How to cut your risk when investing in junior miners

One of the received wisdoms of investing is that you should diversify.

Have some equities, some bonds, some gold, some commodities, some real estate, some cash and so on. Then if one sector takes a hit, you're not too badly hurt.

The problem with this strategy is that you don't make that much money either. It's rare, even in this era of crazy asset price inflation, that every market will rise together.

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The way to make serious money is not to diversify, but to intensify. Find the sector that's in a bull market such as tech stocks in the '90s, or metals now and then 'get all over it'.

But that's also the way to lose everything. If you're not out by the time the party's over, you give back all your gains and wake up with a nasty headache.

So what should you do?

I have a solution or a compromise at least. It's called the 'prospect generator' model.

The advantages of the 'prospect generator' model

Mining exploration is expensive. And it's risky. The game for a junior mining company is to raise money, drill, hope you hit some high grades, raise more money at a higher price, drill again, hope you hit some more high grades, and so on.

It's been compared to a burning match. If you don't hit some high grade before the money runs out, your fingers get burnt.

This cycle is full of uncertainty and it's extremely dilutive for shareholders. In exchange, however, you get a huge payoff if the company hits the jackpot. But only if the company can afford to sustain itself until then.

So some exploration companies have adopted a different model. It's known as the 'prospect generator'. And it takes the edge off some of the risks of being an explorer.

With the prospect generator model, a mining exploration company finds a basket of properties with potential and then finds partners ideally deep-pocketed ones such as mining majors to develop them with. The partner will share the hefty exploration costs in exchange for a large chunk of ownership. The more they spend, the bigger their ownership.

If the explorer makes a significant discovery there's still some 'blue sky'. But if it doesn't, the game's not all over. And if the explorer has a property it thinks is really special, it doesn't have to farm it out. It can keep it all to itself.

Two solid-looking junior mining stocks

A few months ago I mentioned an explorer called Vena Resources (VEM.V), which trades on the Venture Exchange in Canada. This is a prospect generator, exploring in Peru. It has some uranium properties, which it is developing with the world's largest uranium miner Cameco; some gold-silver deposits it is developing in partnership with Goldfields; a zinc mine it is building in a deal with Trafigura; and numerous other projects including some coal- based ones.

Vena didn't fly quite as high as other uranium stocks because it wasn't a pure uranium play, but it was still seen as a uranium company. In the aftermath of the Japan disaster, uranium stocks have all been hammered. Vena has gone from 50c (I recommended it at 45c) to around 35c, through no fault of its own.

But is it all over for this company? Absolutely not even if it is all over for uranium, as I suggested in my last Money Morning. Vena's share price has taken an inevitable body blow. But it has several other assets gold, silver, coal, a zinc mine that's coming into production all of which could easily turn the company around, as could its entrepreneurial management.

So thank goodness for diversification.

Another company I have written about before is Irwin Olian's company African Queen (AQ.V), which also trades on the Toronto Venture Exchange. It has exploration projects all across the more mining friendly parts of Africa a deal with Newmont on a gold property in Ghana, a joint venture on some exciting gold properties in Kenya, some copper-gold prospects in Mozambique, and some diamond projects in Botswana and Namibia.

All of these projects have some home-run potential, in which case shareholders will make many times their investment. But let's say there's a revolution in Mozambique, or artificial diamonds transform the industry and negate the need for natural diamonds. Neither of these would mean it's the end of the road for African Queen. The company would survive, adapt and still have plenty of strong cards in its hand left to play.

So you can see why I like the prospect generator model. It lowers risk in a sector that's all too risky. You may not see quite the bonanza gains that you would in a company with just one focus in a rip-snorting bull market. But at least you know the company will still be there when the market turns against you, as it inevitably will one day.

For the record, I own shares in both Vena and African Queen.

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