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Know how to spot opportunity - and manage risk - with resource juniors.

Photo of Allan Trench By Allan Trench, author

That warm glow that comes with getting investments right was plain to see among investors at mining conferences in the latter part of last year and early 2010. Not content with percentage gains just slightly above the annual norm, many investors sought significant outperformance from minerals explorers and junior miners - and found it.

Investors who looked beyond major miners such as BHP Billiton and Rio Tinto did especially well. The median return from a basket of gold shares was around 70 per cent in calendar 2009, and copper-focused ASX-listed explorers and producers did even better: the median gain was 150 per cent.

The danger as 2010 plays out is that over-confidence will influence decisions by these same investors - with negative consequences. There is nothing quite so dangerous (to themselves) as investors who think they cannot get it wrong.

So what issues should be considered when approaching investment in small explorers?

Here are 10 tips - the result of 20 years' hands-on experience in the sector - to help investors who are looking to make significant capital gains from junior exploration companies and emerging miners:

1. Understand the value of mineral discovery

This tip is plain logic. To know whether a company is under-valued, you first have to know what its exploration success looks like in terms of value. If a company makes a world-class copper-gold discovery, the value of the prize runs into the billions of dollars. Conversely, if the company discovers a small/mid-size nickel, copper, coal or gold deposit, the value may only be in the hundreds of millions. What size is the company's target?

2. Focus on market capitalisation

One of the first numbers to seek in assessing a new company is its capitalisation. Specifically, I ask whether I would buy the whole company for the current market capitalisation. Be careful to include any restricted shares in checking the capitalisation number (such untraded shares are common for recently listed IPOs). Exploration company market values are rarely above $150 million, so be wary if the company has yet to define a clear production pathway and its value is already heading towards that.

3. Ensure the share price upside is material

Investors need to assure themselves that the size (and more critically the value) of the potential prize vastly outweighs the current value of the company. If the size of the prize is in the hundreds of millions and the present capitalisation is less than $20 million, you can tick this box.

4. Spot the triggers for share price re-rating

It is an old adage that under-valued companies often stay under-valued for a long time. This is just as true in junior resources as it is on the broader market. It is critical to spot the potential triggers that will lead to a re-rating. For explorers, new major drilling programs and assay results are the obvious ones. For companies in the development phase, achieving first production and then successful ramp-up fits the bill.

5. Know when to fold

Ask yourself how wrong you are prepared to be. If the drilling program comes and goes, and the shares fail to rise or, worse still, fall, know when to call it quits. Invest on anticipation that a specific trigger will ignite interest in the shares. If that interest does not eventuate, exit.

6. Meet the board and management

Every company will claim to have an experienced board and an accomplished management team. Do some digging for yourself. There are many mining conferences and investor events that provide opportunities to meet the managers of junior miners and explorers. Go along and judge their credibility for yourself.

7. Stick to the larger mineral markets

A fairly new investor in the resources game should stick to companies that target the major metals and bulk commodities markets. Think gold, platinum, base metals (copper, lead, zinc), the major steel raw materials (iron ore, nickel, and metallurgical coal) and energy minerals (thermal coal and uranium). Graduate when you have gained more experience to consider the boutique minor metals such as molybdenum, tantalum, lithium, rare earths, cobalt and others. These markets are small, prone to extreme volatility, and can be a trap for the unwary.

8. Check for liquidity

Several junior explorers are sporadic in their trading patterns, with only a few shares, if any, changing hands on a given day. Look back through the recent trading history of the company. Assure yourself that there is a market to exit in a reasonable time.

9. Read the quarterly accounts, and check for cash

Mineral exploration companies are required to lodge quarterly cash flow statements (and cash flow projections for the coming quarter) along with their activities reports. These make very useful reading. Does the company have enough cash for the next quarter? In those cases where cash is tight, has the company shown an ability to raise funds successfully in the past without damaging their share price in the process?

10. Choose carefully - after making peer company comparisons

There are at present around 100 ASX-listed gold exploration companies alone, more than 600 when other metals are included, and about 800 when oil and gas companies are included. Therefore, you are unlikely to hit upon the most attractive gold investment the first time you hear about a junior company. Before investing, make research comparisons of peer companies. As a guide, I invest in about one of 10 junior companies I research.

The above checkpoints apply to the general case of investing at the junior end of the resources sector, and I hope they will help in making your investment choices in what is a very exciting sector.

About the author

Allan Trench is Adjunct Professor of Mineral Economics at the Western Australian School of Mines, the Independent Chairman ASX Listed Venturex Resources, Navigator Resources, and a Director of Pioneer Resources. He is the author of a number of books on investment and business management, including the Insider's Guide series published by Wrightbooks-Wiley.

From ASX

The resources section of the ASX website has useful information on investing in the resources sector.  

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