How to Speculate in Junior Mining Companies

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Speculating in junior mining companies requires a somewhat counterintuitive approach. Many investors believe that in order to make money speculating in junior mining companies, they should find companies with low valuations that have large resources. The reasoning here is that the value of the potential mine far outweighs the company’s market capitalization, and that the latter should rise to meet the former.

I would argue that the best speculation stocks among junior mining companies generally have resources that are valued below that of the company. Let us look at two examples of intriguing speculative mining companies to see why.

The first is Chesapeake Gold (CHPGF.PK). Chesapeake Gold has a market capitalization of just $133 million, but it owns the Metates property which, once in production, will be capable of producing over a million ounces of gold “equivalents” (1 ounce of silver = 1/63th of an ounce of gold) for more than a decade once it is in production.  Furthermore, the mine will have relatively low production costs. It follows that the Metates mine is going to generate far more annual cash flow than the current market capitalization of the company, and that Chesapeake Gold is an excellent investment opportunity.

Compare that to Mandalay Resources (MNDJF.PK). Mandalay Resources has a market capitalization of $255 million. It has two properties in production — the Cerro Bayo silver/gold project in Chile and the Costerfield gold/antimony project in Australia. However, production is very limited, and if the company doesn’t find more resources it will cease in about five years. Furthermore, if we calculate the value of Mandalay’s expected cash-flow based on its estimated resources, the shares trade at a premium.

While Chesapeake Gold seems to be the superior choice, I would rather put my money on Mandalay Resources. The market agrees. Not only is Mandalay Resources valued at nearly twice Chesapeake Gold’s market cap ($255 million versus $133 million), but the former company’s shares have dramatically outperformed the latter company’s shares as the following chart — courtesy of stockcharts.com – illustrates. Why, then, is Mandalay Resources the superior investment?

Chesapeake Gold needs over $4 billion to build its Metates project. It will have to sell the right to future production, issue stock, assume debt, or sell part of the property in order to see it into production. It may also receive a take-out bid, but such an offer would be dwarfed by the future cash-flow that the company would be sacrificing. The fact of the matter is that Chesapeake Gold technically owns the massive resource at Metates, but this resource has little value unless the company has the means to extract it profitably. A bet on Chesapeake Gold is a bet that the company will increase shareholder value through a clever financing strategy.

Mandalay Resources, on the other hand, is focused on using the cash-flow from its ongoing operations in order to expand its resource base, or to develop small mines on new properties. The company won’t go from minimal production to a million ounces of gold overnight, but it will add production steadily without having to raise exorbitant sums of capital. Since management already has a track-record of doing this, it makes sense to bet that it will continue on this path towards success. If management is able to continue on this path, then investors are paying roughly 7-times earnings for a company that can grow production at 20 percent – 30 percent per year.

While there is nothing wrong with speculating in Chesapeake Gold — and I think this is one of the better companies in the low market-cap/large unfunded project category — well-run mining companies that focus on small projects that their budgets can withstand will be winners going forward.

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