Digging for Opportunity in Precious Metals, Part 3

VANCOUVER ( Bullions Bull Canada) -- Part I and Part II of this series presented an overview of the precious metals mining sector. In those pieces, I noted that these companies have been (in the most neutral terminology possible) chronically undervalued in our markets.

The basic business model of these miners (and all commodity producers) was described/explained. Specifically, it was demonstrated that, over time, all such producers must "leverage" the price of the commodity they produce -- as a basic proposition of arithmetic.

However, despite being in the best-performing commodity sector for the past 12 years, and despite the superlative fundamentals for precious metals going forward, as the saying goes, all gold and silver miners "are not created equal." Notably, there is a dramatic schism between the large-cap corporations in this sector (which tend to attract the most investor dollars and attention) and the smaller producers.

As is frequently the case with "golden opportunities," there is a catch when it comes to investing in junior miners, and adopting a smaller-is-better investment strategy. In "tough times," there is one thing larger companies are generally much better at than smaller companies: Staying alive.

Investing in smaller mining companies implies accepting a higher level of risk on an individual basis, even though collectively, these companies offer superior profitability and superior growth profiles -- both in terms of production growth and the growth in their reserves. Thus to offset this individual risk and capitalize on their collective superiority, it's essential for investors in these miners to hold a "basket" of such companies.

This can be done in one of two ways. Those investors ready, willing and able to add a basket of these companies to their portfolios, one at a time, can begin to (cautiously) do so. Those not ready for that level of commitment can look to one of the miner-ETF's, which focus on smaller-cap gold and silver mining companies.

The original entry into this niche was the Market Vectors Junior Gold Miner ETF ( GDXJ), although there are now similar funds, offering competing collections of these smaller precious metals producers. Understand that these companies are not for "traders," nor the faint-of-heart.

To understand the night-and-day difference between these companies, it's best to begin by looking at the typical large-cap business model with respect to precious metals miners. As with large corporations in general, their philosophy is the epitome of simplicity -- in other words, utterly simplistic. Bigger is better.

In a world populated by small corporations, and blessed with abundant resources, this simplistic mantra was in fact a general economic truism ... about 100 years ago. In today's world of scarce resources, already over-populated with mega-corporations, it is a dinosaur-strategy, assuring one's path to extinction.

While this observation is appropriate to most of the corporate world, it is especially easy to illustrate the truth of this (modern) principle by examining precious metals mining. Look at every large gold mining company on the planet, and one will see the clear illustration of a strategic decision by management: The choice to operate a (relatively) small number of mega-mines, vs. choosing instead to produce gold from a larger number of smaller mines.

At a very elementary level, this strategy may seem to represent wisdom. The simplistic corporate mantra is that larger operations must be "more efficient" than smaller ones. While this assertion is not necessarily true in general, it is patently untrue with respect to precious metals mining (and most forms of mining).

In a world of diminishing resources, resource scarcity implies two realities in mining. The number of (undeveloped) "large deposits" in the world is steadily declining, and the "grades" (i.e., richness) of the ore is also steadily declining. This means extracting/crushing/refining more and more tons of ore to get less and less ounces of gold.

From an environmental standpoint, this is an appalling dynamic. To begin with, the amount of environmental disruption/devastation that results from mining operations rises exponentially with the size of the mine. One large mine (typically) doesn't produce an amount of "pollution" equal to four mines, one-fourth its size -- but often two or three times that quantity. Yet even from the standpoint of corporate efficiency, this is clearly an inept, if not suicidal, strategy. In our world of scarce resources, nowhere is this reality more apparent (and expensive) than with respect to energy. At best (i.e., producing high-grade ore from efficient mines), mining companies represent a highly energy-intensive form of industry.

Deliberately choosing to produce gold from deposits with rapidly declining grades, in an economic paradigm of soaring energy costs, in an energy-intensive industry, is nothing less than a recipe for destroying one's own profit margins. Out of desperation, the large-cap gold miners have turned to polymetallic deposits for their jumbo mines, bolstering their sagging bottom-lines by using the "credits" from these other metals to offset soaring production (energy) costs.

However, these non-precious metals credits (typically copper) also dilute the business models of these corporations -- transforming them from true "gold miners" to "diversified miners." In turn, this undermines the valuations of these companies -- as analysts and investors alike reward "pure" producers with higher valuations, if for no other reason than their earnings potential is much easier to assess.

Similar dynamics apply to the smaller producers, the "junior miners." However, a close examination of these dynamics shows us that smaller is better in every case. Resource-scarcity -- in the form of declining grades -- is also a reality for junior miners. But there is a major distinction.

For the reason previously mentioned (along with simple, human greed) large mineral deposits are coveted and developed ahead of smaller deposits. This means the problem with diminishing grades is much more acute with respect to the jumbo-deposits to which the senior producers choose to limit themselves than with smaller gold (and silver) deposits.

Look around, and discriminating investors can find junior miners producing, or ready to go into production, with high-grade mines and even the occasional "bonanza-grade" deposit. High grades translate into both higher profit margins and much less dependence/vulnerability with respect to higher energy prices.

However, "smaller is better" goes well beyond higher grades in the mining industry. As previously mentioned, smaller mines produce a much smaller industrial "footprint" from their mine sites. This directly translates into quicker/easier permitting for these mines to go into production.

It also means less "land claims" issues with aboriginal groups, and generally quicker and more-amicable negotiations where mining operations do impact on such claims. Similarly, a smaller "footprint" means less opposition from environmental organizations/interests.

Smaller mines require significantly less infrastructure to support them. This usually translates into enormous differentials in the capital costs required to go into production. Indeed, declining grades and soaring capital costs are resulting in more and more of the grandiose mega-mines that had been planned by the senior miners being temporarily shelved or even permanently abandoned. Smaller is better.

Whether it's small, vs. large or ETFs vs. stocks, expect these investments to represent wild, roller-coaster rides, which require both steady nerves and a longer-term investment horizon in order to provide the time necessary for the fundamentals of these companies to assert themselves -- irrespective of any/all attempts to suppress their share prices. There is a "pot of gold" at the end of this rainbow.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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