INVEST in Junior Companies
... But first understand the RISK
JIM PUPLAVA on...
Dillution... Pumping & Dumping
Keeping shareholder dilution to a minimum can impact investment returns in a major way. Companies should either negotiate better terms from the start with their brokerage firm or renegotiate the terms as the project is developed and the risks are removed from the property. It is better to negotiate fair and equitable terms from the start. If that can’t be done, the company should try and break away and secure better terms from an investment bank, fund managers, or large private investor/shareholders. This is possible if the project is economical or if the property has been drilled enough to remove most of the geological and metallurgy risks. The other possibility is the depth and reputation of management. An experienced, proven, and reputable management team can often negotiate favorable terms right out of the gate when going public.
Pump, Dump, and Short Cycle
There is another aspect to the finance cycle that most investors—and in many cases junior mining executives—may not be aware of. This is the pump, dump, and short operations conducted by some of the brokerage firms that underwrite junior exploration companies.
On a daily and weekly basis, there are numerous financings that come to the market. Most of these companies will never make it, despite the high hopes of the founders and the brokerage firms that take them public. The odds of a junior mining company making it into actual production are about 1 in 2,000. Many of these companies will survive by either consolidating, locating another property, or starting the process over again. In addition to the high risks involved in exploring for gold and silver, generally there aren’t enough buyers to absorb all of the selling that comes into the market from new financings. This is where the pump, dump, and short cycle comes into play.
The Pump
In order to sell shares to the public, the brokerage firm will promote the new offering with a high degree of hype in order to induce investors to buy into the offering. Once the offering is complete, the mining company now has the funds to begin drilling and exploring for gold. As drill results start to come in, enthusiasm for the stock heightens. With most investors having little understanding of how to read a drill or assay report, they tend to get overly hyped. The brokers tend to get everyone excited and talking about the stock. Often the hype can build into a frenzy with the new company being" talked up" as the next big mining play because of their discovery of the “The Dream and Fantasy Mine.” At this point enthusiasm for the stock is at a peak and the brokerage firm that sponsored the company starts unloading their broker shares, which they received as a fee for doing the financing. These shares are acquired at a very low cost. Since many of these shares are acquired on an option basis, the firm can sell the shares as broker warrants as their inducement to do the financing. So these are shares that can be easily sold into the market, because there is very little cost associated with the shares. The brokerage firm has no cash at risk. It is pure profit.
The Dump
The brokerage firm takes advantage of the enthusiasm and hype as an opportune time to unload their shares to an unsuspecting public. Investors at this time are caught up in all of the hype, believing they are going to make a fortune in the stock. That enthusiasm by the public creates demand for the shares, which are unusually bid up in spectacular fashion. Eventually, the brokerage firm has sold enough shares to absorb all of the buying and the stock starts to crater with individual investors losing big money. The brokerage firm may also begin to spin the firm’s biggest clients out of the stock in preparation for selling them the next “Penny Dreadful” (the firm’s next offering).
During the pump phase of operations, a penny stock can often climb to heights in the market that can mesmerize investors with thoughts of making large fortunes. The brokerage firm and its brokers are talking the stock up and talk on the street can fuel a stock rally that resembles the Internet boom in the U.S. in the late 90’s. However, during this time as the stock price gets elevated through hype, the company’s management—along with the brokerage firm and large shareholders who acquired their stock earlier at lower prices—use this opportunity to dump their shares. Eventually the news starts to fade, the price of the shares start to fall, and small investors, who bought into the market at the top on hype, are stuck with high prices shares.
In some cases the pump and dump operations are conducted in collusion with the brokerage house that took the company public.
If it is a reputable company with good prospects, an investor simply needs to hold and ride the cycle out. Eventually, more drill results and favorable news on the company will help to elevate the shares again as the company expands its drilling operations with successful results. However, this does not always happen. Most drilling will result in some degree of mineralization—most of it will not be worth much. It may simply be iron ore, which is worth less than actual gold, silver or other base minerals. The hype was over the possibility of finding large gold and silver deposits. The company may find some gold and silver, but it may be so small or uneconomical that it is virtually worthless.
The Short
In addition to pumping and dumping a stock, a brokerage house will often begin shorting the stock after a brief time period following the initial financing. They do this to make money. They sell the stock short into the hype phase when the price of the stock is rising and investor demand is at its peak. Eventually, enough selling comes into the stock to absorb all buying and the stock then begins to fall due to additional selling pressure. The brokerage house will stop talking up the stock and eventually the news dries up and the stock craters. At this point, they will quietly start buying shares and cover their short position at a nice profit from disappointed investors who, are now selling their high-priced shares at a lower price.
Some brokerage firms make more money shorting the shares of companies they underwrite than what they actually made in financing the company. It is all part of the business and the brokerage house makes money on either side of the trade. In Vancouver, the mindset of some brokerage firms is based on failure. Most of the junior mining companies that are taken public will never reach production. The vast majority of companies will fail. Given the odds of failure, brokerage firms have found it more profitable to bet on failure than to bet on success. The simple fact is that most junior mining companies will fail or never reach the production stage. Even then, very few companies will ever become profitable as most mines don’t make money.
Only a very small group of companies ever break out of the pack or the vicious pump, dump, and short cycle. Those that do are the real winners and they are rare. Finding these companies is not an easy job, which is why most advisors recommend buying a large basket of juniors to protect and diversify a portfolio. All you need is one spectacular company to make up for all of the ones that don’t work out. Because of the high degree of failure of most junior mining companies and the shenanigans that take place in the finance cycle, an investor is better off investing in a mutual fund or dealing with a knowledgeable advisor.
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are via the Merrill Lynch Gold and General Fund or via the CF Ruffer Baker Steel Gold Fund
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