WHAT IF the low valuations of some junior mining companies are really all they're worth? As the market shakes off years of exuberance, Brent Cook, co-editor of the Exploration Insights newsletter, searches for the truly undervalued—finds as rare as gold itself. In this interview with The Gold Report, Cook talks about high-margin deposits that the rest of the market can't see. 

The Gold Report: Brent, 2012 was difficult for many gold investors, and you paint a pretty bleak picture for certain junior mining companies in 2013 as well. 

Brent Cook: We've actually had two pretty tough years on the TSX Venture Exchange. It is off about 30% from its peak in 2012 and around 20% for the year. That comes on top of a 35% decline in 2011. I do think much of the froth is washed out and we will see some opportunities in 2013.

During the most recent boom years, 2009 and 2010, roughly $11 billion ($11B) was raised on the Venture Exchange. Most of that has been spent without much success. Going by John Kaiser's database of about 1,800 Venture Exchange listed companies, there are around 600 that now have less than $200,000 in the bank and a full 62% of the 1,800 companies have a median working capital of only $1.1 million ($1.1M) or less. These companies are trading at less than $0.20/share, which means that unless things improve dramatically in the next year, many of these companies are going out of business or will push excessive dilution on current shareholders just to stay alive. The Venture Exchange will truly be the land of the walking dead. 

This coming year will be a cleaning-out process that in the long run is good for the sector. 

TGR: The Exploration Insights portfolio was not immune to what happened in 2012. It was up 4% from early January 2012 to late November. Are you convinced all of the companies in your portfolio should remain there?

Brent Cook: We've got to go through a cleaning-out process as well. We've had some real disasters, where the investment thesis didn't pan out. We've also had a couple of big winners. The majority of the stocks that we own are undervalued, but they have held up well compared to the indexes. I just finished reviewing our 2012 performance and we have so far done surprisingly well on stocks we bought and sold in 2012, with an average gain of about 49%. Unfortunately, the stocks we have held for over a year didn't do as well, taking our year over year average gain down to about 13%. I'll have the final numbers out in our Jan. 6 issue.

TGR: What are you telling your readers to give them hope?

Brent Cook: The truth. Hope is the worst reason to own a stock. We're not going to see $3,000/ounce (oz) gold, and we are not going to see junior stocks go to the moon this next year. If an investment thesis doesn't pan out, we sell and take the loss. If, however, the thesis continues to work, we hold onto the stock or buy more. This is very speculative money in a very high-risk sector. Unless the risk trade comes back into favor this next year, and I don't think it will, it's going to be another tough one for the explorers and junior miners. 

That's all negative, right? But this is the smart time to pick up selective companies that have something of value. This is when investors can make money by buying intelligently and patiently. We may not be at the bottom, but it certainly isn't the top.

TGR: What sort of trading range do you see for gold in 2013?

Brent Cook: What's more important to me than gold's trading range, at least with regard to the junior explorers, is that the industry is not able to supply new deposits and discoveries to replace what is being mined. This is a serious issue that in the long run bodes well for this sector. Since about 1995, the number of ounces discovered has been trending straight down. According to the Metals Economic Group, in 2011 approximately 10 million ounces (Moz) were discovered, but 83 Moz were mined. That gap in production versus discovery is the opportunity, regardless of the gold price, which I think is flat to marginally higher in 2013. 

TGR: A lack of discoveries is hurting the industry? 

Brent Cook: It's getting tougher and more costly to find gold. That is the real issue. A company that raises $5M gets half as far as it did eight years ago.

During the past six years, the major gold-mining companies have spent the equivalent of 40% of market capitalization developing new deposits. It is projected that they would spend another 60% of their capitalization developing the new mines they have on the books just to keep production even. Moving reserves to production comes at a big cost. I've posted an article on my website that goes into a lot more detail regarding the dismal state of both the gold miners and explorers that should help readers understand the depth of the problem and opportunity. 

TGR: Let's get into your process. One phrase you use a lot is: "How much is it going to take to turn this rock into money?" What calculations do you use to help determine that?

Brent Cook: There aren't any easy numbers I can throw out there. Every deposit presents different challenges and companies spend tens to hundreds of millions of Dollars figuring out how much it is going to cost to turn the rock into money. 

Actually, one rule of thumb is the cutoff grade used in estimating the tonnes and grade of a deposit. In theory, that cutoff grade should be what a company or resource estimator projects is the break-even point between making money and losing money. If the cutoff grade is, say, 0.5 grams per tonne (g/t), then I like to see an average grade that is at least twice that, say, over 1 g/t, because above that is where you really make the money, if the cutoff assumption is close.

Then you've got to look at metallurgy. This is probably the most important aspect of any deposit once it has been found. For instance, an oxide deposit sitting on the surface in Nevada with a cutoff grade 0.2 g/t can still make money, whereas another deposit in Nevada at 5 g/t cutoff won't. 

It is highly variable. All that the retail investor can do is guestimate if the grade and tonnes are sufficient to cover the probable capital and mining costs.

TGR: It's pretty easy for the average retail investor to get lost in a feasibility study. They are quite technical. I'm certainly guilty of this: It's easy to look at the internal rate of return (IRR) and judge a deposit based on that. Is there a way to determine whether the IRR number is realistic?

Brent Cook: IRR is a good metric to look at, especially if it is after taxes. 

TGR: Is there a minimum threshold?

Brent Cook: I think 20% after tax, although it depends on where the project is located and on the exploration upside. That upside is the intangible that often decides if a deposit gets bought or not.

TGR: What are some practical ways a retail investor can do due diligence?

Brent Cook: Talk to management. Get comfortable with the team. There are a lot of good people in this industry and they are not hard to recognize once you start talking to them. 

Go to the company's website. How accessible it is? How much information does it give in news releases? Does it back up the data? Be wary of a company that puts out a news release with no maps, no sections and no data. Watch for news releases that report high grades smeared over long intervals, and always search for historical data from the property being promoted. Most properties have a history that gives you some insight into possible tonnes and grade.

TGR: Does a mine need to come into production and be successful before valuations go up in areas like Colombia, where there's a lot of exploration but not much coming up yet?

Brent Cook: I was looking at the share prices of a number of companies that jumped into Colombia and put out initial results that many considered good. They excited investors with spectacular surface samples, and even some drill results. The results took many of the companies straight up and subsequently straight back down. Reality has set in. A lot of those discoveries turned out to be small plugs or narrow, high-grade veins that don't offer much size potential. For the most part, it was pretty obvious what was being promoted but people wanted to believe. Now they don't seem to believe anything.

TGR: Is there a parting thought you'd like to leave us with? A crumb or two of hope?

Brent Cook: This coming year is going to be a fantastic time to buy undervalued, high-margin deposits that the rest of the market doesn't recognize. The long-term prospects for the exploration sector look real good to me, but you better know what you are buying and why. I am afraid most of the fools have been washed out of the market.

TGR: Thanks for that, Brent.

Brent Cook: My pleasure.