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Andrew Allentuck

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In for a wild ride?

Andrew Allentuck

 The usual proposition of investing is that you should be able to sleep at night with whatever is in your portfolio. But for those weary of financial services stocks that persist in rolling up good returns for investors, there is another market, one with potentially huge returns and legendary scams. This is the land of junior resource projects, where great fortunes are made and other lost in such flops as Bre-X Minerals Ltd., the fake gold find in Indonesia claimed by management to have had 8 per cent of the world's known gold deposits. That fraud collapsed in 1997 and the shares, once quoted at $286.50, became worthless. Nevertheless, there are numerous small companies with great potential for finding gold or oil or whatever. The knack for the investor is to understand — really understand — the risks of plunging into little-known companies.

Mal Spooner is a prominent small cap resource investor. As President of Mavrix Fund Management Inc. in Toronto, his reputation for doing the unconventional has grown with his stature as a lead performer in his own rock band. But his returns have been both grand and awful. His Mavrix Explorer Fund, a portfolio of junior players in the trees and rocks sector, produced a 29.0-per-cent average annual compounded return for the three years ended March 31, 2006. Not bad and decently ahead of the 26.3-per-cent average annual compound return of the S&P/TSX Total Return Index in the period. But on the way to this year's so-far happy outcome, the fund produced the natural resource sector's second worst return in 2005, a 12.6-per-cent loss, as well as its second best but still awesome, 68.9-per-cent return, in 2003. He is candid about the risks.

"Ten per cent of our stocks usually account for 80 per cent of our performance," Mr. Spooner explained. "If you don't find those 10 per cent, you have a lousy year. That is the nature of investing in this segment of the market. There are always going to be periods of extraordinary wins and terrible losses."

Sebastian Van Berkom, President and CEO of Van Berkom and Associates in Montreal, is a veteran small cap investor. Equity prices in natural resources and energy stocks are riskier than the market in general, he said. The companies' returns are leveraged on the underlying prices of the resources they process. In spite of these risks, investing in the sector makes sense, he noted.

"Materials stocks since World War II have underperformed the market," he explained, "But the growth potential of juniors is attractive. After all, it is easier for an oil company producing just 1,000 barrels a day to ramp up to 15,000 barrels than it is for a large company to go from 25,000 barrels a day to 100,000 barrels a day. Then add in the fact that oil and gas reserves decline as they are pumped." The odds are with the junior, he suggests. Right now, his money is on relatively small producers like Duvernay Oil Corp., gas specialist Iteration Energy Ltd., Zargon Energy Trust, and service companies like Enerflex Systems Ltd., which makes pipeline transport compressors, and drilling company Savanna Energy Services Corp.

Risk management is key to avoiding losing one's shirt in junior resources. Alex Lane, lead manager of the Dynamic Power Small Cap Fund, has done well, producing a 42.0-per-cent average annual compound return for the three years ended March 31, 2006, substantially ahead of the 29.3-per-cent average annual compound return of small cap funds. His approach is a mix of intuition and calculation.

An investment analysis begins with a constraint, Mr. Lane said. The project must have a bullish outlook for the price of its commodity, he insists. Then one must know the quality and size of the resource. In turn, that that supports a discounted cash flow projection. To be a good investment, the company has to be led by a management team that knows its business and can raise money from investors and bankers. And the investor has to take account of the political risk if it's in an unstable country.

On his list of companies that meet these tests are Palladin Resources Ltd., an Australian company listed on the TSX as PDN that will open a uranium mine in Namibia this fall. He noted that he holds Equinox Minerals Ltd., a copper, cobalt and uranium mine being built in Zambia. And for domestic exposure, he noted that he holds Highpine Oil & Gas Ltd., an oil and sour gas project in Alberta with prospects of a price spike if converted to an income trust.

Self-preservation has to be the style of investing in junior small caps, suggested Chris Fernyc, portfolio manager at Bissett Investment Management in Calgary. He pilots the Bissett Small Cap Fund and the Bissett Microcap Fund.

"A hole in the ground is just a 6/49 ticket," he said. "There are good explorers, but for every good one, there are 10 shysters." He has four investment rules:

  1. Insist on actual operations with earnings
  2. If there is no cash flow, look somewhere else
  3. The balance sheet has to show the money to finance company plans
  4. There has to be value, not just price momentum.

Do the returns in junior resources pay for the risks? It's a matter of when you look as much as where you look. The Commodities Research Bureau's Metals Subindex from 1947 to 2005 shows that since 2003, sector prices have nearly tripled. But that was a long time coming, for in the period from 1975 to 2003 prices, though volatile, had no upward trend. Today, said Darren Ford, portfolio manger of the Stone & Company Flagship Growth Industries Fund, high commodity prices will give well capitalized companies attractive returns. The juniors, he added, will "give the spice." But no one is promising that this time the ride will be smooth.

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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