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Clif Droke

Clif Droke

Clif Droke is the editor of the two times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock…

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Basics of Penny Mining Stock Speculation, Part 3

In the previous two articles on penny mining share speculation we looked at the basic principles for successfully investing in junior mining companies. Our main focus was on knowing when to buy and sell. In this installment we'll discuss the mechanics of what to buy and how to identify the best mining companies based on fundamentals.

The merits of owning mining shares are many. In his classic book "The Battle for Investment Survival," Gerald Loeb made the following observation: "I think if one went to the trouble of reviewing the figures, one would find the better mines lived much longer than many corporations. One is very much more apt to extend an ore body than to find new sources of profit to bolster a perishing industry."

Loeb provides us with the rudiments to successful speculation in the mining sector in general. He asserts that despite the complexities involved with the gold and silver mining business, mining shares nevertheless have great interest and great value for those in a position to get the right information and evaluate it correctly. Loeb endorses investment in mining shares of companies with proven ore bodies and established reputations. He writes, "I feel the best ones are more attractive...than general investment trusts...[and] that appraisal of mines is more certain than appraisal of industrial or [other] prospects." He notes moreover that the specialization of gold mining companies is likely to hold an additional advantage: "The frequency of granting options in mining finance is often the source of really huge and unexpected profits, very often out of all proportion to risks."

Loeb praises gold mining shares as coming nearest to the perfect means of preserving current purchasing power for future use, viz., the hoarding of metallic gold where it is legal. "Gold companies are relieved of any effort to find markets for their product in contrast with the usual extensive and costly sales departments of ordinary business concerns," he writes. "Furthermore, the price of gold has broadly increased for centuries." He adds that gold shares are devaluation hedges and that "the desire for gold is the most universal and deeply rooted commercial instinct of the human race."

Now that the groundwork has been laid establishing the investment value of gold mining shares, let's take a look at the fundamental requirements for purchasing shares of gold mining companies.

In his book, "Making Dollars With Pennies," R. Max Bowser lists several factors that must be considered for a prospective penny stock purchase. These requirements can be applied to junior mining stocks as well.

The first factor to consider when purchasing junior mining or other gold shares is a company's book value, which is roughly defined as being the difference between all of a company's assets and its liabilities, dividing the resulting figure by the number of common shares. According to Bowser, if the book value of a company is equal to or more than the price of its stock, it's a positive and that is the first step in the consideration of which shares to accumulate in the penny mining stock sector. Charles Allmon of the Growth Stock Outlook newsletter once wrote, "If I had to limit my stock selection to only one thing, I would choose book value."

Another prime factor to consider when trying to decide which penny mining shares to accumulate is the highest price per share in the last two years. Writes Bowser, "The objective of our system is to have at least each purchase double in value....So, we would like to know that at least once in the last two years it has been double its current price." He adds that on average, if an issue has performed well in the past it is most likely to repeat.

Another basic requirement for selecting penny mining shares is average daily trading volume. The more actively traded a stock is, the more liquid it is and hence easier to dispose of when the time comes to take profits. Make sure that you as an investor select a penny mining stock that has a fair average daily trading volume that indicates the stock is in demand, otherwise you may be stuck with shares that no one wants when you are trying to sell. Along with this consideration is the number of shares outstanding, which should never be excessive when compared with a company's annual sales.

Another factor that Bowser likes to look at when evaluating penny shares is current ratio on the company's balance sheet. In fact, he considers it one of the most important facets of his personal rating system. This is defined as the relationship between current assets and current liabilities. The minimum that Bowser accepts is a ratio of 1.8 to 1, which means that for every $1.80 of current assets, there are $1.00 of current liabilities. In short, the ratio must be 1.8 to 1 or higher to warrant consideration for purchase according to Bowswer.

Long-term debt is the next important factor to consider when evaluating low-priced shares. "Excessive long-term debt is an albatross," writes Bowser. "Every year interest has to be paid on it, plus part of the principal. And, these expenditures are considered a cost of doing business, so that they are deducted before taxes and thus reduce the amount of earnings available for per-share computations." Bowswer maintains that if the long-term debt is more than 10% of a company's annual sales, it is excessive and does not warrant purchase of its shares.

Another important consideration when evaluating penny shares is a company's current earnings, probably one of the most important of the fundamental considerations in security analysis. Ask yourself, "Is the latest earnings positive compared to the same period a year ago?" If the answer is yes, then this makes for a buy candidate. Observes Bowser: "The very reason for a corporation's existence is to make a profit. Current earnings can indicate future prospects [and] the price of the company's stock reflects current earnings."

Ranking just behind earnings in importance is current sales (i.e, a company's sales during the ficsal year in progress). As Bowser points out, a decrease in sales may indicate that the company's products or services are not being well received. However, the decrease may also be due to economic conditions over which the firm has no control. "Nevertheless," he writes, "a decrease in sales is not a healthy situation, as we are looking for growth in both sales and earnings."

In the next installment in our examination of penny mining stock selection we'll look at the technical aspects of share price analysis.

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