How to Pick a Junior Gold Stock "Do it yourself' Fundamental Analysis by Rick Rule

Successful speculation in junior gold stocks has to solve one riddle. How do you anticipate exploration successes before the financial community reacts to them? The 12-year bear market in gold has given you one leg up. The bear dismantled the research and information infrastructure for precious metal stocks. In the late '70s and early '80s, the big Wall Street firms employed hundreds of brokers who specialized in gold stocks, and dozens of 'hard money' newsletters thrived. Since nobody gives medals to yesterday's heroes, most of those gold experts long ago moved to greener pastures. Here's another leg up: a successful speculator builds a diversified portfolio. Placing all your eggs in one basket often breaks your basket. Always prefer a group of intelligently selected speculations to one large bet, no matter how compelling the story. A contrarian, counter cyclical orientation helps as well. In exploration and speculation one thing never changes: luck favors the trained observer. Luck follows those who use the best tools with consistent discipline. Here are some other tools. The right answers to the following ten questions can help you decide if you even want to bother following, much less buying, the stock.

Look For Value Question 1. "What is the current liquidation value of your company versus the market capitalization?" Compare the company's actual value if auctioned off tomorrow against the value the stock market places on all of its shares. If the market cap outweighs the liquidation value, there may be a rat in the feedbag. Speculation can't stand on one leg alone. You have to forecast both the upside and downside. When promoters are trying to sell a stock, you'll hear how precious metals will soon soar, how exploration will soon hit the Mother Lode, and how their promotion will boost the stock's price. That's all great, but we have to weigh that side against our possible downside, and value is the scale we use. Nothing reduces risk like plain, old value. If a mining company is not a viable business, there's no reason to buy it. A mining company is only worth what it owns. Add up all the current assets (like cash), subtract the liabilities, and add the liquidation value of the company's mineral projects. Liquidation value means what the projects would bring as is. What's the market cap? For a rough estimate, multiply outstanding shares by the current market price. With 10 million shares outstanding quoted at $2.50 a share, the market capitalization is $25 million. If this company has $5 million cash and no debt, its net financial assets are 20% of market cap. Assume the company has four exploration properties. With a cold and steely eye, assign each of them a value. Now let's add it up. Net financial assets of $5 million and say, property assets of $12.5 million for a "guesstimated" liquidation value of $17.5 million, versus a market capitalization of $25 million. If the management can answer other questions, this could be a sensible speculation. More often, however, we find market capitalizations of $100 million and liquidation values of $2 million.

Look For Personnel Question 2. "Tell me about your management and directors, especially their past successes in mining and markets." Do their skills fit the job? If the team cut its teeth strip mining oxide gold deposits in Nevada, it may break those teeth on an underground silver, lead, zinc sulfide deposit in Peru. Be particularly leery of exploration teams with little production experience who are out to bui1d and operate a mine, rather than to sell the deposit to someone more experienced. The reverse can hold true as well: Mine operators are often poor mine finders. The tasks don't resemble each other, and the mindset that is successful in one field is often unsuited to the other. Look at the controlling shareholder's track record as well. Has he made money for investors in previous deals? Sorry, it's not enough to make a mine, we want to make money. Be picky here, too. Can the dominant entrepreneur transfer his experience to the project at hand?

Look For The Means Question 3. "How are you going to make me money on this deal, and when will I make it? This is the question the promoters want you to ask, but make sure you control the conversation so they actually answer it. I once heard a stockbroker explaining a venture capital investment in a technological process. One potential investor asked, "How does the process work?" The broker replied, "It works fine!" Beware of such answers. Make the promoter explain in detail how the company's exploration activities will increase both shareholder value and stock price. Why these questions? We want to understand what sequence of events management believes will occur over that time, and how that will affect share prices. We must assign probabilities to the outcomes forecast, and understand their timing and sensitivity. If management doesn't have a plan outlined, it's probably too early to buy. If the company refuses to keep us informed, or if they promise but don't deliver, we must consider selling the stock. If management doesn't have a geological theory with a plan to explore and prove it, it's probably too early to buy. If the results achieved are below what we've been led to expect, we should sell the stock.

What Are The Goals and Strategies?

Question 4. "What are the company's goals, and strategy? Thousands of public companies specializing in precious metals exploration litter the investment landscape. The vast majorities have always failed. Many "penny miners" have, at best, only sketchy goals. Most have none. Small wonder they couldn't achieve anything - they didn't set out to! When a company expresses goals, make them get specific. Ask about intended results on a per-share basis. What do you care if cash flow doubles and issued shares increase tenfold? Will the company's expressed goals increase share prices? Some entrepreneurs simply seek to increase the assets they're managing to secure their own cash flow. Do the company's goals seem reasonable? Will they raise share prices if they bear fruit? If the answers are "yes," then ask if the company's strategy fits its goals. Many companies look like Don Quixote on his battle mule. Their goals sound grand, but they have no clue how to reach them. Measure their goals against the backdrop of the people. What is their track record for meeting their goals? Have they succeeded in similar endeavors? Are their backgrounds suited to their strategies?

Where's The Money? Question 5. "How much money do you have, how much money do you need to make me rich, and how are you going to get it?" Watch the white-leather-shoe boys blanch when you pop this question on them. Mineral exploration is a capital-intensive business: no capital no business! Start with current assets; cash, treasuries, bank deposits, inventories, prepaid expenses and the like, and deduct current liabilities. This should give you a rough idea of the net working capital. Get a detailed description of monthly "burn rate". What does it cost for rent, utilities, salaries, promotion expenses, professionals fees, listing expenses, etc.? Then superimpose projected exploration expenditures on a monthly basis. If the company has any debt, make sure to add in interest and principal payments. This exercise narrows the playing field fast. Many small public exploration companies with less than $1 million in net working capital spend $600,000 annually on non-project overhead, while they need to spend several million on exploration to meet goals (and make us money? Past winners are more likely to be future winners. Why do we need to understand the track record of the technical team, the directors and the dominant shareholders? Most successful mines are made, not found. It takes technical prowess to unlock the deposit's geology to production. It takes financial prowess to unlock the capital crucial to mining, so the management team must include experienced, proven fundraisers. "Make the promoter explain in detail how the company's exploration activities will increase both shareholder value and stock price." ]I asked him where he would solve his working capital problems and he informed me that a "hot" west coast broker named Rick Rule would raise all the money he needed at much higher share prices. Imagine his surprise when I identified myself and explained the likelihood of his phantom financing. "When a company expresses goals, make them get specific. Ask about intended results of a per-share basis." When companies detail their financing plans, ask what conditions apply to the receipt of funds. Decide for yourself whether the companies will receive the necessary cash infusions and on what terms. If possible, get the names and phone numbers of their financing sources then telephone those sources and verify that the capital is available. See if the preconditions and terms match the company's own understanding.

Where Is The Owner? Question 6. "Who owns this company? How much did they (or will they) pay for it, and when can they sell it?" Make the company explain its capitalization history to you. If there were escrow or founders shares (shares issued for $0.01 to early insiders), who got them, for what service and when will they be free to trade them? Determine at what price every financing has taken place. Is the stock from those financings already free trading, or can it hit the market later to depress share prices? How many options and warrants are outstanding? At what price can holders exercise them? "Promotion often makes the difference between success and failure."

What About Promotion? Question 7. "Who else will you tell this story to, how will you tell them, and when?" Promotion often makes the difference between success and failure. Promotion is crucial in capital-intensive businesses because it raises subsequent financing with less dilution and increase liquidity and share prices. Since exploration companies seldom pass out gold watches to thirty-year shareholders, you want increasing share prices. Make the company (preferably its promoter) detail its promotional plan. Who is the audience? What is the message? Who is the messenger? Do the three mix? What is the promotional budget? Is that sufficient? How will the promoter raise additional capital? At what price and from whom? Question Companies must budget at least $150,000 annually for promotion. Sad but true. At least two management road shows through Toronto, New York, and London should be scheduled annually and one yearly tour of the company's focus properties for analysts. North American companies that don't appear at the "gold shows" are almost automatic losers. Institutional investors finance exploration but retail investors provide market liquidity. Promoting to only one constituency is a flawed strategy. Promoting to retail investors should take into account that Canada has 30 million people and the U.S. has 300 million. Will they spend their money in markets that have the money? Most Canadian companies know almost nothing about U.S. securities regulations. Promoting in the U.S. is against American regulations and will get rougher and tougher. Make sure that the promoter knows and complies with federal and state laws. If the promoters are not aware of these regulations and don't have concrete plans for complying, forget about their stocks. In fact, if they don't have plans to list on NASDAQ or AMEX, greatly discount the rest of their promotional plans.

Where Can It Go Wrong? Question 8. "What can go wrong, how can I know what is going wrong, and what will you do if it goes wrong? If company management can't name at least three things that could go wrong, they haven't thought through their enterprise. Make them describe the three worst fears for you as a minority shareholder. Make the promoter describe specifically how you as a shareholder will get negative information and warnings. Ask what telltale signs you should look for and how you will get information (from the promoter, by fax is the best answer) to help you assess these risks day-by-day.

Who Is Your Promoter? Question 9. "Who's buying the beer?" If a company has answered these questions in reasonably good form, get to know the promoter personally. No company will answer every question perfectly, but candor and reasonable responses will tell you who to spend more time with. As you build a bond with the promoter, get him to tell the real story. Because your interrogation took control of the promoter's spiel, you have helped him order his thoughts about his company. Now let him lapse into "streams of consciousness," and listen carefully for tidbits of information you would never get from his canned spiel.

"Where can I learn more?" Question 10. Get annual and quarterly reports as far back as you can. Read what they hoped to accomplish, and compare that to what they did accomplish. Get newsletter write-ups, securities analysis' reports, and news releases as far back as you can.

Credit: Global Resource Investments Ltd. - www.gril.net