dandy in the junior world, but things fell apart quickly.
The global financial-market crisis that has had a stranglehold on the world’s stock markets wreaked havoc on the junior miners. By October 6, one in three juniors traded would hit new 52-week lows. And I suspect this one-in-three extreme doesn’t tell the full story of how bad things truly are.
With junior resources stocks currently trading at an average of twenty-five cents on the dollar from just five months ago, a complete loss of investor confidence, and the inability to raise capital in the midst of these seizing financial markets, I suspect many juniors will not survive this storm.
To start with the prices of most of the commodities they either explore for or produce have plummeted. For the producers this translates into much lower margins and cash flows, and this can be catastrophic for the majority of juniors that run small-scale operations and have thin cash balances.
And for not only the producers but the explorers, falling commodities prices translate into falling project valuations. This makes these companies less attractive to potential suitors. But even if projects remain promising at these depressed prices, the ripple caused by the global credit crisis will hit the juniors with the force of a powerful tsunami. Buyouts are a junior’s best friend, but when the entire commodities supply chain is infected with these credit woes, M&A activity grinds to a halt.
Thanks to the depressed commodities prices and illiquidity in the credit markets, companies are clamping down on capital expenditures. This means exploration budgets are tightened, development projects are placed on hold, and growing cash becomes priority.
With so much uncertainty in today’s markets most larger commodities producers have radically altered their spending habits. And this means much less flexibility for acquisitions. Again, this is devastating for the juniors.
So with falling commodities prices and decreasing prospects for joint ventures or buyouts from the senior companies, juniors must look to investors for a vote of confidence and infusion of capital. But things don’t get any easier here. In fact finding investors now may be about as easy as finding ice cream in hell.
Investors must have an incentive to speculate in juniors. When commodities prices rise, the stocks of their producers/explorers should positively leverage their gains. This is the nature of accepting individual company risk and simple profits leverage. And this leverage should be especially prevalent for the juniors.
But not only were the juniors lagging in the latter part of the latest commodities upleg, they were declining. And this was readily apparent in the gold stock arena. There was wailing and gnashing of teeth when gold launched to $1000 in early 2008 and the juniors merely ground sideways. Investors were just not seeing their risks being rewarded.
In fact the only leverage the juniors have seen recently is to the downside. In the downward spiral since July, the mass exodus out of the juniors has showcased extreme capitulation. Those that stayed in own a portfolio of juniors with staggering unrealized losses. And those who sold out on the decline have yelped all the way home with their tails lodged well in between their legs.
I have personally heard from countless investors who swear they will never speculate in juniors again. And those who do venture to return to this arena will do so ever so gingerly after an extended period of mourning for their losses. The fact of the matter is there is a complete lack of confidence in junior resources stocks. And investors are nowhere to be found.
This lack of investor confidence is a huge problem for the juniors. Often times confidence, exuberance, and promise is all juniors can cling to in rallying investors to buy their shares and bid up their stocks. But this cheerleading doesn’t work for banks. Banks won’t even think about funding a junior until it’s defined an economically feasible project. And most juniors have no such asset.
So since equity financings are the only option for most juniors to raise capital, and investors are nowhere to be found, this presents quite the dilemma.
With no credit, lower commodities prices, vastly lower stock prices, and a lack of investor confidence, many juniors are likely to be in a period where it will be impossible to raise capital. Not only will there be less demand for junior equity, but many of their share prices are so low now that they do not have enough shares shelved to acquire material-enough proceeds from an offering to make a dent in their capital requirements.
No equity financings mean insufficient capital for marketing and promotions, insufficient capital for meaningful exploration programs, and insufficient capital for overhead expenses. And for many companies an environment like this can quickly lead to the end of the road.
Only those juniors that have the ability to remain flexible on the capital front will survive. A handful of elite juniors that own top-shelf projects will retain the ability to raise capital in the equity markets. But the rest will have to rely on the savvy management of working capital that is already in the books.
Some juniors may have the necessary capital to continue business as usual for many quarters into the future. Some juniors may be able to survive by throttling back on their exploration and/or development programs. Some may survive by outright halting capex and riding out the storm. But without the ability to procure financing many will fall by the wayside and outright fail.
So what is the point of this bleak outlook for the juniors? Well other than pointing out that these extraordinary and unprecedented markets have placed many juniors on the precipice of catastrophe, I believe an extreme cleansing of the junior landscape will create opportunities in the coming months and years.
Even with a major shakeup it doesn’t mean the junior trade will cease to exist. Yes, there may be a rough go as this global recession plays out, but I don’t believe that the unfortunate circumstances of a once-in-a-lifetime financial market crisis has the moxie to put an end to this secular commodities bull.
Extraordinary pressure has been placed on the interim fundamentals of the commodities markets. And a rebalance will cause significant collateral damage on the junior front. But for a variety of reasons, I believe commodities will continue to be the best-performing asset class in the decade to come.
And juniors have and will always play a vital role in the commodities markets. They are the mavericks of this industry that scour for resources on every corner of the earth. Many juniors are led by some of sharpest and most innovative technicians and managers in the industry. Some of the most experienced and successful exploration geologists are guiding their small companies in search of the next great mineral deposit or oil field.
What drives these juniors is the same thing that drives investors, the opportunity to score vast riches. When discoveries are made and advanced toward economic development junior stocks skyrocket. The principals of these juniors often have large equity interests in their companies, and it is to their incentive to drive their stock higher. And this all leads into the symbiotic relationship between the larger producer companies and the career explorationists.
Juniors play an instrumental role in feeding the commodities supply chain either directly or indirectly. Sometimes a junior will actually become a producer itself. But more often than not juniors serve to provide the larger producer companies with fresh new projects. Interestingly many juniors have no interest in seeing a project all the way through to production. Many would prefer to take the spoils from their finds and go back out to look for a new one.
As the junior markets reshape and rebuild, there will eventually be a revival. The strong juniors that were able to survive mixed with the new ones that emerge to take advantage of the next commodities upleg will again offer investors vast opportunities. And it may take a whole new generation of investors willing to risk their capital, but the juniors will again find the financial resources to rejoin the supply chain.
Until this time comes I suspect the junior markets will continue to exhibit gut-wrenching volatility. It is a shame that even the premier juniors that have excellent projects and sound financials will suffer until this market finds its balance. But when a balance is found and growth returns, there will be unbelievable buying opportunities.
We look forward to the time when we can again confidently recommend junior speculations. Thankfully we grew weary of the juniors when they were nowhere to be found in gold’s upleg in the first part of this year so we completely stayed away from them in the second half of this year.
The bottom line is this crazy financial-market crisis is likely to have such a devastating impact on the juniors that what many people thought was a junior bubble might just turn into a double-bubble. If the global commodities bull carries on like I expect, this junior crash is nothing more than a premature reactionary event to extreme market conditions. And this will be followed by yet another bubble-type atmosphere when confidence returns to this arena.
Like reptile ecdysis, the carnage we see today will shed a thick layer of skin as many juniors fail in these tough markets. But once the skin is shed, a new junior market will emerge that could be stronger than ever. Now it might take some time for fundamentals to shift and for a new generation of investors to emerge, but juniors will again have their day in the sun.
CFD CENTRE
