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Gold Junior Miners GDXJ ETF Analysis

Commodities / Gold and Silver 2010 Oct 15, 2010 - 12:01 PM GMT

By: Zeal_LLC

Commodities

Diamond Rated - Best Financial Markets Analysis ArticleGold’s relentless climb to new record highs is driving a renaissance of investor interest in junior gold stocks.  This fascinating subsector amplifies investing’s usual risk-reward equation to breathtaking extremes.  While the great majority of junior golds will end up worthless, the few that strike it big enjoy some of the largest gains ever seen in the financial markets.  We’re talking 100x+ returns!


There are many hundreds of these small explorers scouring the planet today for the next great gold deposit.  Other than a little fraction with small-scale mining operations, junior golds have no internally-generated cashflows.  Their business model is so bleak banks almost never give them loans.  Their only source of sustenance to maintain exploration activities is from issuing new shares to stock investors.

The risks borne by these brave stock investors are staggering.  Even with today’s stellar gold prices, even if a particular junior is lucky enough to find a sizable deposit, it usually takes around a decade to bring a new gold mine into production.  And though exploration is very expensive for these little companies, development costs are orders of magnitude higher.  The odds are overwhelmingly stacked against juniors.

Even elite market-darling juniors, with wide investor followings, are not immune from these colossal risks.  A case in point is NovaGold, with its massive world-class deposits that have long earned it universal adoration.  In November 2007, it shocked investors with a stunning announcement that it was suspending construction of its new flagship mine just 6 months after it started.  On open the morning after this bombshell hit, its stock gapped down 27%.  It ultimately plummeted 53% that single day on 20x normal volume!  Junior golds are never for the faint of heart.

But amazingly, this sector’s enormous inherent risks aren’t the biggest challenge for investors.  A far bigger problem is refining the small pool of high-potential winners out of the great sea of dross destined to fail.  In the US and Canada alone, there are well over 500 publicly-traded junior gold stocks!  Even a superficial analysis demands several hours per junior, while serious analysis takes over a dozen hours per company.

Run these numbers, and an investor would have to devote between 1500 hours (9 months) and 6000 hours (3 years) to thoroughly explore today’s universe of junior golds!  Obviously such a crushing time cost is ludicrous, impossible for any individual investor to bear.  With no practical way to intelligently target their capital to high-potential junior golds, most investors understandably avoid this sector altogether.

But thanks to our wondrous new ETF era, investors now have a quick and easy way to get instant diversified exposure in some of the world’s best junior golds.  Nearly a year ago, Van Eck Global launched its GDXJ Junior Gold Miners ETF.  This symbol probably sounds familiar, because it apes Van Eck’s popular GDX Gold Miners ETF by adding a suffix of “J” for junior.  Having actively speculated in junior golds for a decade now with much success, I’ve been watching this young ETF with interest.

This week, GDXJ had $1.4b under management.  This may not sound like much with GDX commanding $7.4b, but in the tiny (capital-wise) world of juniors this is astounding.  Out of the 1100+ ETFs that trade in the States, the world’s biggest market for them by far, GDXJ already ranks in the top 10% in market-cap terms!  And its big brother GDX (launched much earlier in May 2006) is among the top 2%.  So these gold-stock ETFs have been wildly successful by any standard.

GDXJ is a huge boon for investors and junior gold companies alike.  On the investor front, GDXJ offers instant well-diversified exposure to an elite group of hand-picked junior gold stocks.  Instead of suffering through endless hours of highly-technical research, or even worse doing none and buying random juniors they happen to hear about, investors can now simply buy this ETF.  As I’ll discuss later, its custodians really are doing a pretty-good job of selecting high-potential juniors to invest in.

And for the companies, GDXJ inclusion is becoming a highly-sought-after goal.  Since juniors rely solely on issuing shares to fund their exploration activities, their stock prices are exceedingly important.  The better their shares are doing, the easier it is to raise capital.  Not only do more investors want to buy juniors that are thriving, but existing shareholders’ dilution is minimized when new issuances happen at higher stock prices.  And GDXJ works to boost its components’ stock prices on two key fronts.

First, GDXJ directly invests in these companies.  As more stock investors buy GDXJ to add junior exposure, this ETF grows.  This new capital is shunted directly into the underlying juniors it holds.  Second, the mere inclusion in GDXJ is increasingly becoming something of an assertion of quality.  While I was skeptical when GDXJ launched about how good its pool of juniors would be, its managers are definitely doing their research.  So GDXJ inclusion leads to more direct-investment interest in specific juniors.

So whether you own GDXJ or not, its very existence is very bullish for junior golds in general.  By effectively eliminating the vast time costs of research, and instantly providing well-diversified exposure, GDXJ is opening up a major new conduit for stock-market capital to flow into junior golds.  The more capital invested in them, the higher their prices will fly and the bigger their ultimate gains will grow.

As of this week, GDXJ holds 59 stocks.  But not all are junior golds, as this fund certainly does have some eccentricities as all ETFs do.  The criteria for inclusion allow silver as well as gold, and producers as well as the explorers that dominate the junior realm.  But despite GDXJ’s silver stocks, it really does offer outstanding exposure to the junior universe.  This table shows its top holdings this week.

These columns reveal each component’s symbol, the metal it is primarily involved with, whether it is a producer or explorer, and the country each stock is listed in.  This country allocation is a bit misleading, as some of the components that GDXJ owns Canadian shares in also have major-market listings here in the States.  Nevertheless, most of the Canadian and other foreign listings held by GDXJ either do not trade here at all or only exist on the highly-illiquid and dangerous Pink Sheets.

GDXJ loosely bases its allocation among its different components on market capitalization, so the rest of the columns explore this angle.  The light-gray dollar amount shows each company’s actual market cap, translated to US dollars where necessary, this week.  The light-gray percentage shows each company’s fraction of the total market cap of all 59 of these stocks.  And then the final column shows the percentage of GDXJ that its custodians are currently allocating to each company.

As a lifelong student of the markets, I’ve spent years working with all kinds of indexes to better time my own trades.  And for a wide variety of reasons, I believe weighting stock indexes by market capitalization is the best approach by far.  Bigger companies are more important to investors, who have a lot more capital deployed in them.  Thus their impact on an index that includes them ought to be proportional to their heft in the marketplace.  And impressively, GDXJ is running close to true market-cap weighting.

If you compare the gray and black percentages above, in most cases they are pretty close.  Where they are not, there are good reasons.  An example is AND, which commands 5.4% of all components’ market cap but just 3.3% of GDXJ’s weightings.  Elite major Goldcorp just made a huge $3.4b offer for Andean Resources, which drove its stock price up sharply.  In our weekly Zeal Speculator newsletter, we realized a nice 156% gain on AND’s stock soon after this offer.  So AND’s stock is far higher than usual now, but once this deal is done it will cease to exist.  GDXJ’s custodians will boot it out soon here.

Based on GDXJ’s weightings, 85% of it is deployed in gold stocks and 15% in silver stocks.  And these silver stocks are actually major producers, with large market caps in the context of this ETF’s holdings.  Though I believe GDXJ would be superior without this silver exposure, it isn’t a big problem.  Every junior-gold-stock investor I’ve ever met owns silver stocks as well, and silver leverages gold’s runs higher.  The silver exposure in this ETF doesn’t derail its mission, but it does dilute the pure junior-gold exposure.

58% of GDXJ’s component weightings is in producers, with the remaining 42% in explorers.  Since the vast majority of junior golds are explorers, this may seem illogical at first.  But it is not at all.  While explorers dominate in sheer numbers, most aren’t worth very much since they have yet to find any significant deposits.  But the junior producers, who have beat the long odds to bring mines into production, have proven themselves.  So they have more investors and much-higher market caps.

Thus in any market-cap-weighted universe of junior golds, the relatively small number of producers will always outweigh the large number of explorers.  The real acid test for this ETF is in the quality of its juniors.  With well over 500 to choose from in the US and Canada alone, picking 50 great ones is not easy at all.  While market caps offer some guidance as the largest juniors are often among the best fundamentally, it still takes endless research to handpick the best for inclusion.

Since long before GDXJ was even a twinkle in Van Eck’s eye, we’ve been doing deep and extensive junior-golds research at Zeal.  Over the past 9 months alone, we painstakingly analyzed all the publicly-traded junior golds in the US and Canada.  This universe of juniors was so large that we split them into three distinct categories, early-stage junior golds, advanced-stage junior golds, and junior gold producers.  We spent 3 months per category examining every company in each in order to uncover our favorites.

This massive project, on top of many years of similar research in the past, has given us some of the planet’s best and most-comprehensive knowledge on the world of junior gold stocks.  After thousands of hours of our own hardcore research, I’ve always been interested in how GDXJ would stack up against our own favorites meticulously handpicked for their awesome projects and superb fundamentals.

As we finish each of our 3-month deep-research projects, we publish comprehensive reports outlining the fundamentals of our dozen favorites in each category.  Elite stocks included in our latest 9-month trilogy of reports on early-stage, advanced-stage, and producing juniors represent 29% of GDXJ’s weight.  And if you include all our favorite precious-metals stocks off the last couple years’ reports, this number jumps up to 48% of GDXJ’s weight.  So GDXJ definitely has a major overlap with Zeal’s favorite juniors.  Knowing firsthand the quality and depth of our extensive research, to me this reflects highly on GDXJ’s custodians.

This young ETF’s value to traders goes far beyond its instant diversified exposure offered.  It also acts as a great tool to track junior golds as a sector.  Prior to GDXJ, there have never been any widely-accepted professional indexes specifically tracking junior golds.  And despite its silver dilution, GDXJ’s extensive and impressive junior-gold allocation makes it the best such tool ever seen.  The longer GDXJ’s track record accrues, the more useful it will prove as a tool for timing entries and exits into junior golds.

This last chart compares GDXJ, and its big brother GDX, with the benchmark HUI gold-stock index.  While GDX is comprised of large gold and silver stocks just like the HUI, GDXJ is totally unique.  There is some unwelcome overlap though.  Together big silver miners CDE and HL make up 6.8% of GDXJ, but they are also included in both the HUI (9.6%) and GDX (1.9%).  Nevertheless, GDXJ is really starting to outperform.

Since GDXJ is just shy of its first birthday, we can only examine its performance over the past year.  During that time there have been a couple gold-stock uplegs as defined by the HUI.  The first ran from February to May while the second started in July and still has yet to climax.  Back during that first upleg, GDXJ ran 39.5% higher over the exact span where the HUI rallied 32.9%.  Thus GDXJ’s pool of juniors only offered 1.20x leverage to the HUI this past spring.

That was certainly low and disappointing.  Since most juniors have yet to find any gold, they are vastly more risky than established gold miners that generate their own internal cashflow.  Investors need to be compensated with much-higher returns for bearing these enormous junior-specific risks.  And during this year’s spring rally, this just wasn’t happening.  But GDXJ is not to blame for this junior underperformance.

Junior golds’ primary constituency is individual investors.  But ever since 2008’s once-in-a-century stock panic, the majority of individuals have been hiding their heads in the sand.  These ostrich investors have been languishing in zero-yielding cash, foolishly ignoring some of the best stock-market rallies ever seen.  So with few investors around since the panic to bid up junior golds even though gold was strong, these companies have really failed to leverage the HUI in the past couple years.

But interestingly, individual investors are finally starting to return after being missing-in-action for two whole years.  This is wonderful to see, an extraordinarily bullish sign.  As they bring their mountains of sidelined cash back into the stock markets, the gains in key high-potential sectors like commodities stocks should be huge.  And junior golds are already becoming a beneficiary of this welcome trend, having their best rallies in recent months since well before the stock panic.

Upleg-to-date since late July, GDXJ has surged 41.4% to the HUI’s 23.4%.  This represents vastly-improved leverage of 1.77x!  While still anemic by 2006 standards, the last time investors got really excited about gold stocks, it is still impressive.  I suspect this is a harbinger of things to come, as the record gold prices are driving the biggest renaissance of investor interest in gold stocks that we’ve seen in years.  Since juniors are such a tiny sector in the grand scheme, it doesn’t take much buying to drive big gains.

While GDXJ is great on many fronts and a boon for investors and juniors alike, I don’t believe it is the best way for serious investors and speculators to own juniors.  If you are willing to put in some effort, you can build your own custom junior-gold portfolio with much higher potential than this ETF’s.  By handpicking your own juniors, you can easily avoid GDXJ’s major-silver-miner dilution as well as its over-diversification.  While owning a basket of 59 companies really reduces risks, it also really reduces returns.  When one of its components surges, its rally is greatly diluted by all the other components lagging it.

Statistically, any custom portfolio you build with 5 to 10 well-researched high-potential juniors should vastly outperform GDXJ.  And we can help you on the research front, as we’ve already done all the heavy lifting and expert work here at Zeal.  Right now we have 3 fascinating fundamental reports available for purchase on our website, profiling our dozen favorite early-stage, advanced-stage, and producing juniors in great depth.  All of these elite juniors have fantastic potential, and the prices on these 25-page reports run from just $35 to $95.  This is a steal for hundreds of hours of world-class research!  Buy some today!

On the timing front, we publish acclaimed weekly and monthly subscription newsletters where we actively trade junior golds as opportunities arise.  We have many positions on our trading books today that are likely to soar from here as more individual investors return to this long-neglected sector.  Our popular newsletters document all the ongoing research, analysis, and probabilities governing our own trading.  Subscribe today!  You’ll learn a great deal, become a better investor, and accelerate your wealth creation.

The bottom line is the young GDXJ junior-gold ETF is very impressive.  It provides stock investors with diversified, turnkey access to this high-risk-high-reward world.  It really helps junior golds as well.  In addition to creating a large new conduit for stock-market capital to flow into juniors, it helps build junior-gold awareness.  And its custodians are really doing a pretty-good job in picking high-potential stocks.

Nevertheless, like every other ETF GDXJ will wildly underperform a smaller handpicked basket of the very best stocks in its sector.  While GDXJ is great for casual investors, serious investors can enjoy far-superior returns by owning fewer higher-potential junior golds.  Still, GDXJ is growing into a great tool to track junior golds as a sector, and to fine-tune entry and exit timing for individual junior-gold-stock trades.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2010 Zeal Research ( www.ZealLLC.com )

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