The forgotten gold stocks that could make you rich

The gold bull is strong, so why aren't the shares of junior mining companies soaring? They will, says Dominic Frisby

Every year in early March the Prospectors and Developers Association of Canada hold a conference known as the PDAC. It's the biggest mining conference in the world and one of the most fascinating: this is where you go if you want to know what's going on in the world of commodities and what subjects are on the minds of both miners and their investors (which we do).

So what was the theme this year? During my three days in Toronto, the same question came up over and over again: why, when gold is in the best bull market for decades, have the share prices of the junior mining companies been underperforming so dismally?

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We have seen stratospheric rises in precious metals in the last few months. Gold has gone from $650 an ounce in the summer of 2007 to almost $1,000. Silver has almost doubled from below $12 to around $20. And platinum has risen from $1,300 to more than $2,000.

Yet the small companies that explore for, develop and produce these metals have barely budged. This is despite the fact that they have long been considered by the market to act as a kind of option on gold: the received wisdom was that you would see three times leverage over the underlying metal. So if gold moved 50%, the corresponding move in a junior would be a 150% rise. This time around, far from rising exponentially, shares in many juniors have actually fallen.

This hasn't always been the case. If you had bought the HUI, an index of unhedged gold producers (ie, those that were selling their gold at the market, rather than a pre-arranged, price) in early 2001, you would be up over 1,000%, even as gold rose a mere 300%, giving the three-to-one ratio investors expect. But if you bought gold stocks in 2004, you would only be up 110%, while gold itself is up over 150%.

Then look at the CDNX. This is an index of stocks traded on the Canadian Venture Exchange and heavily weighted towards junior mining firms. The chart above shows that while gold is up 50% over the last year, the CDNX is down 10%! See the charts above. In other words, since 2004 gold has been outperforming gold stocks, whatever their size.

How ETFs ruined the market

It is no coincidence that 2004 was also the year that the first gold exchange-traded fund, GLD, was launched. ETFs make investing in gold convenient and cheap. There is no storage fee, no mining risk, no company risk and no country risk. So it's no wonder they have been phenomenally popular with both private and professional investors. GLD's gold holdings now at almost 650 metric tons are enormous: GLD is now the eighth-largest holder of gold in the world. Only a few central banks and the IMF hold more.

Amazingly, at the current rate of growth, GLD will overtake the Japanese Central Bank by the summer to become the seventh-largest holder of gold. The upshot is that capital that might otherwise have been going into gold stocks has instead been going into the gold ETF (it's easier and feels safer to pour cash into an ETF than to stock-pick miners).

Rising costs and falling news flow

But this isn't the only thing causing miners trouble at the moment. The other factor is rising costs: mining is highly energy intensive and so has been hit hard by hundred-dollar oil, but the costs of hiring are also rising, as are the costs of all the equipment miners need from trucks to the acids used to extract metal from ore. The weak dollar has further eroded profits for many. Costs are met in stronger local currency often the Canadian dollar but the metal is sold in weak US dollars.

Since corporations are valued based on expected future profits (rather than on a simple proportional relationship to the gold price), this means that investors have been unwilling to bid-up valuations they see falling margins, rather than rising profits.

Another worry is what companies refer to as "news flow". One of the ways that miners who haven't actually started producing anything yet keep investors interested and prices up is to offer them a steady stream of exciting-sounding news. If this dries up, investor interest often does too. And that is exactly what is happening to many small stocks. Good news usually comes in the form of the latest set of drill results. But right now there is a shortage of drills, which has led to delays in drilling programmes, so that doesn't help.

Nor does the fact that even once you've got your drilling done it is hard to get your rock samples analysed for their mineral content and your news out. Due to the commodities boom, laboratories are inundated and are taking months, rather than weeks, to report back to companies with their results. Worse, this slows everything down: sensible companies don't keep drilling until they know the results of their sample tests. Hence the longer the results take, the more thumb-twiddling they end up doing and the less news reaches the market.

It might get worse for junior miners

Could it get any worse for juniors? Well, yes. The effect of the credit crisis on mining should not be underestimated. Investor psychology has changed and the general appetite for speculation has disappeared and let's not forget that most exploration is little more than speculation, and so, therefore, is investing in exploration companies. What's more, mining exploration and development is extremely capital intensive (ie, very expensive). Ongoing funding is essential and that's hard to find during a credit contraction.

The result? Many firms can't borrow money and are forced to raise money in the equity markets at low share prices instead, which dilutes existing share holders (which they don't like). The final bit of bad news and something that I was told several times in Toronto is that many of the major hedge funds are long on the big gold producers and short the juniors. This will be holding prices down, and if they keep at it which they might, given that it has done them well so far it will keep doing so.

Is all this going to change?

Now for the good news. This state of affairs won't last and when change comes it should come very fast. I can't say exactly when it will happen, and not every dog will fly, but I do think that this is a supremely good buying opportunity.

Firstly, the fundamentals for precious metals remain wildly bullish. We are in the early stages of a global banking crisis, with global money supply also utterly out of control. That alone makes a rising gold price pretty much a given. Still, as regular MoneyWeek readers, you don't need lecturing on gold and silver (see our precious metals pages for more if you do!).

You'll also know that adjusted for inflation, gold's all-time-high was over $2,000. Newsletter writer Greg McCoach even claimed at the PDAC that if inflation were measured as it was in the 1970s, gold's all-time-high would be around $6,500. So there is a way to go to beat that. With the new ETFs coming to the market, inflation rising and investors looking for safe havens, demand for gold will grow. With no major discoveries in the past few years, supply will not.

So what does this mean for stocks? During each bull move in the gold market, gold itself tends to move up first. Then the big miners move. Then silver soars. Then, finally, the juniors start to move. We are, I would say, past the halfway mark in this run in gold, which began in August 2007. Indeed, silver, which lagged at first, suddenly started to accelerate in December, while everybody was busy talking about platinum and wheat, and even began to outperform gold. It is now the turn of the juniors.

What might get things moving? One thing might be a new ETF. GLD was launched in 2004, but it was a year to 18 months before trading volume really got going. In 2006, the ETF GDX, which tracks the HUI, was launched. As GLD is a simple way to get exposure to the bullion price, so GDX is a simple way to play gold stocks. And in the same way that GLD took a while to get established, so will GDX. But as it does, more and more capital should flow into it and, by extension, into the gold stocks. Indeed, volume on GDX is already starting to increase rapidly.

However, money can't keep going into large-cap miners and ETFs indefinitely. At a certain point, it has to go into the juniors, which are now so cheap that much of their gold in the ground is being priced by the market at a mere $100, one tenth of its above-ground value.

Other catalysts for a move could be thousand-dollar gold, a landmark that could happen any day now, generating a greater interest among retail investors as gold gains publicity. Or a significant gold discovery could trigger a move. Indeed, that discovery may already have been made: I lost count of the number of firms at PDAC who have drill results due. Otherwise it could be a high-profile merger or takeover: the PDAC is when the miners of the world convene and the Chinese were there in force this year.

A lot of deals were discussed. Some may be being done.

The junior miners to buy now

Back in November, I tipped a few junior miners in MoneyWeek. How have they done? Some well, some not so well. First up was Peak Gold (CA:PIK), which I tipped as a buy below 70c. You can still buy it there it closed last week at 65c. They recently raised cash, but the intended deal fell through, leaving them with diluted share holders and a pile of cash. Still, I'd hold on they could make a takeover bid any day now.

I also liked Gold Resource Corp, which I said to buy at $3.50. If you did, and sold last Friday, you'd have made a 23% gain. Another was Jinshan, but it hasn't yet fallen to the level I wanted us to buy it at it is still a buy below $2.50.

I also tipped two Aim companies. KEFI at 3p, now 3.5p, and Leyshon (Aim:LRL) below 24p, now 28p. Both are up, but by the time you've paid for the spreads on the prices, there's just a few per cent of profit left. That's Aim for you!

My silver juniors have performed better. Excellon was tipped below 1.40 and I closed out of it last week at 1.85: a 31% gain. First Majestic (CA:FR) was tipped as a buy below $4 and closed last week at $5, a 25% gain. Great Panther was tipped below $1.25 and, having gone as low as 85c, closed last week at $1.50, a 20% profit. Finally, I went for Aquiline at below $8. It is now $9, so we've made about 12.5% there.

All in all, that means no big losers and an overall average gain of 17.5%, including the Aim stocks and excluding currency change, which isn't bad in the current market conditions. In fact, I comfortably beat the CDNX, which is down over the same time period. Still, annoyingly, you'd have been as well off owning gold and silver. Silver is up 33% in that time and gold 21%.

So what would I recommend now? The following stocks all look good value to me and are all mostly producers: explorers in need of cash will be more vulnerable as the credit crunch deepens.

Capital Gold (US:CGLD/CA:CGC) is producing gold at a cost of below $300 from their El Chanante mine in northern Mexico. They've got an extremely competent management team, which got the firm quickly and cheaply into production, somehow avoiding all the pitfalls of mining. They've got a good PR team, the potential to increase their resource dramatically, and all sorts of major companies sniffing around. Start accumulating this stock below 70c lower if you can hold it, ignore market noise. Phone me in 2012 and I'll tell you what to do with the hundreds of thousands you've made. An easy double from here within 12 months.

Gold Resource Corporation (US:GORO). The credit contraction won't be a problem for these boys. The firm recently raised all the money it needs to take them into production at the end of the year. It has three excellent resources in southern Mexico and is effectively a family business the Reid family owns a lot of shares and manages the business. Don't expect fireworks immediately, but later in the year as it moves up onto the Nasdaq and into production we should see some. This is one patiently to accumulate at $3.75 or below even $4 and to hold.

Olympus Pacific Minerals (CA:OYM) must be a buy below 38c. It has rather a lot of paper on issue, but some decent assets in Vietnam and the Philippines. It also has a small amount of production, and a great deal of exploration, upside, and some exciting potential news flow in the coming months. Management is good and experienced. The chart currently looks brutal, but the shares are cheap, trading at the same price as when gold was $550. It does have this tendency to spike up intermittently, so if it spikes, make sure you take some profit.

KEFI Minerals (Aim:KEFI). I don't much like investing in Aim in general but remain a huge fan of this one below 3p. Although it isn't producing yet, its assets and management have what it takes to make a good mine. That said, the stock is illiquid and the spreads wide, so be patient. Kefi's less risky mother company, EMED, also has potential. Its Slovakian drill results are good, but its short-term future depends on the successful permitting of its Spanish copper mine. If that works out, the sky's the limit.

Leyshon (UK:LRL). This is a good play on the Chinese gold mining industry and a buy below 25p. For some reason, every time it hits 30p it comes back down I assume a big player must be selling at 30p, but I think that, when that selling dries up, we should get a nice move.

Wits Gold (ZA:WTG). This one is run by arch gold bug Adam Fleming of the great Fleming dynasty. It has vast reserves of gold and uranium in South Africa which is interesting, but these are very deep in the ground, which will present logistical problems. A buy at 8-10,000 rand.

Of the silvers, I would again recommend Excellon (CA:EXN) below $1.40, First Majestic (CA:FR) below $4, and Great Panther (CA:GPR) below $1.25, if they get there on this correction. Aquiline (CA:AQI) has gone into a bit of a freefall, but I think it's a great company and, if it goes below $7, buy the heck out of it. It has the world's largest undeveloped silver resource and has takeover' written all over it.