Speculating and investing in this sector is difficult. It is a far more difficult industry than others and that is why companies continue to struggle and fail even with the luxury of high metals prices. We've written extensively about the recent major bottom in the precious metals sector and the very positive outlook for the equities in 2012 and likely 2013. One can make money if they buy and hold a mutual fund or ETF but they can generate far superior performance with a basket of the right companies. The following explains what we look for in order to uncover the juniors that will deliver outstanding returns.

Capital Structure

Capital structure refers to share structure, market cap and the financial position of the company. First, we want to see a share structure that is low in shares outstanding but also low in its fully diluted count. This means there aren't tons of options and warrants that can weigh down the stock after it begins a good run. The overall share structure can also be used to grade management. Remember, most of these companies do not make money and there way to raise money is to sell more shares. Compare the achievements of the company with its current share structure. Has the company been productive or has it been ineffective and carries a bloated share structure?

Second and most important, the more cash a company has the better. In looking at non-producers, it is obvious that the companies with significant capital have an advantage over those who have less than $2-3 Million in the bank and may have to finance within the year. For producers, we want to see enough cash flow and capital in the bank that the company can grow its production with minimal dilution.

Projects

In analyzing explorers and developers, we want to find the companies with projects that are likely to become a mine and are likely to be coveted by a large or major company. Consider the location. Is it in a friendly mining jurisdiction like Mexico, Nevada or Quebec? Is the location near an operation of a larger producer or major company? If the answer to both is yes than it is far more likely to become a mine. Also, we want to see projects that not only can be mined but mined profitably. How did the market respond to a preliminary economic assessment? Would the project payback cap-ex in a few years or five? A past producing property is another good sign.

Let me provide an example. We added Trade Winds Ventures to our model portfolio last summer. The stock experienced a deep pullback but had stabilized for a few months. Trade Winds had a deposit literally right next to Detour Gold's multi-million ounce deposit at Detour Lake. It was a no brainer. This wasn't a grand slam but it was a very nice return in about five months. The key, which is our next point, is we bought it when it was cheap and not while it was zooming higher in 2010.

Buy Takeover Candidates on the Cheap

This is especially true of the explorers and developers. You are an investor and so are potential acquirers. You both want something that has growth potential at a reasonable price. Like a major company, you will not chase something that has already moved and has little upside from its present market value. Thus, buy these targets cheap. The market is coming out of a major bottom so there should be plenty of candidates. On the first day of the year we added a US-listed development company that we thought was cheap. Technically, it had very little downside. It's up 25% since then. Had we bought it 12 months ago we'd be down 25%.

Favor Junior Producers with Development Projects

Juniors who make it to production will do well but it it those juniors that can go from zero or one mine to three or four that will be the biggest winners. We prefer producers but we are looking for those that are likely to have multiple operations. Producers that have strong development projects in the pipeline have advantages over pure development companies and those producers lacking the assets to grow production. For example, our favorite gold stock for the past two years and largest position in the model portfolio is set to put its second mine in production in the coming months and then its third mine into production by the end of 2013.

Find Management Teams with a Track Record

This is especially important if the company wants to be a producer. Mining is an extremely difficult business and therefore your odds of success will be much higher with those who have done it before. Two of our biggest winners, Gold Resource Corp and First Majestic Silver, were led by people who had a great track record. At the same time, the absolute biggest names will command a premium in the market, so be judicious. Management is always important but in building and operating a mine, it is paramount.

Technical Catalyst

Again, for the more speculative non-producing juniors, one should always buy on the cheap or at least buy something that hasn't made a new high in a year or two. When the market turns favorable, juniors can rebound quickly as we've seen. For small producers and development plays we look for a technical catalyst. If the stock is near very strong support then we know the downside is limited and the risk to reward is favorable. If the stock is close to breakout out of a multi-year base then we know it has room to move significantly higher sooner rather than later.

In recent commentaries we've told you why you should be buying. This time we tell you what to buy, without actually giving names. Hopefully you can extract a few nuggets from this piece that will serve as a springboard for your research. We are excited because this bull market is going to quietly ramp higher over the next several years. The present is probably your last chance for at least a year or so to buy many companies on the cheap. You can go at it alone or you can consult a professional.

Good Luck!

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