Going for Gold: A Micro-Cap Strategy
Gary over at SMT is fond of saying that if a trader doesn't think big, he will never score big. Well, I am implementing a strategy into the Docfolio which definitely falls into the big thinking category. The idea is to build a book of micro-cap precious metals miners with the goal of scoring one or two huge success stories. Typically, the largest winners during secular bull markets are companies that are poised for explosive growth within the industry at the center of the bull. Such companies are rarely found in large-cap names which have already experience a rapid growth phase and are suffering under the inertia of managerial bureaucracy.
Consider a few names from the last great secular bull:
Now, I recognize there is a fundamental difference between the growth of a new industry versus one that has been around for centuries. When the gold bull is finished, I am sure the list of wild success stories will be considerably shorter than the list from the tech bubble, and the median gain of those successes, considerably tamer. However, the trait of human nature that contributes to speculative fervor will remain as reliably irrational has it has been for as long as there has ever been a market of any sort on this planet.
Given this propensity for speculation, I expect to see a slew of present-day micro-caps scoring 20, 50, or even 100-bagger returns by the time the gold bull is coming to its crescendo. However, unlike the tech bubble, which was full of companies purporting to do things no one really understood, most people comprehend that for a precious metal miner to make money, the company needs to be pulling metal out of the ground. Therefore, I do not intend to leave my potential fortunes to pure chance. I have several criteria by which I filter my choice of companies.
The primary filter, as you may have just deduced, is production. I do not want to own exploration companies. There are way too many fly-by-night outfits with management teams very proficient at marketing to investors and diluting shareholders, but highly unlikely to ever find an ounce of anything. I simply do not wish to spend my time trying to discern which of these companies has the wherewithal to eventually produce something. I will consider only companies with proven reserves and proven management.
A second criteria is cash flow. A quick glance at the balance sheet can tell me whether new funding will be required in the next couple of years. Share dilution is a scourge to this type of strategy. Along the same vein, I will read a couple years' worth of news on each company, if available, to make sure they are not making a habit of share issuances.
The final criteria is, of course, capitalization. In general, I consider a company to be micro if its market cap is under $1 billion. Exceptions can be made based on the company profile and recent stock action. For example, if an expansion of known reserves recently caused the company's capitalization to pop from $900M to $1.1B, I'm not going to eliminate it from consideration. In fact, I'd be more likely to chase in this case.
Which brings us now to entries and exits. As a trader, I am not very good at chasing moves. The cycle analysis I undertake for the perusal of Members is designed to catch important swing lows (or highs) and ride an intermediate trend, not to chase breakouts. However, breakouts, especially when they occur in conjunction with positive news, are an excellent way to invest. Much like the patterns we saw with drug companies winning FDA approval for new products back in the 1980s and 1990s, breakouts on revenue-positive news during an industry's expansion phase will typically produce phenomenal returns over the ensuing years.
I will, or course, add a company to the Docfolio for reasons other than a breakout, but if I have a micro-cap on my watch list and it breaks out based on an increase in production or known reserves, I will immediately follow that break. After the inital position is taken, the strategy will be to add to these positions each time I identify an intermediate cycle low for gold. Unlike my trading positions, however, I will not try to trade around intermediate declines with the micro-caps. One would not want to miss a positive news event for the sake of getting too cute within this strategy.
As for exits, there are three ways a sale would be induced. The first is a negative news event such as a share dilution undertaken solely due to cash flow problems. Unfortunately, such news will often clobber the stock before an exit can be managed. However, this is a risk that has to be accepted within this strategy. The second type of take out would be via acquisition. One of my general trading rules says that any company I hold that receives a buyout offer is immediately sold. While bidding wars occasionally occur, experience has taught me that the risk of a deal falling through far outweighs the chances of seeing a better offer. Finally, all positions will be exited once I believe the gold bull market has run its course. If I am astute enough, I will be exiting too early rather than too late, as the backside of bubbles tend to be quite vicious.
Without further ado, here is a sampling of the names I am following:
The success of this strategy is predicated on two basic assumptions. The first is that my selection criteria will be effective in identifying at least one company which will experience spectacular success. The second is that I will continue to be able to successfully read intermediate cycles in gold so as to preserve trading profits and roll a portion of them into this strategy near cycle lows. Given time, patience, and a modicum of providence, however, a trader does have the wind of a secular bull at his back.