04 August 2008

Junior miners: market manipulation or just underperformers?

The precious metals rally that ended in May 2006 was a very good time for almost any investment in mining, whether it was the AMEX Gold Bugs Index (HUI),the Philadelphia Gold and Silver Sector Index (XAU) or junior mining companies. But after that rally, something changed. After the spot gold price reached $730 in May 2006, there was a correction period that was followed by a rally to $1,030. Another correction followed and the gold price seems to near a bottom at the current levels around $900, still up roughly 24% from its May 2006 high.
The HUI-index has now fallen to a level just below the May 2006 high at 390. The XAU Index also seems to flirt with the support level around 160, which once again corresponds with the highest level reached in May 2006. The fact that these indices underperformed the precious metals price by more than 20% is already pretty shocking, but the picture becomes even darker when studying junior miners. The benchmark indices for Junior Mining companies, the FSO Index (see www.financialsense.com) which consists of 40 junior mining companies, is down almost 30% from its May 2006 high! Charts from Frank Barbera on a.m. website even show that the FSO/XAU ratio actually more than halved since the first quarter of 2007.
But what causes this severe underperformance of junior miners compared with large caps and with precious metals prices in particular? Some say that market manipulation is to blame. Market manipulation is one of those terms that always appears when precious metals or related stocks perform badly. The question is whether market manipulation is really that unrealistic. Let's take a closer look at some mining funds in Nunavut Territory in the North of Canada.
Nunavut was established in 1999 and is thereby the youngest Canadian province. Nunavut Territory is extremely rich in natural resources and as such offers great potential for various industries, including mining, fishing and tourism. As soon as precious metals prices started to rise, the (junior) miners in Nunavut saw their share prices rise along with the precious metals rally. Some of the companies that benefited were Cumberland Resources, Miramar Mining and WMC Resources.
One thing that those four Nunavut-plays have in common is that they were all taken over by large cap mining companies, that continue to look for Nunavut miners. In 2005, shareholders of Australian mining company WMC Resources had two potential buyers outbidding eachother. Eventually, the winning bid was made by BHP Billiton at A$7.85 per share, significantly higher than Xstrata's A$7.00 per share offer. This was a significant premium over the A$5.00 share price before the battle started. UBS Securities however rated the company in a valuation range of well over A$10 per share.
Cumberland Resources was acquired by Agnico-Eagle Mines in 2007 and did well. The company's shareholders received $7.48, roughly a 25% premium over the share price before the acquisition was announced. Shareholders who bought their shares two years prior to the deal would have easily made 400% return on investment.
Miramar Mining was bought by Newmont Mining this year for C$6.25 per share or a 23% premium over the price before the announcement. Those who bought Miramar shares two years prior to the deal made 84%, still not bad, but certainly a good deal for the buyer.
All above-mentioned deals may be 'good deals' for the buyer, but they are certainly not bad deals for the sellers. This is a situation that could now easily change. With junior mining shares having hit rock bottom, a 50% premium is still hardly something to cheer about for investors who saw their shares drop more than 50%.
Some of the Nunavut miners that are still independent seem almost guaranteed takeover targets, but the question is whether it's really worth it. Some deals outside Nunavut show a pretty scary picture. For instance, Aurelian Resources received sell recommendations with a price targets as low as C$1.40 in addition to a tsunami of negative rumours about Ecuadorian Government's mining laws. You have to ask yourself why all the bad news and downgrades are not affecting Kinross Gold Corp's judgment of Aurelian (still considered attractive at a share price well over C$8). The latest rumour is the Ecuadorian Government possibly bidding for Aurelian, which is the reason why the share price is still well-below the offer. This scenario is just another way to scare off investors, quite similar to news coverage of the the Venezuelan mining laws affecting Gold Reserve and Crystallex. So far, it's all rumours and one has to wonder whether these countries are really going to create a tremendous job loss and harm relations with any foreign company operating locally, or whether it's all one big Jim Cramer-esque conspiracy.
Geopolitical risks however do not apply to the Nunavut miners, but market manipulation may be as applicable to junior miners as it is to the producing miners in 'less politically-stable" countries. Fact of the matter is that takeover candidates are no longer by definition the desired stocks to hold. One of those takeover candidates is the junior (partly-)Nunavut play Trade Winds Ventures.
Trade Winds Ventures had a high in 2004 of C$1.65. It then fell back to the current five-year low of C$0.13. And what's really changed since then? Momentum, that's really all I can think of. In their Detour Lake project (Ontario) alone, they have 800K ounces of indicated resources and 1.5M ounces of inferred resources. In addition to that, Trade Winds have projects in Nunavut, China and in B.C. The company has an institutional share holder base, C$2.8M cash and has a market cap of only C$10M!
And this is just one example of a ridiculously cheap junior miner. There are so many players out there with ridiculous market capitalisations. The only thing you have to accept is that there is no guarantee that your investment will go down further in the short term. Whatever you do, don't sell. In the long run, the true value of these companies will emerge. For now, all we can do is hope that no one will take them over at a 30% or even 50% premium, for there is so much more potential in these junior miners. As for my disclosure: I hold no shares in Trade Winds Ventures, but I will buy on Tuesday the 5th as soon as Canada is open again.
Good luck to all.

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