A junior mining stock is a mining company in its early days. It may have successfully explored and found a good deposit; it may have completed a feasibility study on the deposit and have raised the finance to develop it into a mine. The earlier an investor finds such a company (that does become a healthy profitable company) the more return an investor is likely to make. The risks on such a company are great so an investor needs to have his finger on the pulse of the company to keep and profit on his investment.
Risk Reward Ratio
One of the most commonly held perceptions on gold or silver mining stocks is that they should perform the same as the gold and silver price. So far they have not; however, eventually they should, under certain conditions…
Investors look for total return. This is a combination of income and capital gain. The gold price provides the capital gain; mining shares should add to that. Why should they? They can add to total return by providing an income stream; however, they must provide the same capital gain or more that the gold price itself to justify the additional risk to gold. Bear in mind that there is no opportunity cost in holding gold as opposed to Treasuries. Treasuries appear to rely on Congress, whereas gold has no counter party.
A mining company that does not intend to pay dividends, or is not doing so (despite already being in production) is unlikely to provide such returns.
Bear in mind too that where mining companies do provide dividends, they do so based on the average gold price over the previous year or half year. Waiting for such an average price entails risk. These risks are many and can sometimes be so worrying that a substantial leverage to the gold price is needed.
All mining companies are just companies listed alongside fellow companies on the Stock Exchange. All companies carry corporate risks. A ‘Junior’ mining stock is the share of a mining company.
It differs from the developed mining companies in that it should have better prospects. These risks include:
- Directors’ competence
- Health of the Balance Sheet
- Level of company indebtedness
- Has it hedged its gold production to raise capital?
- Size and quality of the reserves from which future income will be derived
- Performance of the costs being incurred in producing the metal
- Political risks in the country where mining is taking place
- Potential labor problems
- Price prospects of the metals being mined as well as the accumulated income over the previous period
- Intended capital expenditure on future mining areas
- Expenditure in lengthening the life of the mine
- Dividend policy of the Directors
- Prospects facing equity markets, the economy and its investors, as a whole.
These are variables that are not solely dependent on the price of the mined metals. Moreover, they are factors that weigh heavily on the risk:reward ratio that investors must contemplate before they invest.
Investors, a Source of Risk
This week investors in general pulled markets down. The fear of a recession has grown so large that global equity markets lost 4-5% in one day. In the last month global markets have lost between 9 and 19%. Little of this had to do with the daily performance of these companies. The falls had to do with investor perceptions of the conditions (ie risks and potential rewards) that companies have to work in. The perception is that equities in general will have to endure stagflation or deflation.
Yet investors also become a source of risks to market prices. With losses facing investors, the need to sell good investments to repay the margin calls, weakens an investor’s ability to invest in the first place. When the credit crunch initially hit, it caused a broad, market sell-off including precious metals. It took time before the gold and silver prices themselves recovered, but it did and today there are far fewer leveraged investors in the market place.
Investors always react to their own personal conditions before they respond to the investments. While today there are leveraged speculators, they do not pose such a risk to gold and silver markets. This does not mean that gold and silver prices will not fall. It means that the gold and silver markets have matured and developed to the point that they will recover quickly, moving higher as the dramas increase.
The mining share risks must be equated to the risks investors face when investing in other equities. An equity market investor compares other equities to gold or silver mining equities. If investors can get a better total return by investing in soap-producing companies, then they will go there. But he will be used to corporate risks in companies in general and view them through those experiences. Markets often reflect that sector’s average risk, giving different earnings yields to different sectors commensurate with those risks. Sad to say, many gold and silver mining companies have not focused on their shareholder’s needs, but on their own. In those cases there is no reason why they should move better than the general market.