Gold and Silver Volatility is Opportunity

James West

By James West
May 6th, 2011

Many folks are writing in perplexed about the horrible performance of gold and silver explorers on the TSX and TSX Venture relative to the stellar performance of those two monetary metals. There are a number of clear reasons for that, and there are opportunities that should be acknowledged, and taken advantage of, if the speculative capital is available to do so. The volatility we’ve seen this week is nothing less than the best buying opportunity – especially in silver – since the end of January.

The first reality that has emerged since the beginning of 2011 is the sharp disconnect between those performance curves (precious metals vs. exploration companies). When the gold bull first emerged from the dark barn of his multi-decade slumber, he predictably charged straigh north, and gold exploration stocks, which had slumbered and in many cases expired along side of the gold bull, suddenly were dragged right along with the gold bull into the glorious daylight. If gold rose, stocks rose. In the corridors of Bay Street and Howe Street, investment banks were busily inking deals to finance acquisition and exploration at a rate not seen since the 80’s, when another gold bull got loose.

After the meltdown in 2008 caused a global puckering of sphincters, however briefly, the game is very much back on, but with a major difference. Companies are getting much bigger financings, but not necessarily at better valuations, resulting in a) lower quality deals being trotted out for public consumption, resulting in; b) giant overhangs in the stock of the junior explorers who take the financings.

Remember these banks have made a lot of money in the last decade, so their capital bases have become exponentially larger. However, the variety and quality of deals isn’t necessarily larger or better, and so while the quantity of investment vehicles at the starting gate grows, their quality diminsishes proportionately. Since less than 5% of exploraiton deals become mines, that statistic just means more crappy deals out there. Just because you see a recognized name investor participating in a deal, its not a stamp of validation. Its merely a sign that those banks have to do more deals of diminishing quality to keep that bigger pile of cash they have working.

Seafield Ventures is the poster child for bad financings and bloated option and warrant positions. In 2009, the company issued a total of 38.6 million shares at prices of $0.35, $0.04, and $0.125. The financings brought in a total of $3.1 million. Average price: $0.08 per share. And yes, each share purchase came with a warrant to purchase an additional share at a price, on average, only 30% higher. So double that number of shares at an average price of $0.104 per share. Then, because there were such a colossal number of shares outstanding, and because the TSX policies stipulate that the option package each company can award to its near and dear is equivalent to 10% of the issued and outstanding shares, management wasted no time whatsoever bequeathing thesmelves large low cost options, which, in the ensuing great news, were duly exercised and sold into the strength created by the string of great press releases issued by the company upon outstanding drilling success.

So, despite intercepts like 369 metres grading 1 gram per tonne gold, and 449 metres grading 1.29 grams per tonne gold at the Miraflores deposti on the company’s Quinchia deposit, and despite the latter assay sparking a volume spike of over 180 million shares traded in the 8 sessions following, the share price peaked at $0.77 before the locked and loaded shotguns of the participants from previous financings, and the insiders and management, shot the share price down from that high to $0.50 within 22 trading sessions.

This also goes a long way to illustrate a point that became a theme for me at that time, where I stipulated that ‘geology doesn’t matter’. Geologists rushed to criticize and take the remark completely out of context, as expected, but the point was proven: despite outstanding geology, the share price plummeted. Last Friday, it closed at $0.26, which was the price, perversely, that it closed at (within $0.03) the day before that first great intercept was announced. Now, they could probably announce an intercept of 500 metres grading an ounce per tonne, and nobody would touch it. Just like Bre-X was the nail in the gold exploration coffin for years after that scandal broke, fiascos such as that surrounding Seafiled and lingering onward as the company muddles onward in a state of absolute silence, have the same effect on investors as serving cow pie for dessert at a dinner party. Nobody’s going to come back to your next soirée.

Cheap Shares for Miles
Seafield’s dreadful private placements aside, ill-conceived financing structures and bloated option packages are not the only catalyst for a market that disconnects so thoroughly from its underlying physical commodity price. Consider the fact that the TSX Venture market is worth, on any given day, a nominal total of $80 billiion. Now consider the chart below. (Courtesy of Q1 Publishing)

Wall of Paper

There’s $5 billion worth of free trading paper entering an $80 billion market, most of which was purchased at a discount. That’s a lot of downward pressure. Nobody wants to be the exit strategy for somebody else’s discounted investment, even though that’s the premise upon which the investment banking – resource exploration relationship is based. Institutional investors pay wholesale prices for shares for buying in quanitity, and the retail investors with no access to financings are the exit strategy.

The problem is, in our age if instantly available information and socailly connected opinions, the retail audience is cottoning on to the business model, and they don’t like it. So increasingly, we, as individual investors, are looking for companies that have been financined on a non-brokered basis, and especially are looking for deals with no major overhang in the stock in the form of cheap warrants and huge option deals. Which is harder and harder.

It used to be, when the average company financing was in the $1 million to $1.5 million range, that a major discovery would carry the share price through all the cheap warrants and options that are just part of the industry. But now, with more and more financings happening in the $10 million plus range at earlier and earlier stages of development, we’re seeing increasing numbers of great discoveries wallow in misery while the stock churns through millions of discount options and warrants.

Then there are the flow-thorugh deals, where investment dollars are tax-deductable for Canadians, and so the share has a much lower real cost base relative to a non-flow-through share, which is why you see flow-thorugh financings priced at a premium to non-flowthrough shares. Also, thanks to the tax credit, there is an incentive to off-load the share at any cost and ride the warrant.

Thus the increasing crappy performacne of TSX resource shares versus the stellar performance of the metals on which they are based.

Whats more, you don’t need to be a rocket scientist to understand that the global financial marketplace is becoming increasingly unstable again, and that the apparent ‘recovery’ that the mainstream media has been attempting to spoon-feed us for the last 24 months has in fact been nothing more than Quantitative Easing and Stimlus influencing the numbers that are supposed to be indicative of economic health. Bernanke admits targeting the NYSE and S&P 500 numbers specifically, stating that as long as those numbers are healthy, economic sentiment will be good, and companies will hire and banks will lend and invest. Okay, Cinderella.

But whats really happened, is the banks prefer to gamble in their own rigged casino rather than lend or invest, anc companies prefer to use the money to downsize and brace for the worst, instead of hire. Tailspinning home prices, declining employment, spreading soverign debt deterioration, and anemic growth in every economy except China, who has shrewdly impoverished its population to capture the world’s manufacuring mandate – all these factors have combined to create the current atmosphere of dread that has turned us into a planet of day traders. Investment, thanks to the great example set buy our so-called leaders on Wall Street, no longer exitsts. Its day trade or no trade. The result: even with great deposits shaping up economically in every corner of the world, its mostly institutions who are enjoying the economic benefit provided, because the markets are skewed horribly in their favour.

Bright Spots
Its not all doom and gloom. There have been over 400 of 1600 TSX and TSX Venture companies that have doubled in price in the last 12 months. The vast majority of those still trade under $0.10, so that number doesn’t really mean much in the grand scheme of things.

But with gold soaring ever higher in incrementally greater leaps and bounds, there is only one source in the world for the replacement of all those ounces ferreted away into vaults around the globe for safe-keeping: gold mines. And the only place in the world where we are in the buinsess every day of financing, disocvering and building new gold mines is on the TSX and TSX Venture. And with such an interconnected world, we as individual investors are in a better position than ever before to sniff out the good deals and side-step the more fragrant, flagrantly over-financed deals.

This month, we are only identifying 4 companies, because in view of the ever-changing playing field of the global economy, we are having to adjust our criteria for investment ever tighter. The volatility of the commodities markets has created superb opportunities, and the ability to identify companies that have been structured and financed artfully represents even bigger opportunity.

On the first Sunday of every month, James West’s MidasLetter Premium Edition identifies the top 3 stocks on the TSX Venture Exchange that are expected to double within 12 to 18 months, 9 out of 10 times, or your money back. Subscribe now for $49 per month, or $499 for one year, at 30 day instant refund period from your first subscription day if not 100% satisfied.

James West

James West

Editor and Publisher

I employ a Capital Efficiency Model that dictates money should never be exposed for longer than is absolutely necessary to the possibility of being lost. Thus, I routinely sell half my position when a stock doubles from my entry price, and I sell stocks that lose 20%, unless there are...
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Midas Letter is provided as a source of information only, and is in no way to be construed as investment advice. James West, the author and publisher of the Midas Letter, is not authorized to provide investor advice, and provides this information only to readers who are interested in knowing what he is investing in and how he reaches such decisions.

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