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Seeking Value in Junior Gold Miners

Commodities / Gold and Silver 2011 Mar 03, 2011 - 02:48 AM GMT

By: The_Gold_Report

Independent investor Chen Lin takes advantage of high metals prices by investing in companies with the financial strength to stay the course until the resource is in production or can be expanded, making the company an attractive takeover target. For metal miners, the sustainability factor is critical because it can take years to get a mine to cash flow-positive status. Chen shares several of the companies he owns that he believes will return significant capital appreciation in this exclusive interview with The Gold Report.

The Gold Report: How important is technical analysis for you? Is it more useful as an entrance or exit point for a stock? Or, do you use technical indicators as a longer-term approach?

Chen Lin: That's a very good question. I know technical analysis pretty well, and I watch a lot of indicators. Technical analysis probably helps most when entering or exiting a stock. You can also see some pretty good entrance points. Technical analysis also helps when the technical indicators improve and a lot of new technical buyers come into the picture; you can predict the stock will do well. But fundamental analysis is always most important for me, and value is the most important factor.

TGR: What indicators do you use—moving averages?

CL: I don't follow those too closely; I look at the chart and I can see the trend. I set up an alert at my Fidelity account to email me whenever gold is crossing certain moving averages, such as the 200-day moving average. I use these as reference points to see the general trend for the stock. I also use Relative Strength Index (RSI) as a good indicator to see how a stock is overbought and oversold.

In general, you want to start selling when a stock is overbought and buy when it's greatly oversold. But the company's fundamentals are the most important. If it's undervalued, it may still rise—like one stock I own that recently had a 90 RSI—which is extremely overbought—but is going higher still because the stock is undervalued from any perspective. It just rose so sharply, I had to sell some; but I'm keeping a lot of shares.

TGR: After a stock is fully valued, do you attempt to ride it as a momentum play to squeeze out more juice? Or are you just happy to take your money off the table and use it to enter another value play?

CL: Usually when a value stock reaches its valuation, it rides higher than its valuation and tends to get overvalued. Day and momentum traders rush in; so, stocks actually appreciate a lot in a very short period. Then I just start selling and taking profits gradually. Sometimes it will get a very big pop in one day when I'm selling, and I use those indicators to sell more. But in general it's very hard to catch a peak. So, taking profits is a process instead of a one-day event.

TGR: You play anywhere from penny stocks in the single-digit millions up to the $3–$4 billion market-cap level. That's a real advantage for an independent or non-institutional investor. Even most hedge funds don't have that luxury. Obviously, liquidity issues don't scare you. How do you manage those situations when a stock may not be marketable?

CL: I generally follow different rules, but first you have to know where the market is going. If the market has just started to rise, you can get into illiquid or risky stocks because, as the market rises, liquidity will come and illiquid stocks will become more and more liquid. But if the market is getting more mature and dangerous, you might want to sell them; for example, back in summer 2008, I sold all my junior stocks. For every stock, I set a rule for when I would sell. When they got to a certain level, I got out. By the end of 2008, I started to buy junior stocks—illiquid stocks.

TGR: You buy when you see activity in very small stocks?

CL: Activity is a good indicator, but it's not the only indicator. I'm a value investor, so I look mostly at the valuation. But in general you want to invest in companies with rising volume and increased trading activity. That means more people are interested in the stock. So, if you believe that liquidity will be on the rise, then you can take a heavy position in a small-cap stock.

TGR: How do you start when you're looking for a metals stock versus, let's say, an energy stock?

CL: Metals stocks are very different in valuation from energy stocks. I generally like a metals stock with a world-class asset or potentially world-class asset. For an exploration company with 5 million ounces (Moz.) gold or gold equivalent in a desirable location that a major might be interested in taking over, you can put a value on the company. That's because we know what price majors are paying for the gold.

The most recent takeover was for almost $1,000/oz. in the ground. Of course, there's a potential to expand the resource too. For production companies, you look at the production profile. You look at the average cost, the cash flow and the balance sheet. A production company can immediately leverage to higher gold and silver prices. Use those numbers to calculate cash flow, and you have an objective valuation of the company.

TGR: Chen, do you currently favor silver over gold? Is there more upside, percentage-wise, to silver than there is to gold?

CL: Yes, I think so. I probably have a little more silver than gold because silver started relatively late and is just coming up. Gold starts first, and silver always outperforms gold in the second half of a bull market. That happened in the '70s, and I think it could happen in this round.

On February 18, the margin of silver reserve requirements for silver contracts was increased by the exchange. Silver exploded because funds were betting heavily against silver, and they had to cover their shorts. It could easily go to $40/oz. and to $50/oz. There's still a big short position in silver, and it could outperform gold.

TGR: Where would you be investing today if commodities weren't in an upswing?

CL: If the underlying commodities were not in an upswing, I would be more focused on stocks with high liquidity—those with strong balance sheets and strong cash flow. When they generate cash flow, they don't need to come to market to raise money. So, then they're relatively insensitive to commodity prices. Another very important factor to consider is the cost of producing the commodity. That's also in the cash flow model. If the commodity price stopped rising, or started to go down, I would invest in those stocks.

TGR: Do you have a metal stock you want to mention?

CL: I like Pretium Resources Inc. (TSX:PVG). That was my pick in early January. I met CEO Bob Quartermain at a conference, and we had a discussion. Quartermain was the founder of Silver Standard Resources Inc. (TSX:SSO; NASDAQ:SSRI); he retired, and then came back to run this company, which is a gold asset spinoff of Silver Standard.

When we met the stock was in the low $6 range, and I believed it was very much undervalued. So I put it in my newsletter, and it's appreciated a lot. You can see it's up about 50% in the past two months. But it's still a very undervalued stock.

So why do I like it? One factor is that it has a very large gold deposit next to a large Seabridge Gold Inc. (TSX:SEA;NYSE.A:SA) deposit. Seabridge has 50 Moz., Pretium has 40 Moz. gold, is drilling and has more results coming. Its 40 Moz. low-grade deposit has already given the company some valuation. If you compare Pretium to NovaGold Resources Inc. (TSX:NG; NYSE.A:NG), it's very much undervalued just on the low-grade part. But on the high-grade part it's all blue sky. There is some basic valuation, and a lot more upside yet to be seen. They recently did an IPO, and the company is well funded for the next two years.

TGR: Is there another metal stock you want to mention?

CL: In our last interview, I mentioned a couple of silver stocks. One was Alexco Resource Corp. (TSX:AXR; NYSE.A:AXU), a very high-grade silver deposit in the Yukon. They own the whole district, they have started mining operations and they have a mill running. They're beginning to produce 3 Moz. silver per year, but they can gradually increase to 5 Moz. and eventually to 7 Moz. What's so special is that it's a very high-grade silver/lead/zinc deposit, and if you apply lead and zinc credit, the silver cost is below zero. So, you're talking 3 Moz. at zero cost. It's free silver. If they go to 7 Moz. at zero cost, $30/oz. silver means a huge cash flow. So, it's becoming an amazing cash flow generator.

TGR: Another silver play?

CL: Yes: Golden Minerals Company (TSX:AUM; NYSE.A:AUMN). Golden Minerals and Alexco have similar characteristics, namely that their silver is extremely high grade. El Quevar is Golden's flagship property in northern Argentina. It's in the high Andes, and there's nobody living there. There's plenty of water. The company has only explored a small area, but has already found very high silver content, and it's expanding its resource.

Early on, the company was talking about 6 Moz., but it can build a much larger silver mine and increase capacity. Because of the grade, today's silver price gives the company a huge margin. Plus, Golden Minerals owns huge properties throughout South America and Latin America, including Mexico. It's a spinoff from Apex Silver, which went into bankruptcy, and all the exploration properties came to Golden Minerals. Apex put in their claim very early, and they own a lot of very good and important properties throughout South America.

TGR: Another company?

CL: I have owned a gold stock called OceanaGold Corp. (TSX:OGC; ASX:OGC) for a fairly long time. In early 2009, I got in at around $0.40, and I still own a very large position in it. The stock has not been doing very well over the past few months because the company raised money to build a Philippine mine, and the market didn't take it well. That brought down the stock quite significantly in just a few months.

I have been adding a little more stock to my already large position, partly because they have a very stable 270,000 oz. (Koz.) per year operation in New Zealand. Potentially, the cash costs can come down next year, but at current gold prices they are generating a huge cash flow. Plus, it has this new mine in the Philippines coming on, and the company can dramatically increase its gold production and reduce costs because the cash cost is below zero if it's getting credit for the copper.

TGR: You invest in very small stocks. Can you mention one?

CL: Majescor Resources Inc. (TSX.V:MJX) is a tiny company, and so liquidity is quite limited. I met the CEO late last year. The main property is in Haiti. The fascinating thing is, the company already has a huge historical resource drilled by the United Nations and verified by German engineers. It has over 1 billion lbs. of copper and very high-grade gold—about 250 Koz. gold at about 14 g/t.

The Haiti property is right next to a property of Newmont Mining Corp. (NYSE:NEM). Newmont's CEO did an interview recently, and he mentioned that the Haiti operation is the most promising up-and-coming project for Newmont. The market cap right now is just $9 million, and that's why I see potential. If successful, this can be a home run. Of course, if it's a failure, you lose all your money.

TGR: Majescor is obviously a takeover candidate with a $9M market cap. Somebody can probably have it for $20M.

CL: Exactly, and hopefully a lot more. If Newmont wants to build a mine, it's going to pour maybe a billion dollars into a world-class flagship mine. Majescor already has the mining permits, while Newmont is still applying for them. I think people will eventually find this company; we're trying to get in there first.

TGR: Something else you wanted to mention?

CL: It's a rare earth company—American Manganese Inc. (TSX.V:AMY, OTCPK:AMYZF). Manganese is a very important metal used to make steel and batteries and China controls about 97% of the electrolytic manganese metal (EMM) market. This could be the next rare earth trade. If you compare American Manganese side to side with Molycorp Inc. (NYSE:MCP), there are very good similarities, but its market cap is still just 1% of Molycorp's. I think there's a lot of upside here.

TGR: If this stock doubles, it gets large enough for small-cap mutual funds to buy it.

CL: Exactly. That's the beauty of this stock. Right now, the mutual funds couldn't buy it. So, once it rises, mutual funds get in and push the stock to much higher levels. I got in at half of today's price. The company recently did a private placement, and I heard some funds were fighting to get in on that. Even though it's already doubled from our initial purchase price, those kinds of stocks may not initially have a lot of liquidity. Once they get to a $100 million market cap, the mutual funds get in and more investors realize that this could be the next Molycorp. Liquidity will increase, and you ride the liquidity and rising volume; the stock can go much higher from here.

TGR: Chen, do you have another gold stock that you want to mention?

CL: Colossus Minerals Inc.'s (TSX:CSI) stock didn't do anything in the past year. That's typical, because traders only care about a mining stock until about a year before it's in production. The company's mine is going into production next year, so the stock can break out from here. Colossus has very high-grade gold. It also has platinum and palladium credit, and so the cost of gold will be below zero. They have 200–300 Koz. gold coming out. Production costs are always rising, but this is a world-class, low-cost producer. That should attract a lot of majors who fight for low production costs. A major could take it over. It's only an $800 million market cap.

TGR: Thank you, Chen. This has been very informative.

Listen to Analyst Chen Lin on Jay Taylor Radio (2/22/11)

Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc., publisher of J. Taylor's Gold, Energy & Technology Stocks newsletter and Roger Wiegand's Trader Tracks. Using his wife's Roth IRA account, Lin invested $5,411 in December 2002, and by December 31, 2010 it was worth $1,188,993—with no cash added. You can see his portfolio chart here.

A doctoral candidate in aeronautical engineering at Princeton, Chen found his investment strategies were so profitable that he put his Ph.D. on the back burner. Chen worked in the Internet and computer area where he founded a few start-up companies. After the tech bubble burst of 2000, Chen was able to move his technology portfolio into the resource sector with considerable success. Chen employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis. To subscribe to Lin's What Is Chen

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DISCLOSURE:
1) Brian Sylvester of The Gold Report conducted this interview. He personally and/or his family own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Timmins.
3) Ian Gordon: I personally and/or my family own shares of the following companies mentioned in this interview:Timmins Gold, Golden Goliath, Millrock and Lincoln. My company, Long Wave Analytics is receiving payment from the following companies mentioned in this interview, for receiving mention on my website, Golden Goliath, Millrock and Lincoln Gold.

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