Today's essay is a warning for anyone thinking about putting money on a small mining stock...

Late last month, I showed you a "hidden" danger of gold-stock investing. Don't get me wrong... I'm a big fan of trading gold stocks. You can make fantastic returns if you get the timing right.

But you've got to go into the sector with your eyes open...

One big thing you need to have your eyes open to is how these companies are raising money. Mining businesses need to raise money all the time – to develop a mine or continue exploring. And when they do, shareholders can see the value of their stock drain away.

There are a few ways for gold companies to "dilute" their shareholders. One you must be on the lookout for is "warrants."

A warrant gives its owner the right (but not the obligation) to buy a stock at a set price (called the strike price), within a set time period. When the owner of the warrant uses it ("executes" it), it creates a brand new share.

Now... warrants can be a great thing if you own them.

Take Reservoir Minerals, for example. In October 2011, this junior mining company sold 15.2 million "units" for C$0.65 each. These units included a share and a warrant. The warrant allowed its owners to buy a share of Reservoir for C$0.90... regardless of the market price of those shares.

In July 2012, Reservoir made a fantastic copper discovery. Shares of the tiny company soared from around C$0.55 to C$3.85 each. Warrant owners could buy a share for C$0.90 and turn around and sell that share for more than four times as much.

The thing is, it's hard to get your hands on warrants. So for most "mom and pop" investors, warrants represent a source of risk...

Remember, junior resource companies have no assets and huge capital costs. The only way they can raise the money to do work is to sell shares... And when a company raises money at a lower price than the shares are trading for... shares fall.

An extreme example of this is Glass Earth Gold, a junior gold explorer with two discoveries in New Zealand. Here's a chart of the last two years of trading:

The company made a solid discovery in July 2011. To follow up on that discovery, it sold over five million "units," which consisted of a share and half a warrant – good for two years at a strike price of $0.80, for C$0.55 each in October 2011. The shares alone represented 8% dilution.

The stock sold off hard. The share price recovered, but only to the price of the offering, C$0.55.

In June 2012, the company sold 11.8 million units at C$0.20. This was a huge, 17% dilution, before you consider the warrants. Those units consisted of a share and a warrant good for two years at C$0.35.

And just like last time, the share price collapsed.

The company raised money again in October 2012. It sold 1.8 million units at the same terms. This was another 2% dilution without the warrants.

Shares plummeted again.

In August 2011, Glass Earth had 60 million shares out and sold for C$0.60 per share. Today, the company has 87 million shares out. That's 45% dilution to anyone who has held shares for that long... And there are another 16 million warrants outstanding that will come due if the share price rises.

If those warrants are exercised, they will slice the Glass Earth Gold "pie" into over 100 million pieces. That represents a total dilution of about two-thirds. That's a huge loss of value even before you consider the loss of the share price.

And that is a perfect example of how warrants, and their creation, can destroy an investor's capital. So before you plow next month's rent into a junior mining stock, make sure that you investigate the warrants.

This is relatively easy to do. You need to know two bits of information... shares outstanding and "fully diluted" shares. The first is simply the number of shares that exist today. The second number is the total volume of shares if all the warrants and options are counted.

You can find this information on the company's website, in the annual reports, and on most stock screeners. Keep your eyes open for it.

ABOUT THE AUTHOR

Matt Badiali, Growth Stock Wire

Growth Stock Wire is free daily investment newsletter written by veteran market traders. Every morning, GSW readers receive a pre-market briefing on the day's most profitable investment opportunities