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October 02, 2009

Base Metals Stocks
by Scott Wright

The base metals markets have been some of the most exciting to trade in this commodities bull. From trough to peak, copper, zinc, nickel, lead, and aluminum have seen staggering gains of 575%, 537%, 1124%, 888%, and 163%! Naturally, gains of this magnitude have made the mining of these metals an incredibly lucrative business.

Base metals producers that had been down in the dumps after a decade-long commodities bear are finally able to taste prosperity. Not only are these miners now able to profitably mine their metals, but prices have been high enough to incentivize them to build more mines.

This new environment has allowed not only the bellwether producers but hundreds of startups to take to the hills in search of the next generation of mines. The downtrodden base metals industry and its crumbling infrastructure is finally in line for an upgrade!

Stock traders of course quickly caught on to the potential riches of investing and speculating in base metals stocks, and this sector soared. BM stocks swung in the same direction as their underlying metals, with many seeing gains that amplified the actual performances of the metals.

With this sector growing in popularity and size, it became increasingly important to better understand its constituents. But picking the best stocks to trade became an arduous task within such a fast-growing population. This prompted our research division to embark on a project to identify high-potential base metals stocks. And the culmination of these efforts was packaged into a 2006 research report that profiled our favorites.

This report equipped us with a refined group of stocks to trade when the timing was favorable. And most of these stocks performed incredibly well, leading to excellent gains on many of our newsletter trades. Interestingly, in the years following the release of this report 7 of our profiled stocks were acquired (most at very large premiums) amidst major industry consolidation.

After such large gains leading into 2007 and 2008, the base metals were due for corrections. With the miners finally able to ramp up supply, enough so to allow a little wiggle room in the above ground inventories, the speculative risk premiums attached to BM prices were quick to fade.

The corrections in zinc, nickel, and lead ensued in 2007, with copper and aluminum following in mid-2008. And by September 2008 all of the base metals had been subject to very healthy corrections. In a normal market environment the selling would have been exhausted by then, but the ensuing bond and stock panics would take hold of commodities and throw all rationality out the door.

By the time the stock-panic-induced commodities maelstrom had blown over, copper, zinc, nickel, lead, and aluminum had plummeted 69%, 77%, 84%, 78%, and 62% from their respective highs. Unfortunately these sharp declines were the result of sentiment-driven panic selling. But as you will see, the reverberations of such activity have had and will have a direct impact on fundamentals.

The BM stocks had varied reactions to this correction-turned-panic-selling environment. The larger mining companies didn't correct nearly as hard as the metals initially. While these stocks are influenced by commodities price action, they are also heavily influenced by the activity of the headline stock markets. And with the stock markets remaining steady through about mid-2008, the larger base metals stocks hung in there.

The smaller base metals stocks, namely the juniors, did not fare as well. They started correcting upon the initial base metals weakness in early 2007. These little guys just didn't have the support of institutional buying and quickly lost interest from their core investor class, the retail investor.

But regardless of whether a BM stock was large or small, they were all sucked into the panic-selling vortex of autumn 2008. And by the time all was said and done, when panic selling climaxed in late November, the BM stocks had been crushed. As far as anyone was concerned there would never be a need for industrial metals again.

Thankfully this irrational selling was met by traders who recognized how oversold these markets truly were. At Zeal we were among those contrarian traders that didn't buy into the cacophony noise of neo-Great Depression talk. And we took advantage of one of the biggest sales extravaganzas of our lifetimes.

In the heart of the panic in our acclaimed monthly newsletter we took long-term positions in a handful of commodities stocks, including a BM stock that as of this week has an unrealized gain well in excess of 100%. Indeed rationality has slowly returned to the markets, and we have seen a marked base metals recovery. But prices are still a far cry from pre-panic levels.

The aftereffects of this stock panic have really accentuated a radically-changing BM stock landscape over the last few years. And many of our subscribers and report customers have asked that we update our BM stock research to reflect these happenings.

So in order to uncover which companies will thrive in this new environment, we've taken task to re-examine the universe of BM stocks. And the first thing we discovered is that this universe has greatly expanded in the 3 years since we last pooled these stocks together for analysis.

With prices going from one extreme to the other we've indeed seen a lot of consolidation, but there are also a lot of new players to the game. In a bull market the entrepreneurs come out of the woodwork. Whether qualified or not, a lot of folks seek to take advantage of the current environment and strike it rich.

Amazingly, the pool of base metals stocks listed on the US and Canadian exchanges is now in excess of 300. With such a large population it is increasingly important that investors be prudent picking their stocks. In order to filter this group and narrow them down to our favorites, it took hundreds of hours of painstaking research. And while arduous, this process was quite rewarding. It is fascinating to learn about the companies that bring the world's industrial metals to market.

Base metals miners come in all shapes and sizes. Some of the biggest and best producers have market caps in the tens of billions of dollars. These majors mine a wide array of metals and have diversified portfolios of projects that span the entire globe. But while these majors are responsible for a large portion of global supply, these $10b+ companies represent only about 2% of the BM stock population. Taking it down a level, only 5% of the stocks in this pool have market caps that exceed $1b.

Beneath the realm of $1b companies, we venture into the world of the small-caps. But with the formal definition of small-caps being $300m to $1b companies, we still only capture a small portion of BM stocks. Only about 3% of the stocks in this sector qualify as small-cap stocks. To find the majority, we must look multiple levels below the small-cap range.

The next classification is micro-cap stocks, those companies with market caps between $50m and $300m. But this micro-cap range is host to only about 11% of the BM stock pool. Believe it or not you actually have to look under the $50m level, the nano-caps, to find the majority. This nano-cap realm is host to 81% of all BM stocks!

While there are solid nano-caps that have the qualities one would expect in companies this size, unfortunately some are no different than the dot-commers of yore. Dot-juniors as I call them are companies with fancy names and a bit of land, but are not likely to ever make a contribution to metals mining. They are leveraging the concept of the greater commodities bull and typically spend more money on marketing than drilling.

Dot-juniors aside, regardless of market cap there are plenty of excellent BM stocks to choose from. Whether nano-cap or large-cap, these stocks offer investors the opportunity to greatly leverage the base metals bull markets.

Also regardless of size is an overlying theme I found to be pretty consistent across the entire base metals complex. This being major cutbacks on capital expenditures. In the hundreds of financial statements and accompanying managerial discussions that I've read, there is a recurring theme that includes such initiatives as "capital conservation", "production cuts", and "reduced capex". And the reasoning behind these initiatives all ties to reactionary efforts in adjusting to current economic conditions.

Usually it is fundamentals that guide price action, but as a result of the stock panic it has been the other way around. With prices falling so far and fast, price action has altered fundamentals. With the fear virus of a depression permeating all the way to the large consumers, commodities demand has temporarily fallen and shifted the economic balance.

Now in the long run fundamentals will reign supreme and commodities demand will continue to trend upwards, thus guiding prices. But unfortunately a situation such as this is going to have its consequences. In this new environment the suppliers must adjust their output accordingly to weather the storm.

For the producers this means throttling back production rates, and for the industry as a whole this translates into a slowdown on the exploration and development fronts. New mines won't be coming online as fast and the discovery of new deposits will be fewer and farther between.

Now if the secular trend was radically changing and the commodities bull was over, this conservation activity would be righteous. But the commodities bull is not over, and unfortunately this massive cutback on E&D will have a huge structural impact on the base metals mining industry. When demand does pick back up, the pipeline of replacement and growth projects will again be lagging. And this is likely to create an environment of extremely tight supplies and lofty risk premiums all over again.

In surveying the base metals stocks it is readily apparent that an industry that was making strides to improve infrastructure and line up the next generation of mines has hit a wall. The mining companies simply do not want to spend money in this uncertain environment. And this will really pinch supply in the coming years.

Not only do these miners not want to spend money, many simply can't afford to anymore. With metals prices down, so are revenues. And this obviously limits their abilities to bolster treasuries. With less capital available, it makes expansion decisions ever more difficult. And in this business, expansion and growth comes with a hefty price tag. It takes a colossal amount of capital to explore for, discover, develop, and then operate a mine.

And if it is difficult for those companies with cash flows to put capital to work on E&D, imagine how difficult it now is for companies that have no sources of revenue. Availability of capital is a key issue in this industry's current struggles. Not only have lower and more volatile metals prices made banks (that obviously have problems of their own) think twice about issuing mining companies debt, the equity side is even more precarious.

Smaller mining companies that have limited or no access to the credit markets must solely rely on selling stakes of their companies to investors to raise capital for E&D. And unfortunately, for many of these companies the equity markets have all but dried up.

Investors who typically risk their capital in the smaller companies that focus on E&D have seemingly abandoned this industry. And for those companies that can still perform equity financings, it is a lot more expensive thanks to their much lower stock prices. With shares so cheap, capital-raising efforts are much more dilutive to existing shareholders.

Now putting our stock-research hats on, the mission is to find which companies can survive and thrive in this environment. Unfortunately many BM companies will struggle to survive, and some will outright fail. In the process of researching the universe of BM stocks, one of the things we do is take a close look at each company's financial standing. And there is a lot of ugliness out there right now.

The smaller companies that were undercapitalized prior to the stock panic are currently in big trouble. Consider this... the average market cap of the nano-cap stocks is only about $10m. With an average share price of $0.21 and average daily volume of about 140k shares, the average daily capital volume of these companies is only around $30k.

How can a company that only swings around $30k on a daily basis attract enough investor interest to raise the capital necessary to explore for and develop a mine? While some of these companies are junk and would never have contributed to the lifecycle of whatever metal they were after, as a whole these nano-caps play a vital role in the supply chain. Even if they are only a food source for the larger companies that seek non-organic growth, if they can't do what they do there will be a big disruption in the supply chain in the years to come.

And many of the larger base metals stocks are struggling with similar issues. In order to replenish reserves these companies need to be constantly exploring for and developing their next mines. But with capital harder to come by from outside sources, this is a lot more difficult than it used to be.

Debt financings are much more expensive than they were before. Not only is it harder to find a loan, but the terms and conditions are now more stringent. The cost of borrowing has grown substantially not only from an interest-rate perspective, but from a time-value perspective. Banks are requiring a lot more hedging these days.

Looking at financial statements also reveals which companies did not manage their financials well prior to the panic. Many BM miners are now way overextended on their debt. With reduced cash flows from lower metals prices and less availability on the equity front, these miners will be strained just to fulfill their debt obligations, let alone put forth capex for E&D.

Ultimately after analyzing the financial standings of the BM stocks, it is easy to weed out those companies that will have a hard time accessing capital and lack balance-sheet strength. But those companies that do have strong financial standings, along with quality operations and project pipelines, have become today's elite BM stocks.

These elite companies are positioned to thrive in these uncertain times and will be the ones that emerge as the leaders of the pack once the commodities bull regains momentum. We recently concluded our latest BM stock research and published a report that profiles our favorite dozen. If you are interested in learning about the fascinating base metals markets and the companies that are positioned to thrive, then this report is for you!

Hot-off-the-presses, it provides detailed fundamental profiles on a wide spectrum of BM stocks. This includes junior explorers that are developing the next generation of mines, along with some of the biggest and most profitable BM producers in the world. Not many people think about where the copper pipes in their homes come from. Have you ever considered where the alloy components of such things as steel, jet engines, and batteries are sourced?

In this report you can learn how it is profitable to extract copper ore from the side of a mountain, turn it into liquid, pump it to a river port through a 100-mile pipeline, dry it, and then send it on a 500-mile barge journey to a depot where it is sold to a smelter for further processing. You can also find out how the economics of a nickel deposit are so amazing that a multi-hundred-million-dollar mine is aggressively being developed and built even today. Become an informed investor by buying your new report today!

The bottom line is the global stock panic has had a resounding effect on the base metals markets. From the prices of the metals to the stocks of the companies that bring them to market, investors are now looking at a radically different marketplace than just a few years ago. But the base metals bulls are not over, and there will still be plenty of opportunity to capitalize on the secular trend.

Stocks are still the best way for investors to leverage these exciting base metals markets. But in this environment where there is still trepidation, investors must choose their stocks carefully. Those companies that are well-positioned today should thrive when there is BM resurgence. And our latest report uncovers those stocks that are likely to have the highest probability for success.

Scott Wright
Zeal LLC.com

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at ... www.zealllc.com/subscribe.htm.

Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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