Brent Cook recently published this fantastic primer on his process for identifying the few junior exploration companies who stand to generate real returns for investors. It appeared in his Exploration Insights on August 10th, and is worth the read if you are interested in analyzing resource stocks (edited from the original).

By Brent Cook

Exploration is a tough business, making a discovery is much tougher, and advancing a real deposit through the hurdles of geology, politics, and the stock market is the hardest test and is rarely successful.

In my last letter, I said that we should move ‘down the food chain’ into companies with stellar, early-stage projects that have yet to be tested—a process also much easier said than done. You can always find a reason not to buy.

There are hundreds of properties being explored and drilled by micro-cap junior companies based out of Canada and Australia alone. Almost any one of these could deliver a good drill hole or even a legitimate discovery, but we know the odds of this happening on any single prospect are extremely low; our job is to very critically evaluate the available data, extrapolate that data into the subsurface, and make an educated guess as to the probable drill results. Basically, where could it go right, and what could go wrong?

It’s obviously an advantage knowing what right and wrong look like.

From the first surface samples, we have to imagine building the mine, guesstimate metallurgy, consider infrastructure, and come to terms with the local and regional politics and environmental issues. You also have to consider the company’s technical and financial capabilities, share structure, cash and burn rate… What good is investing if the next capital raise wipes you out?

Here are the initial filters I use before even considering serious due diligence:

As I’ve noted before at Exploration Insights, I really prefer speculating in early-stage projects but I have been reticent to commit my money, because I’m not convinced that we are on our way out just yet. It is still my opinion that the junior mining sector is in a bottoming process that could easily last into next year. That’s why I have limited my trading positions to a select number of stocks.

Nonetheless, there is no doubt that the mining industry needs new, profitable metal deposits to replace what they are currently mining and that the few successful junior companies will be quite valuable---eventually.

In my opinion, if you are very selective in what you buy, diligent in your evaluation and patient enough to allow the exploration process to play out—you stand a good chance of making money in the junior mining sector.

Brent Cook currently authors Exploration Insights, where he analyzes specific companies in the small-cap natural resource sector and serves as an advisor in mining economics and exploration potential for funds and companies. He has worked in over 60 countries across a wide number of geological environments for major mining companies including Kennecott Mining, Rio Tinto Mining, Barrick Gold, and Freeport McMoran.