Only a Junior Recovery?
Scott Wright, September 9th, 2009
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Every so often I'm asked to describe the role of juniors in the commodities industry. And I simply reply, "They're like rabbits". Rabbits are seemingly insignificant and useless animals. But in actuality they serve a critical role in the food chain as a valuable source of nourishment for larger animals.
Like rabbits, juniors are seemingly insignificant. But their function in commodities lifecycles is indispensable. And also like rabbits, juniors are a valuable source of nourishment to their predators. One of their major roles is to feed the larger resource companies, ultimately serving to provide sustenance and longevity.
The primary purpose of junior resource companies is to explore, discover, and develop natural resources that are economically extractable and can feed the supply chain. They are in a sense responsible for finding the next generation of mines and oilfields. Without juniors, the balance of most commodities markets would be way off-kilter.
But in order for juniors to function they need their own food source, capital. The lifeblood of all junior resource companies is the almighty dollar. And since mineral and energy exploration is so capital-intensive, juniors require sizeable bankrolls to do what they do.
By definition juniors are non-producing explorationists. And since they aren't producing a product there are no sources of revenue. So with no cash flows, juniors must rely on investors to procure the necessary capital to survive. And in order to tap investor capital most juniors must list their companies on public stock exchanges, thus offering investors ownership stakes.
With non-stringent listing requirements at many of the exchanges that provide a market for smaller-capitalized companies, the junior population is quite robust. Any savvy entrepreneur can stake a plot of land, come up with a catchy name for his company, and advertise it as a high-potential resource play.
Because of this junior resource companies are a dime a dozen and the competition for investor capital is fierce. There are thousands of stocks to choose from that are hungry for your dollars. And these juniors will do whatever they can to attract investors to their ventures. But because of their small size and in some cases the exchanges in which they list, the sources of capital are limited.
Institutional capital from such sources as mutual, pension, and hedge funds typically has strict investment guidelines. Most of these funds cannot invest in small-cap stocks. And in most cases they can't even trade on junior level exchanges, regardless of company size. Because of this juniors are heavily reliant on investment capital from the retail, or individual, investor. Investors like you and me are typically the primary source of funds for junior resource companies.
On the promotion side of things juniors can only do so much to market their projects. In reality this sector is heavily dependent on external market forces to drive interest in the fortunes of their proposed products. And the foundation of this interest is a bull market in whatever resource a junior is after. Investors aren't going to "go for the gold" unless fundamentals call for a prolonged period of rising prices.
And it is indeed the secular commodities bull that we are in the midst of that has brought interest to the junior markets. After years of underinvestment in commodities infrastructure and pipelines, prices are finally moving high enough to entice in exploration and development. And investors want a piece of the action.
Since this commodities bull market began, shortly after the turn of the century, investor capital has indeed found its way into the junior resource sector. But as quick as capital found its way in, it has been quicker finding its way out. And any investor in the junior realm the last couple years has felt the pain. Junior stocks have been sold off with reckless abandon since the second half of 2007. The risk side of the classic risk/reward tradeoff has been highly accentuated.
This carnage is best illustrated by looking at the performance of the S&P/TSX Venture Composite Index (symbol is CDNX based on the original Canadian Venture Exchange). The CDNX is comprised of nearly 500 stocks that represent the upper crust of the TSX Venture Exchange (TSX-V).
