Gold Stocks Due for a Breakout Soon

Source: Special to The Gold Report  (11/23/11)

Gold stocks may have been underperforming investor expectations for many months, but that could be changing very soon. In this exclusive interview with The Gold Report, Jordan Roy-Byrne, CMT, explains how he uses relative strength analysis to pick winners for the readers of The Daily Gold Newsletter. His technical work points to a turnaround in precious metals stock prices in the coming months, leading to a huge market top near the end of the decade. In the meantime, investors can feast on some of his favorite recommendations, which he describes in detail.

The Gold Report: Based on your technical analysis, you called the bear market in December 2007 and the bottom, followed by a rally in February 2009, weeks before the market turned. Your Daily Gold Premium market portfolio was up 10.5% in June of this year compared to an overall junior gold stock market that was down 9.5% during the same time. How have you fared in the last five months and what trends are you seeing in the next year?

Jordan Roy-Byrne: At the end of last week, our premium service model portfolio was up about 9% on the year. Market Vectors Junior Gold Miners ETF (GDXJ:NYSEArca), the junior gold stock exchange-traded fund (ETF) I use to compare performance, was down about 18% and Market Vectors Gold Miners ETF (GDX:NYSEArca), the large-cap gold stock ETF, was down about 1%. The last few months have been difficult for a lot of equities. As far as the trends, I try to focus on relative strength. The large-cap gold stocks have been consolidating for most of the year. Silver had that intermediate top early in the year with a parabolic blowoff move. Since then I’ve been focusing more on gold. In the near term and into next year it looks like gold is going to outperform silver. The larger gold stocks have been showing better performance than silver stocks and juniors. Relative strength is very important. You’ve got to find and focus on the leaders because they will lead the next move higher.

TGR: In a recent newsletter, you said that gold stocks are moving closer and closer to a major breakout, which is likely to produce a multiyear acceleration that would set the stage for the birth of a bubble. Can you explain what you mean by that statement?

JR-B: The Market Vectors Gold Miners ETF and the AMEX Gold BUGS Index, used by some analysts, reflect the large-cap unhedged gold stocks. They’ve been in a consolidation phase since the fourth quarter of last year. Even a three- to five-year chart shows that the consolidation has been in a tight range, which is generally bullish. Every time the consolidation makes a low or goes to the bottom area, the weak hands are selling out. So, the stronger hands accumulate more and more shares and eventually the buying demand overwhelms the selling and you get a very strong breakout.

Sentiment indicators, such as how much money is invested in gold stocks, tell me that it’s an under-owned sector. There may be more and more people moving into the metals, and gold specifically, but the gold stocks really haven’t performed well in the last year or two. So, if we get this breakout, it’s going to produce a strong move for probably two years.

A bubble would start after a strong move for a couple of years followed by a long consolidation or a sharp pullback. The next move higher would signal the beginning of a bubble. Looking at market cycles and at other people’s research, a lot of market cycles tend to last 17 or 18 years. This bull market for precious metals is in its 11th or 12th year—a point when it is going to start to accelerate. So, we’re not that not far away from the beginning of the bubble, which could be in two to three years.

TGR: Did gold stocks really get that far ahead of themselves that they needed to be in this long consolidation?

JR-B: They did need to be in a long consolidation because we had a very strong move from the 2008 bottom. Market Vectors Junior Gold Miners ETF went from about 15 to 65. That’s a large move in only about two years. After a very strong advance, it takes a lot of time to work off the overbought condition. It can be worked off either as a sharp, short correction or over time with consolidation. Market Vectors Junior Gold Miners ETF or the AMEX Gold BUGS Index has not had a sharp correction to work off those huge gains. So, the consolidation has gone on over time. I do think that these stocks are very undervalued, with improving fundamentals. I look at the gold:oil ratio as a leading indicator for what kind of margins you could expect for the gold producers. Oil represents 25% of the cost of mining, so, it’s critical that silver or gold outperform oil and do better than the other cost inputs.

TGR: The performance of the juniors versus the established companies seems to indicate that there’s not much speculative interest yet in the juniors. What’s going to happen there?

JR-B: That’s a great point. The sector is still very under-owned and the juniors are underperforming. It also depends on how you classify the juniors. Personally, I prefer the established juniors—companies maybe with a $200 million (M) market cap or a little larger, because at that point you know that they’ve made it. The true juniors, with a $20–30M market cap are stocks that are really risky. They perform well when you get a huge increase in speculation, as we saw in ’06 and ’07 and obviously, early ’09 when everything came off the bottom.

That sector of the market should do very well in the next couple of years and when the bubble begins. A lot of people who invest in those types of situations just assume that because gold is going up, juniors automatically do well and you can pick these penny stocks that are going to go up fivefold or tenfold immediately. To be really significant, a junior has to find well over a million ounces (Moz) in a good area where there are no political and permitting issues. Or a junior needs to be able to put one large mine into production or multiple smaller mines.

TGR: The junior gold index in your newsletter shows a descending triple-top pattern. Is that building into an upside breakout or will it continue going to lower highs?

JR-B: I do think the bottom is in. My index classifies juniors. A lot of the companies in my index were juniors two years ago and they’ve been very successful, so the average market cap may now be $500M to $1 billion (B). A junior index is going to go up over time and the companies are not going to be cheap juniors forever. Let’s just compare it to Market Vectors Gold Miners ETF, which has been in a strong consolidation where the lows have remained the same over time. It’s like a rectangle. My junior index has a downward sloping channel, with lower lows and lower highs. But, I do think the index has bottomed and it had a nice rally in the last month. It’s just going to take a little bit of time for it to work its way back up to the highs. Obviously, I believe the large caps are going to break out first, followed by my junior index, and then the true juniors and the exploration plays.

TGR: You have a model portfolio in your publication with a pretty broad cross-section of resource stocks. Tell us a little about your selection criteria for assembling this portfolio.

JR-B: We look for a combination of strong fundamentals, technicals and management teams with a proven track record. We want companies that are well funded and are not going to do a dilutive financing anytime soon that puts pressure on the shares. We like companies that are involved in the right areas including Alaska, Nevada and some very successful ones in Mexico. Fundamentally, we’re looking for good value. If it’s a producer, we’re looking at cash flow. If it’s not a producer, it’s the price per ounce in the ground, the potential for expansion and the potential profitability of the project should it become a mine. If a company is in a good area, it may get taken over, as a couple of our stocks have been and that’s why they’re no longer in the portfolio.

Technically, a lot of mining share prices consolidate for a long time and then have a very strong move higher. You don’t want to buy anything that has gone up too far, too fast because that’s very dangerous. At the same time, we don’t want to buy anything that is showing persistent relative weakness, because if it keeps trending down, there’s a reason. There are more sellers than buyers and the company is not doing enough to attract more buyers. This is a pretty strict criterion for us, which is why we’ve had decent performance in a year that’s been difficult for a lot of people. I don’t want to have more than 15 companies in the portfolio and right now we have 11.

TGR: Two of your most recent additions are Franco-Nevada Corp. (FNV:TSX) at the high end of the price spectrum and Corvus Gold Inc. (KOR:TSX) at the low end. Why did you add those now?

JR-B: I decided to add Franco recently when I believed the market was bottoming. It was an easy call because it’s been a great company and a great performing stock over the last couple of years in terms of relative strength. It makes new highs ahead of its peers. It came down from about $48 to $34. We got in at $35. Today, the stock was trading close to $42. You want to buy this type of company when it has a correction like that. That’s why we bought Franco rather than a risky junior.

Corvus is following the project generator model. I have visited all of the company’s projects. Its flagship is the North Bullfrog project in Nevada and it also has a portfolio of projects in Alaska, which it has joint ventured out. Corvus Gold’s management team has a tremendous history. It ran International Tower Hill Mines (ITH:TSX; THM:NYSE.A), which made a substantial discovery in Alaska. The head of Corvus, Jeff Pontius, and his partner Russell Myers have worked together for a long time and had huge success with Tower Hill and have since moved onto Corvus.

When we recommended Corvus, it had about a $20M market cap with $8M in cash. The new NI 43-101 on North Bullfrog shows 1.4 Moz Inferred and I think there’s potential there for more than 2 Moz. Corvus also has the Terra project in Alaska where its joint venture partner is going to start small-scale production next year giving them some near-term cash flow. When we visited the project last summer, the company was just about to begin constructing the mill. Corvus also has another project in Alaska called the Chisna project, where the scenario is really spectacular and some good drilling results were reported a few days ago. With the amount of cash it has, Corvus is not going to need to raise money any time soon. I’m just really optimistic about Corvus and if someone has a two- or three-year timeframe, I think this is one of the top speculations in my book.

TGR: First Majestic Silver Corp. (FR:TSX; AG:NYSE; FMV:Fkft), Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BLV) and Argonaut Gold Inc. (AR:TSX) have been your top portfolio performers, in that order. What are your expectations for them now?

JR-B: I’m more optimistic on Argonaut and Fortuna Silver than First Majestic, which has been a huge winner for us. The relative performance of First Majestic has really tailed off in the last few months. Remember this company had a massive rise in its share price in the last 18 months or so. When you have a very strong rise like that, it’s going to take some time to digest those gains.

Fortuna Silver has a new mine in Mexico called the San Jose, which began commercial production in September. Its silver production is going to see substantial growth in the near future. Fortuna Silver has been the strongest silver stock this year. In 2008 and 2009, Silver Wheaton Corp. (SLW:TSX; SLW:NYSE) was the best performer. From the second half of 2010 until a couple of months ago, First Majestic was the strongest performer.

I have a hunch that in the next 12 months or so, Fortuna Silver could be the big winner in the silver group. The company has very strong fundamentals, is making a lot of money and has tons of cash.

Argonaut Gold came to the portfolio from Pediment Gold because Argonaut Gold acquired Pediment, which was a recommendation of ours back in late 2009. Argonaut is showing exceptional relative strength and a few days ago made a new 52-week high. The stock has been trending higher this year while most juniors have been trending down and large caps trending sideways. Argonaut has fantastic management. It’s the former management team that was with Meridian Gold when they sold Meridian a couple of years ago to Yamana Gold (YRI:TSX; AUY:NYSE; YAU:LSE) for about $4B.

When Argonaut acquired Pediment, the market cap of the company was around $300M. Here’s a management team that sold a previous company for $4–5B and now they’re starting up a new company with a low market cap. Argonaut is a textbook example of a company that we see becoming $1B market cap some day.

Argonaut has one mine in production at about 75,000 ounces a year. It has two other projects, which it acquired from Pediment. I believe both of these projects are going into production in the next 24 months. The company is highly profitable, has a lot of cash and has warrants out that will bring it a significant amount of cash. It’s a really fantastic company and it continues to be my favorite gold stock.

TGR: Which other ones do you like in your portfolio at this point?

JR-B: On the silver side, I also like Endeavour Silver Corp. (EDR:TSX; NYSE:EXK). It’s been a very strong performing stock. Endeavour’s relative strength is right there next to Fortuna. It’s a profitable company that has grown very consistently, both financially and operationally, over the years. It has two mines in production and over $100M in working capital, mostly cash. I believe the company is going to need to make an acquisition at some point to get a third mine into production.

We do have a couple more speculative ones in the portfolio. One is a company named CMC Metals Ltd. (CMB:TSX.V), with a market cap of only about $15M and about $2M in cash. The company’s focus is on two properties. The Silver Hart project in the Yukon is a very high-grade silver property with significant base metals. A year ago, it took a bulk sample from it and received a nice amount of cash flow. This summer it extracted a 1,700-ton bulk sample with a grade that could be 100 ounces per ton (oz/t)—potentially 170,000 oz silver, which could gross the company about $5M with a $3M profit. CMC could do similar bulk samples for the next couple of summers.

Earlier this year, CMC acquired 50% of a past producing gold mine in California called the Radcliff mine in the Death Valley area. Echo Bay Mines owned Radcliff in the early 1990s and had an internal resource estimate (non NI 43-101 compliant) of about 280,000 oz gold. Some 100,000 of that is high grade at about 0.75 oz/ton gold. CMC Metals also owns a mill nearby called the Bishop Mill. It has partnered with the private company that owns the other 50% of this operation. Ore has already been stockpiled there and CMC is looking to start milling in the next couple of months. We should probably hear more news in the coming weeks or after the holidays.

If CMC is able to get this gold production up and running, it’s going to be very profitable with substantial cash flow relative to its market cap. This is a speculative stock, which is trading well off its highs. I believe it has limited downside with upside potential that could produce a five or tenbagger. But, this is one that you really need to do your own research on.

TGR: Is there anything else you’d like to mention or any final thoughts that our readers can take away as to how they should be playing this current market situation?

JR-B: We’ve had a difficult year but I think we’re coming to the end of the sector consolidation. Market Vectors Gold Miners ETF has a strong support that’s well defined. Over the next month or so, I’m expecting more consolidation, but with an upward bias. In the next three months, you should probably expect a breakout to new highs. At that point you’re going to see a lot of the juniors start to get a bid and perform better. But, right now I think you want to focus on the more established companies that are showing some relative strength. Make a list and look to accumulate your favorite stocks on weakness.

TGR: And, wait for the year-end selling to subside.

JR-B: That is also true with juniors who’ve had a tough year. There’s probably going to be some tax-loss selling there. So, that’s definitely something to keep in mind.

TGR: Thank you for your insights and for some very good ideas.

JR-B: Thanks for having me.

Jordan Roy-Byrne, CMT, is a Chartered Market Technician, a member of the Market Technicians Association and a former official contributor to the CME Group, the largest futures exchange in the world. He is the editor of TheDailyGold Premium. His work has been featured in CNBC, Barrons, Financial Times, Alphaville, Yahoo Finance, BusinessInsider, 321gold, Gold-Eagle, FinancialSense, GoldSeek and Kitco.

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DISCLOSURE:
1) Zig Lambo of The Gold Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Gold Report: Franco-Nevada Corp., Fortuna Silver Mines Inc., Argonaut Gold Inc.
3) Jordan Roy-Byrne: I personally and/or my family own shares of the following companies mentioned in this interview: Argonaut Gold Inc. and Franco-Nevada Corp.
4) Argonaut Gold Inc., Corvus Gold Inc. and CMC Metals Ltd. are sponsors of TheDailyGold.com, Jordan Roy-Byrne’s website.