A Beginner's Guide To Mining Stocks October 11

A Beginner's Guide To Mining Stocks
October 11 2012| Filed Under » Commodities, Investing Basics, Investment
If it isn't grown, it has to be mined. You've probably heard some variation of this saying. It is used by people concerned about the environmental effects of mineral depletion as well as people bullish on mining stocks . Although these two groups have a very different emphasis when they speak it, they are both right - mining is big business. Almost every commercial product has elements that started off buried beneath the earth. Here are a few things that you should know before adding mining stocks to your portfolio.

Two Stocks, One Sector
Mining stocks are truly two distinct groups: majors and juniors. The majors are well-capitalized companies with decades of history, world-spanning operations and a slow and steady cash flow. Major mining companies are no different from large oil companies, and many of the same metrics apply with a mining twist. Both have proven and probable reserves, except mining companies break down profit and cost on a given deposit by ton, instead of barrel. In short, a mining major is easy to evaluate and easy to invest in.
The junior mining stocks are very nearly the exact opposite of mining majors. They tend to have little capital, short histories and high hopes for huge returns in the future. For the juniors, there are really three fates. The most common is failure, which leaves a hole in everyone's pocket, including that of the banks and investors. The second fate occurs when a junior has enough success to justify a major paying a decent premium to gobble it up, leading to decent returns all around. In the third and most rare fate, a junior finds a large deposit of a mineral that the market wants a lot of; it is a magical combination of the right deposit at the right time. When this happens, juniors can return more in a few days than a major will return in years.

Valuing Major and Junior Mining Stocks
Although majors and juniors are very different, they are united by the one fact that makes all mining stocks unique: their business model is based on using up all the assets they have in the ground. The catch is that mining companies don't know exactly how much is in a given deposit until it is all dug up. Therefore, the value of mining stock roughly follows the market value of its reserves, with a premium paid to companies with a long history of successfully bringing those reserves to market.

Reserves are evaluated through feasibility studies. These studies independently verify the worth of a deposit. A feasibility study takes the estimated size and grade of the deposit and balances it against the costs and difficulties of extracting it all. If the deposit will fetch more money on the market than it costs to dig up, then it is feasible.

Different Risks, Different Rewards
If a mining major has hundreds of deposits staked and/or being mined, the contents of any single deposit aren't likely to shake the stock value too much. A major is the sum of all the deposits with the aforementioned goodwill tied to history. A change in the market value of a mineral that makes up a larger percentage of the deposits will have a much larger effect than a new deposit or a failed deposit. A junior mining stock lives or dies on the results of its feasibility studies.
Access to top-notch futures studies at no extra cost. Thinkorswim from TD Ameritrade.
A junior mining stock sees the most action leading up to, and immediately after, a feasibility study. If the study is positive, then the value of the company may shoot up. The opposite, of course, is also true. Often, a junior miner won't mine a feasible deposit to the end. Instead, they sell the deposit (or themselves) to a larger miner and move on to search for another one. In this sense, junior mining stocks form an exploration pipeline that feeds the major miners in the end. In this view, the big risks and rewards mostly reside at the junior mining level.

Choosing Between Majors and Juniors
As an aspiring mining investor, you're probably wondering whether you should invest in junior mining stocks or major mining stocks. The answer depends on what you are looking for. Juniors have the potential to offer a lot of appreciation in the right market. This makes them an ideal destination for risk capital, but hardly the best place to put your social security checks. If you are looking for a lower-risk stock with the potential for dividends and some decent appreciation, then major mining stocks may be for you.

The Bottom Line
This is a primer and as such, suffers from being overly broad and simplistic. Before you invest in the mining sector, you should probably know what greenfields exploration is, how to estimate the impact of pricing risk and be able to hold forth on the dangers of buying on a single positive assay. If you are keen enough on mining to do some research, then there is probably room in your portfolio for both mining majors and juniors.