Junior precious metal emerging producers underperforming: Why?

On the message boards there have been quite a few frustrated posts by fellow investors wondering why their already-undervalued precious metal emerging producers have been so greatly underperforming the underlying gold and silver metals. A precious metal emerging producer is a smaller-scale precious metal mining company that is either opening a new mine (either it’s first or second) or is substantially scaling up the production from existing mines. From my viewpoint, a junior miner graduates from an advanced development explorer to an emerging producer when it has all the financing needed to go into production.

I've been wondering the same thing myself, but I am not too worried because the companies I'm holding are so undervalued. If the price of gold and silver hold up, they should be producing such good earnings that eventually the market will "get it" and push up their stock prices substantially.

But still, what is the explanation for this underperformance? Here are some explanations I've heard:

1.     Big-Boy Naked Short Selling - The "big boys" (hedge funds?) are shorting junior companies (perhaps with illegal naked short positions) and going long the precious metals themselves. I've heard this claimed, but have never seen any actual evidence given to back up these claims. I've seen heavy shorting of Minefinders (TSX: T.MFL, Stock Forum) and maybe Golden Star Resources (TSX: T.GSC, Stock Forum), but this does not seem to be an explanation that covers most of my emerging producers. Most of my producers have little or no shorting according to the TSX venture exchange. Those stocks where it is happening should get quite a nice short-covering stock pop if they actually execute according to their plan.

2.     Moose Pasture Dilution - This goes something like:

• Most of the money in the TSX Venture is in the form of index funds which invest in all of the index's stocks (good and bad). I'd love to get some facts and figures and determine how significant TSX Venture index investing is.  The TSX Venture has been bloated by a multitude of "moose pasture" exploration companies. They are referred to as moose pasture stocks because they don't have any real mineral resources proved up, just “moose pasture” that could possibly some day be worth something. A small fraction of these may prove up a resource that is worth money some day, but until then they don't have much value.

• As moose pasture stocks are added to the TSX Venture, index funds have to sell part of their holdings of existing stocks to buy the new stocks. This selling reduces the prices of the existing stocks (bad for emerging producers), bringing down the value of the index funds.

• The addition of these stocks has the net effect of lowering the stock prices of existing stocks (and the index as a whole). The addition of moose pasture stocks is a lot like the end of the dot-com bubble where tons of Pets.com companies and their ilk soaked up the sucker money. In this case it may be the conscious smart money gaming the fashionable index investing craze. This is a reminder of how index investors can get suckered by the smart money players who, when they know where the index investing money has to go, figure out a way to exploit this foreknowledge. Index investing only makes sense in areas where markets are efficient and that implies that there is enough actively managed money to allow index investors to benefit, with the actively managed money keeping the entire index valued equivalently. I don't think the TSX Venture exchange meets these criteria. 

• When index fund investors see that they are losing money, they flee their current index for another "hotter" index. This results in the index funds selling the stock of all the companies in the index causing the prices of individual stocks and the index as a whole to lose value. This is a positive feedback cycle and should continue until there is little index money left in the TSX Venture exchange or until a significant wave of new money buys into the exchange's stocks. Falling nickel, zinc and lead base metal prices further depress the index by trashing the associated Venture base metal stocks pulling down the index as a whole. This furthers the flight from the TSX Venture of index fund money.

• I believe this moose pasture dilution is a significant factor and that the main hope for a junior to escape it is to either "grow up" to the point where institutional money would consider buying the individual stock for its worth (having achieved mid-tier production levels and having left the Venture exchange for the TSX or the AMEX exchanges) or to have a resource big enough and valuable enough to be a major's takeover target. For production I reckon this to be more than 100K oz gold / year or five million oz / silver per year. I reckon two million gold oz is a "big enough" resource to be a takeover target. I don't know how big a resource of silver would be necessary to be a takeover target. In any case, it’s not my opinion that counts; it’s the "fund" money that determines what "big enough" is.

3.     The Fear Factor - When the prices of precious metals are rising because of fear, money leaves junior mining stocks of all forms for safety reasons. This makes sense for stocks which still require financing (which may not be available during some kind of systemic upset), but doesn't really make sense for those which don't need financing as their outlook benefits from the rising precious metal prices. But they all get taken down anyway in the flight to safety. Again, there is the momentum effect where once junior miners start falling, they continue to fall as money exits looking for a safer place or at least one that is not down-trending. I believe that this is the case with junior emerging producers.

The antidote of the fear factor is the "Value Factor" which causes the buying of selected juniors when they are clearly undervalued, supporting their prices. The converse of the fear factor is the "Greed Factor" where junior soar when the price of precious metals are rising because of greed not fear. This greed can come from sheer price rise momentum or from inflation driving precious metal prices and juniors appearing way undervalued. Smart money may at this point be doing value investing, but this fall, as precious metals follow their seasonal rise, I'm expecting to see the Greed Factor kick in. 

To summarize, I'm rather dubious of the "Big-Boy Naked Shorting" explanation, but pretty much accept the "Moose Pasture Dilution" and "Fear Factor" explanations.

So, the life lessons I've been getting from junior precious metals investing are:

1. Wait for the "greed phase" to invest heavily in junior. This year it’s too late for me to follow this advice because I've been long and strong all year and juniors are so illiquid you just can't trade in and out with the money I'm swinging.

2. Only buy juniors that you expect will "grow up" (see above). I don't care how undervalued a junior mining stock seems (well, I guess I have one exception), if it doesn't have a good likelihood of growing up I'm not holding it.

3. Be on the look out for a genuine end to the precious metals bull market and be ready to exit should that occur. This life lesson comes not from the recent junior precious metals company underperformance, but from the collapse of zinc, lead and nickel junior base metal emerging producers. It’s pretty clear that the price of mining stocks (and juniors in particular) get creamed when the underlying metal price is descending rather than rising. This is the case regardless of how much money the stock may be making (or be poised to make) at anywhere near current prices. This is because there is no telling, once a metal's price starts falling, how far it will fall. A falling metal price provokes a flight for safety even if the stock is set to make big money at the current price. I believe it applies to precious metal mining stocks as well, and an exit should be taken regardless of whether one is above or under water, should there be a clear indication that the precious metals bull market is truly over.

With all of the above in mind, I believe I'm pretty well positioned with the junior miners I have. I think I know what I'm doing with each one and have good reason to expect success with each. Of course, it all depends on them executing their plans (or something reasonably close to their plans) and the price of gold and silver holding up or, better still, advancing. The payoff should be quite substantial (easy double at least) for each if this turns out to be the case.

Gold Resource Corp. (OTC:BB: GORO, Stock Forum) - The only one I'm green on. My life lesson from this one is that you are better off with high-quality management whose interests are aligned with the investor's.

Aurcana (TSX: V.AUN, Stock Forum) - In less than two years it will have three silver mines running and be producing mid-tier-level silver. Has shown itself to be competent by opening one mine. Competence has been vouched for by Silver Wheaton (TSX: T.SLW, Stock Forum) giving it $25 million cash for a silver stream.

First Majestic Silver (TSX: T.FR, Stock Forum) - Has held up really nicely. This would be my top low-risk recommendation right now. This thing is really already a mid-tier and expects to more than double production in two years. Has been consistently fulfilling its guidance.

Metanor (TSX: V.MTO, Stock Forum) - producing gold in politically safe Quebec with a mine reopener. Undervalued at the current production level with lots of good news on exploration due. Could grow up to be mid-tier while generating lots of cash flow.

New Guinea Gold (TSX: V.NGG, Stock Forum) - After a long time (ala Roca Mines (TSX: V.ROK, Stock Forum), uh-oh) New Guinea is now in production at 30K oz/year at one mine while proving up a two million oz, very high-grade open pit gold mine nearby. It’s this other deposit that makes it a takeover target.

ATW Corporation (TSX: V.ATW, Stock Forum) - Reopening two gold mines in Australia. A value play in that the market cap is less than what the two mills are worth. Depends on exploration turning up more oz nearby. Highly respected management.

Minefinders - May sell this to make room for other ideas. Not as undervalued as the rest, but big enough project going into production this month (gold and some silver) to be a takeover target.

Golden Star Resources - Okay, at this point I feel like Charlie Brown with Lucy holding the football, but if these guys would just execute, GSS could really be a major winner for me. I'm giving them one more try with the earnings coming out this week.

Silverstone Resources (TSX: V.SST, Stock Forum) - A way undervalued (relative to Silver Wheaton) silver stream licenser with the same management as the respected copper miner, Capstone (TSX: T.CS, Stock Forum). Does not have the same growth profile in acquiring silver streams as SLW, but is way undervalued on a cashflow, annual oz and resource oz basis, so it doesn't really need any additional silver streams to be a quite nice cash generator.

1. What do you think best explains the underperformance of junior precious metal emerging producers?
2. What life lessons have you learned about junior miners from this trying period?
3. Which do you like and why? 
4. What do you think will signal a good entry point for junior precious metal emerging producers?