Beware The Junior Mining Rally

Last December, junior mining stocks were lying by the side of the road, beaten within an inch of their life. The TSX Venture Exchange index - the “Dow Industrials of small resource stocks” - had fallen 75% in four months.

By February 2009, we saw some life return to the sector…

I think that “value” point is here for many of the stocks on the Venture. I think the bull market in gold and silver will continue. And I think a handful of these small resource companies will return hundreds of percent over the next few years.

Today, the whole index is up more than 100%.

It’s climbing higher on the backs of stocks like Linear Gold, which I told you about in March. At the time, Linear had $19 million cash in the bank. It traded for just $22 million.

Linear’s share price went from $1 back then to a recent high of $2.67, a 167% gain. It’s up 287% from its December low.

That’s an amazing rally. And I think the whole sector could be headed higher. But before you jump into your favorite tiny mining stock, a word of caution…

I just returned from the New Orleans Investment Conference. In the past, the conference attracted a thousand or more investors. This year, about 300 showed up, not counting the companies, brokers, or newsletters working the booths.

That is shocking. And it tells me the rally in junior mining came directly from funds. The retail investor is still licking his wounds from last year’s crash. That’s why you’ve got to be careful before you buy into this sector. Let me explain…

If funds are driving up the whole sector, they’re leaving behind booby traps for individual investors. You see, mining companies are “capital intensive.” They need gobs of cash to run their business. But they’ve got nothing to use for collateral on loans. So when they need more money - which they always do - they print new shares. To entice big funds to buy lots of shares, they also issue “warrants.”

A warrant is nothing more than the right to buy a share for a fixed price. For example, Linear Gold recently raised $5 million by selling 4.5 million “units.” Each unit included a share and half a warrant.

These warrants are good until March 19, 2011. Holders can turn each warrant into a Linear share at a cost of $1.50. The stock is trading for $2.50, so those warrants are good for a 66% gain right now.

So over the next 18 months, 2.25 million shares will appear from thin air, priced at $1.50 each. Brokers call that “overhang.” And thanks to that overhang, Linear’s share price will probably fall toward $1.50 as those warrants come into the market. The drag will continue until all the warrants are sold.

You see, when a fund gets into a deal like Linear’s, it will hang on to the warrants until they are profitable - that’s how it makes money on the deal. For the shares, the funds must hold on to them for four months before they sell. That just means they come onto the market in a wave as soon as they can, legally.

There aren’t many buyers of these small mining stocks, so selling in bulk is incredibly difficult.

About a year ago, for example, TD Asset Management dumped 800,000 shares of Keegan Resources, a small gold company. The fund needed to sell, but there simply weren’t enough buyers to sop up all those shares. Keegan’s share price fell from $2 to a low of 39¢.

That’s an extreme case. It happened during the furious end of the bear market in junior mining stocks. (If the economy takes another leg down, it could certainly happen again.) Even in a good market, if a fund decides to take its profits, the small investor - guys like you and me - can get crushed.

I’m excited about the huge rally in small gold stocks. There are hundreds of percent gains to be had. But before you jump in, don’t just look at the rocks. Make sure you know who owns the stock and how many warrants are out there. (Check the company website and www.sedar.com.) At best, they’ll put a lid on your gains. At worst, you’ll find yourself black and blue on the side of the road.

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