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2011 is not a year I've enjoyed – at least, not from an investment point of view.
Although gold is up 15% or so, my portfolio of junior mining stocks, which is largely made up of small gold exploration and development companies, has been walloped.
Bull markets teach you one thing. You can buy any old house or any old tech stock or any old lump of metal and, if the market's strong, it'll go up. Everyone's a genius in a bull market.
Bear markets, however, teach you something very different.
There's nothing like a bear market to pull the wool from your eyes and expose which companies are well run and which aren't. There's nothing like a bear market to expose flaws in your own thinking and research; in your strategies and risk management.
There's nothing like a bear market to teach you a bit of truth – about the companies you're investing in and about yourself.
I've made more mistakes than I would have liked this past year. In the hope that you can learn from my experience, here are some of the lessons 2011 has taught me…
Having a strategy is only half the battle – you have to stick to it
In a bull market the art is to buy and not to sell early. In a bear market the art is not to buy and to sell early. The art is in identifying one from the other. And part of that art lies in knowing your market and how it works.
Long-term (secular) bull markets in any asset – from real estate to stocks – can go on for many years. But within those macro trends, much smaller cycles are at work.
Take commodities. A secular bull market in a metal might go on for a decade or more. When you consider the mining cycle, it's easy to understand why. When a metal is in a bear market and the price is falling, mines gradually become uneconomic as costs outstrip profits. Mines are shut down, workers get laid off, and funding for exploration dries up.
Then, for whatever reason, demand for the metal improves. Suddenly there isn't enough. Prices rise. After many years of bear market, it's a while before people believe those higher prices. But, eventually, money drips back into the sector. Old mines get re-opened and some of the capital finds its way into exploration.
Bingo, somebody makes a discovery. But many thousands of metres of drilling need to be done to prove it, and all sorts of feasibility studies need to be undertaken before a mine can be built. This can all involve many years of negotiating with authorities for the right permits, securing funds from banks, hiring staff, and so on. From seed money to commercial production can be a decade or more.
So it's no wonder bull markets in metals last so long.
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But that's the process of building a mine. The exploration cycle is much shorter.
Let's say the silver price is rising. The media picks up on it. Suddenly everyone wants to invest in silver. A company thinks it might have some, so it tells everyone, gets them excited, raises some money, and then drills. Everyone gets even more excited as they wait for results, the results come out, maybe it's got something, usually it doesn't - but it might have, if it can just drill a bit more, so it raises some more money.
Eventually, reality sets in. Either the company hasn't got anything, or even if it does, it's going to take ten years to build a mine, so what's the point? People lose interest – and the stock sells off. This whole process is considerably shorter than the secular bull market for the underlying metal.
Looking at the CDNX – the Canadian stock exchanges on which many junior resource stocks are listed – you can see a real mini-boom-bust cycle at work. The booms don't last more than three years.
I had a good 2010. I got various sell signals in early 2011, which were confirmed in the summer. But I kept thinking: 'I'll wait for a rally' before I sell. And then I thought: 'there's more juice left in this one'.
That was my mistake. It's one thing knowing the game, another playing it. In future, if I get a sell signal, then I am going to make sure I sell, even if it means taking a small loss. That's a lot better than watching a small loss become a big one.
It's like they say: beating yourself is half the battle.
Selling risky stocks too early isn't the worst thing you can do
If I look back at the past few years, there's only one sale I really regret. It was a gold stock that tripled in the two years after I sold it. I had already done very well from it and the capital created other opportunities. Nevertheless, it was one of those that I wish I'd let ride.
But for that one sale, there are as many as 30 I'm very glad I made. Most companies don't make it from exploration through to a mine. Most small caps don't become large caps. In an extremely cyclical market like small cap resource stocks, selling too early is not a bad fault to have.
Yes, if you have been lucky enough to pick a real winner early, and the signs are there that this is one small cap that's set to be a large cap, then be prepared to let it ride. But I still recommend selling enough to cover your initial stake.
One reason why I sometimes fail to sell when I should, is that in the course of researching a company, I often get to know management well. I might go on a trip to visit a mine, which often involves a couple of days off the beaten track in a jeep. Or I might run into them in the convivial environment of a conference or, better still, a mining lunch. That can mean it's hard to make a detached decision about them.
That's why taking notes helps. Jot down your positives, your doubts, your price targets, your inklings, your reasons for investing, your current thoughts on management, what promises they made – anything.
Then keep referring back to those notes. Have your targets been met? If so, is there further upside? If not, sell. Have management done what they said they were going to do? If not, why not? Were they over-promising? Unlucky? Or simply incompetent? It all helps separate your emotions from your rationale.
Making notes can often stop you from having to learn the same lesson twice. I'm hoping that writing this Money Morning will help me – and you – to avoid making any of these same mistakes next year. Here's to a profitable 2012 for us all.
• This article is taken from the free investment email Money Morning.
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Dominic Frisby
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