When looking at junior stocks, one must develop filters. We recommend looking at junior stocks based on four important measures: sector, management team, stage of development, and deal structure. Order of importance is up to the individual investor. This is the third post in a series of four that addresses the above four topics.
For every investor, picking junior stocks based on stage of development is a very personal choice. Laying out the options is easy. Understanding the risks is much harder.
A grassroots exploration company is a good investment if you like the sector and the company’s management team. However, you have to be willing to diversify significantly in order to pay for your losers. The return is huge if grassroots exploration companies hit the mother lode. The brain, however, often forgets all the times they miss. With high-risk exploration companies, we recommend a strategy of diversifying and not falling in love, and when profits come early, take the principal off the table and trade with the profits.
Grassroots is gambling. Over the long term, the only one that wins is the house, and if you’re reading this entry, you’re probably not the house.
Companies that find something become very binary. Either something turns into something great or something really is nothing. Pre-resource statement, post-grassroots is the stage of development where smart money can be made.
Kool-Aid needs to be filtered, and the rose-colored glasses should be worn only half on to properly look at exploration companies. Good investors build 3-D models of intersections, research the location, get comfortable with the process, and develop taste buds to detect the Kool-Aid. Lots of companies in the exploration stage that will never become mines will still go up in value.
Risk goes up because everything from politics to process gets closely examined, and valuations increase but not always with a return. Every project is feasible at first glance in the company-paid-for study. There are hundreds of pages to read, and by the time you understand the technical reports, you will have a sense of whether the project will be a winner. Unlike in the exploration stage, you cannot make money on marginal projects; you need the project to become a mine. Sell anything that is marginal and focus your dollars on the winners.
The market, however, punishes good projects for bad decisions made by management. Some investors base their entire trading strategy on looking for fallen angels, where the fall from grace was due to a bad management team or a bad financing, because they have faith that management will change or the company will get taken over. Good projects can be had cheap when investors have the stomach to wait for change.
This is where the big boys play. Returns decrease, liquidity increases, and theoretically, risk has gone down by this stage. However, lots of companies make it to this stage and then stumble. Finding the open check book to finance a mine and leaving some ownership with the original investors is not so easy. There is also additional risk in mine construction, permitting, and commodity pricing.
This is a stage of investment that is suitable for institutional investors and probably does not deliver adequate risk and reward for smaller investors. Smaller investors can get enough liquidity and substantially larger rewards with similar risks if they do their homework in the first three stages.