By lottery ticket I’m talking about lowly priced, speculative stocks with great potential; rather than actually trying your luck at the latest Powerball or the Big Game, although I’ve been known to do that too! In the investing game my lottery ticket is (surprise, surprise) a junior silver exploration company, Excellon Resources. It trades in Canada under the symbol EXN.V and in the US on the pink sheets under the symbol EXLLF. [See here for a discussion on pink sheets.]

I won’t belabor the bull case for silver. Instead, this post will be a fairly in-depth (for me anyway) look at the fundamentals of this company with some technical considerations thrown in at the end.

Background
Excellon’s claim to fame is its Platosa property in northeastern Durango State, Mexico. Mexico has one of the friendliest legal environment for mining companies. Given the victory of Felipe Calderón over the leftist López Obrador last year, this situation is expected to continue. Platosa is located down the Eastern slope of the Sierra Madres, along the famous Mexican CRD (carbonate replace deposits) belt where many massive silver/zinc/lead/copper mines have been found.

Extremely high ore grades
The Platosa property is characterized by its extremely high ore grade. The company presentation (PDF) shows mineralization of 50 oz/t for silver and around 10% for both lead and zinc. I just about fell off my chair when I first saw these numbers which are so high that a quarter to a tenth of them may make somebody else’s flagship property.

On the other hand, this highly concentrated ore body is not great in extent which I guess is nature’s way of evening things out. The NI43-101 (a Canadian standard for reporting reserves and recourse for mining companies) conforming report prepared in August 2006 shows only 184,500 tons of resource, although if more recent discoveries were included, the total would like be around 350,000 tons. This is miniscule compared with the 5-50 million tons that a large scale CRD could contain.

The high grade ore does allow even a small scale test mining to be profitable. This is precisely what the company has been doing for the past two quarters: generating positive cash flow from test mining to self-finance its exploration activities. For now, Excellon needs to deliver half of the silver it mines to satisfy a silver backed debenture. Its bottom line will improve significantly when the debenture matures this July.

The company currently has 146 million shares outstanding at approximately US$1.20 each which gives it a market cap of US$175 million. It also has 13 millions options outstanding.

Intrinsic value
The intrinsic mineral value can be calculated from the resource amount, mineralization level and valuation for metal-in-the-ground as outlined in the table below. My assumption of $5/oz for silver, $0.25/lb for lead and $0.40/lb for zinc was fairly conservative. A smaller silver concentration than the company currently claim was assumed. I arrived at an intrinsic value of US$114 million, or 65% of the current market cap.

Income model
The picture is rosier when one considers the potential income after retiring the silver debenture. Using the annual tonnage, ore grade and recovery rate contained in the most recent report, it’s reasonable to expect the company to generate US$26 million in the first year based on current metal prices.

If the company were to cease exploration altogether and concentrate on its small scale mine activities, there may be six years of mine life left. Using US$26 million as a baseline and a discount rate of 12% and growth rate of 15% (both are subject to debate of course) the DCF model gives a present value of US$163.5 million, which is close to the current market cap of US$175 million.

Latest quarterly report
Excellon’s stock price was temporarily depressed following the latest earnings announcement where the bottom line number was a measly $216k, a big let-down form the $7+ million in the prior quarter. However, over $2 million was an accounting artifact due to the re-valuation of the silver debenture. In addition, there was some operation problems at the mill that reduced the amount of ore processed in the quarter. The company further stated that they encountered an unexpected mineralized zone while constructing an access ramp. Rather than letting the ore going to waste it was processed and resulted in a drop in the overall ore grade for the quarter. It seems one can’t avoid hitting something when digging in this place!

The technical picture
The weekly chart shows that Excellon has consolidated along the top rail of a large triangle that it broke out from at the end of 2006. The daily chart shows a “W” formation off the strong support at C$1.25-1.27. Short term momentum indicators are pointing up.

Conclusion
Much of this article was written prior to Wednesday, April 11 when the stock jumped over 9% following a new drilling announcement, although I would have to say the content of the announcement was very much expected if one actually paid attention to the map of the property and previous drilling results. I believe my analysis above still stands.

In summary, Excellon is a profitable, exploration company – a combination that is exceedingly rare. Naturally, the stock is leveraged to metal prices, but the real jackpot potential lies in the possibility of discovering a large CRD in the vicinity of its Platosa mine. According to my DCF model, current valuation is largely supported by the test mining activities alone; therefore, investors are getting a near “free ride” on Excellon’s exploration potential.

Disclosure: I own this stock. My “lottery ticket” analogy was meant to highlight the speculative nature of this stock: just like any lottery game, the jackpot may be huge, but payout is far from guaranteed.

I came across this excellent article that I want to share with you:
Here is the rewrite in my own words of Rules of Thumb For Shorting Stocks from Minyanville.com

1. Don’t short because of valuation. “Expensive” stocks can become more “expensive”.
2. Determine when the bad story will unfold. Timing is everything.
3. Get out if it doesn’t play out within a time limit. You don’t want to be bulldozed over by “irrational exuberance”.
4. Watch out for potential buy-outs. Don’t want it to ruin your day/year.
5. Don’t fight with the big guy. A big stakeholder will probably do something to prop up the price instead of letting the company rotten.
6. Big holding insiders are signs of confidence, if not heavy controls. Not the best candidate for short.
7. An already-heavily shorted stock is really to your disadvantage, especially at the time when you want to cover it.
8. Puts may be a better way to go.
9. Trade in/out to be flexible.
10. Do you basic homework in technical analysis.
11. Don’t squeeze the last cent of the profits. Look at the risk of waiting to cover versus the potential reward.
12. Understand the bullish side, and be totally unconvinced before you take big action.
13. Employ ETFs. It will reduce your risk, and more importantly keep your calm.
14. Make sure you can afford to take the loss if it doesn’t work out.

There are more times that I lost money when I short stocks. But I’ve found out that the primary reason is that I lost my emotional calm and patience. To increase your trading calm, you should reduce your trading size.

The March non-farm payroll report was surprisingly strong: a total of 180k jobs were created with 56k in construction and 36k in retail. The gain is corroborated by the ADP number which showed a gain of 106k in private sector jobs. Were the markets open on Friday, it would most likely have been a +1% day.

That said, we need to keep everything in perspective. The gain in construction jobs was clearly due to non-residential construction taking up the slack from residential construction. But with the lag between the two averaging 4-5 quarters, the peak in non-residential construction may not be far behind (given that residential construction peaked in summer of 05). While reports on office rents remain mixed, I couldn’t help but wondering whether one wants to be on the opposite side from Sam Zell and whether the sale of his Equity Office Properties signals anything.

Ahead of the curve – the book
Last September, I reviewed Joseph Ellis’ Ahead of the curve, a book on forecasting business and market cycles. His primary approach was to look at various indicators on a trailing three months, year-over-year change basis, and discern any leading/lagging relationship to known market cycles. Two key findings were

• Real consumer spending (PCE) is the leading indicator to business/market cycles.
• Employment is a lagging indicator.

The book contains many fascinating charts, many of which are published and updated on the web (Link). On the topic of employment and market cycles, see charts 11-3, 11-6, and 11-8. The unemployment rate is seen to appear “favorable well after consumer-spending growth has peaked and the bear market has been under way for some time.”

Real consumer spending (as measured by PCE, personal consumption expenditure) is tagged in the book as to be the key driver to market cycles. Chart 8-4 shows that bear market start after real PCE starts to slow. The most up-to-date series is plotted below.

Click to enlarge

The most recent decrease in the rate of change in PCE started last December, but it’s still at elevated levels. Obviously, the data series itself is far too noisy to be a predictive tool. For that we will have to consult an excellent article from Paul Kasriel of Northern Trust: Recession Imminent? Both the LEI and the KRWI are Flashing Warning. Kasriel makes a cogent argument that we may be at the cusp (not there yet!) of a recession. It is a nice and quick read.

In summary, the March jobs report was exceptionally strong and I’m sure the market will react appropriately. However, it may not be the strong endorsement of future economy that many will believe it to be. In my opinion, the up-coming earnings season and subsequent market reaction will reveal a lot more about the intermediate term market direction than anything else.

For the month of March from 3/1/07 to 4/1/07,

1. Net worth is up by 3.28%.
2. Value of my company holdings (stock options, ESPP, etc.) is down by 5.35% partially due to my liquidation.
3. Everything else excluding my home and cash is up by 4.54%.
4. If including cash in #3, it’s up by 3.46%.

My portfolio has not changed much since the end of February. I have liquidated majority of my holdings that correlate to the general stock market. Right now I only hold 0.2% of my net worth in such stocks/funds. I also still hold some short positions in QQQQ and housing stocks which only hedges against less than 7% of my own portfolio. I’ve closed out about half of my hedges, and some unsuccessful shorts.

Here is the current composition of my portfolio:
1. 55% in metals.
2. 35% in energy.
3. 10% in consumer staples, water, and agricultural stocks.

Here is the current composition of my net worth:
1. 62.6% in my portfolio+cash+misc.
2. 20% in my company holdings.
3. 17.4% in home equity.

Last month I commented:

I believe the secular bear market in stocks may have resumed. The unfolding of such secular bear market however does not necessarily mean a fall in the absolute price of the stock market this time around. Rather, the stock market will fall on an inflation-adjusted basis, and also against gold. There is also a chance that Fed stops the downward spiral in time, and create a bigger bubble in everything going forward. The most likely timeframe is in 2008/2009 for next (potentially higher) peak. In fact, the stock market can put in a higher high in 2009, but not necessarily beating the accumulated inflation since 2000. I do expect the stock market to go lower than the low on 3/5/07 this year. I also expect the general stock market to put in less than 3% gain for the entire 2007 year.

After much seesawing in March, this stock market really has some inexplicable strength, except in a few isolated mortgage stocks and financial sectors. Fundamentally speaking, the problems in subprime and Alt-A mortgages will create a huge problem for the market going forward. Yet technically, the market doesn’t seem to go down much at all. How much longer this market can hold up? I’m still waiting for a safer entry to short more. In the meantime, NEW century mortgage has filed bankrupt, and several other mortgage companies keep falling.

I’m not sure whether a higher high will come first before a lower low than the Feb/March low. Although my belief is that a lower low will materialize later this year, my conviction is wavered by the market strength. My current plan is still going short against financial/housing/general market and possibly adding some tiny long positions in energy or gold. But I will take my loss if the bull market runs away to the upside again.

Best luck navigating in the dangerous water.

Special note: returns were calculated by subtracting 3.00% APR return of my cash position.

Volatility Index

VIX [ http://www.buythebottom.com/vix.html ]
Commercials are recent buyers of the VIX. Thus far, the setup looks more neutral than anything else. A classical COT setup to the long side would result if net-commercial position rose near or above 4,000 contracts.
Last week I mentioned that the VIX looked overextended to the downside and would probably retest its 10-day moving average (MA). Over the next several days, the VIX did indeed rally and is now trading above its 10-day MA in the 14 to 16 dollar range. With the bullish setup in the stock market right now, I would expect the VIX to decline over the next little while, and ultimately end up under $12. However, if we see the VIX rallying and closing above $16, that would tell me that volatility decided to stick around. Speaking of which, a move above $16 for the VIX would probably also translate into further weakness in the stock market.

Broad Markets

Russell 2000 [ http://www.buythebottom.com/rut.html ]
This index is not the most bullish looking one, but the setup is to the upside never the less. It is important to note that commercials were gradual sellers over the last 6-months as the stock market was rallying. But as soon as the market declined, commercials turned into aggressive buyers. What is very bullish, is that the market’s decline was – relatively speaking – a minor correction. In fact, the RUT tested 810 last week; only 20 points shy from its all-time-high. It looks like we will hold recent reaction lows at 790; critical support is located at 760.

S&P 500 [ http://www.buythebottom.com/spx.html ]
This is one of the most bullish looking setups from all of the stock indexes. Again, this is a great example of how commercials were steady/gradual sellers during the most recent uptrend in the 2nd half of 2006, but after February’s decline they turned very aggressive on the buy side. Recent reaction low is at 1,410, while critical support is around 1,370.

NASDAQ 100 [ http://www.buythebottom.com/ndx.html ]
The Nasdaq has been range-bound (1725 – 1850) for over 4-months now. It will be very bullish for the market if/when this index breaks out to new multi-year highs above 1850. The commercial setup remains to the upside, with recent support near 1,750 and with critical support near 1,715.

Dow Jones [ http://www.buythebottom.com/indu.html ]
The commercial setup in the Dow, looked very bearish until two weeks ago. Back then, my hypothesis was that net-commercial position would turn back up only if we saw a decline in the markets. February’s meltdown gave commercials the opportunity to buy the markets as evidenced by the COT charts of the above four indexes. Make note that commercials are buyers at relatively high prices, which is unusual and very bullish for stocks in the intermediate term. Recent support is at around 12,250 with critical support at around 12,050.

The market is setup to the upside, and if we hold recent reaction-lows, I would expect the indexes to challenge their February highs in the not too distant future. Moreover, what happens over the next month or so may set the trend for the rest of the year. That is why it is imperative to have an open mind so that we are able to hear what the market is saying. Otherwise, if we are biased and our perceptions are slanted, it does not matter if the market will dance around in a clown-suit, our filters will ignore it, and we will never hear the market’s tune.

Commodities

Crude Oil [ http://www.buythebottom.com/wtic.html ]
Last week I mentioned that it is important to respect the trend. In oil, the trend was more or less side-ways, but more bullish than not, after it broke below $60 in March and then reversed to ultimately close back above $60. In any case, now that oil broke above $64 the intermediate-term trend (approx. 6-months) is clearly up. I maintain that right now it is important to respect this uptrend, as long as oil is above $64 on a closing basis.
Some may wonder why I am not putting more emphasis on the COT setup. The reason for this is that the COT setup is not 100% clear. Yes, net-commercial position declined over the last couple of months, and the current setup is bearish. The problem, however, is that commercials are not aggressively bearish. For example, if net-commercial position dropped to -100,000 I would put much less emphasis on the uptrend. The thing is, before net-commercial position is going to drop to -100,000, oil will probably first move up into the mid to high 70s. To recap: commercials are sellers, but they are not aggressive sellers meaning the current uptrend may very well stay intact for the next little while, or it may even breakdown today; this is why the trend is very important to follow right now.

As for the commercial setup itself, commercials were slight buyers of oil last week, even after crude rallied and broke above $64. This is unusual, as normally commercials sell into strength. At the same time, it is probably wise to wait for future COT reports to analyze more data before jumping to conclusions.

Gold [ http://www.buythebottom.com/gold.html ]
The commercial setup with gold is neither here or there. It leans to being more bullish than not, but then again – I would fall back on the intermediate-term trend in this market for guidance, which is currently pointing up.

Currencies

US Dollar [ http://www.buythebottom.com/usd.html ]
The COT setup is to the upside while this index is trading sideways in a range from roughly 82.7 to 83.5. If we hold 82.5 that would translate into a bottom; also a breakout and hold above 83.5 would also probably translate into a bottom being put in. If/when a bottom is in place, a logical target for the rally would be at the first area of major resistance around 85.5.

Staying with the energy theme, today’s focus is the mid-tier uranium miner – Denison Mining. It trades in Toronto but is also accessible via pink sheets (Yahoo symbol: DML.TO/DMLCF.PK). I wrote Uranium: The Big Picture a while back when uranium oxide (U₃O₈, aka “yellow cake”) was priced at $42 a pound. Its price has since mushroomed to $95 a pound with almost no pull back along the way.

Cameco (CCJ) is the 800lb gorilla in this space. As mention briefly here, the flooding in its Cigar Lake mine opened doors for many smaller competitors. The current Denison Mines is the product of a merger between the old Denison (DEN.TO) and International Uranium (IUC.TO) which operates a uranium tailings (recycling) facility in Utah in addition to exploration properties in Canada and Mongolia. Denison’s star asset is its 22.5% stake in the McLean Lake production joint venture but it also has other mines at the construction stage, as well as equity stakes in several junior uranium companies. There is a lot more info in their Jan 2007 company presentation (Power Point).

Technically Denison seems to have just broken out of a consolidation triangle which is normally a good entry point.

For more on buying Canadian stocks via pink sheets, read here. The company is said to be preparing for an AMEX listing which should gather it many more fans.

Disclosure: I own this stock. As always, do your own due diligence before making any financial decisions.

I saw this at Bloomberg video clip at financialsense about naked short selling.

This is why I always hold my shares in Cash Account (even though my account is a marginable account). Even though this is not helpful due to all the violations of FTD (failed-to-deliever), at least I don’t hand these shares to the shorts.

This is also why I advise people to get their physical gold/silver delivered because that is the most secure and best way to combat the shorts. In stock market, the FTDs can go on forever. But in the physical market, it will force the physical delivery harder and delayed.

In the April’s issue, Kiplinger’s personal finance brought out the author James K. Glassman who wrote the book “Dow 36000″ in 1999 to talk about the “risk anomaly” between the long term performance of stocks and bonds. I fully agree with him that LONG TERM stocks are a much better choice than bonds. But the unforunate news is that long term can sometimes mean 20 years. (for example, from 1929 to 1949, the annualized inflation-adjusted return was 1.2%, and from 1966 to 1982, the annualized inflation-adjusted return was -1.5%).

How many 20 years can you afford to wait? At most two. 20 to 40, and 40 to 60. Actually unless you have planned and saved diligently from 20 to 30, your salary usually is not at its peak earning power for majority of the career choices. If you count from 30 to 50, you probably have only 1 twenty years period available for you to save & invest, assuming that from 50 and beyond, you will shift your portfolio to a more conservative allocation.

Despite the recent stock market fall, everywhere I looked, I see very few signs of panics and bearish sentiments in the general investing public, including this article from Kiplinger’s. This is probably not a good sign, although not a strong predictor for future stock market performance either.

Coming back to Glassman’s point that the long term excellent performance of stocks versus bonds means that stocks should not be “riskier” than bonds, I must argue that there are really two dimensions to the word RISK. Usually the simplest terms from probability theory, besides mean (or so-called average), the second order term is standard deviation. You must consider both. Even though the average return is better, the standard deviation of the return is much bigger in bonds than in stocks in stocks than in bonds (must be sleeping when I typed that). That’s what I call RISK, a bigger standard deviation in the return (in the short term).

I have serious doubts about the recent double bottom in the stock indexes. I still believe that there will probably be a lower low ahead of us this year. Although the technical charts of the stock indexes look good, fundamentally speaking the stock markets are facing one of the most serious situation: inflation that is simply not going away plus a slowly deteriorating housing market plus an unstable mid-east conflicts. I simply cannot concur “why stocks are a bargain”.

Frugal, I finished my taxes last week. Ha!

My post on oil generated some nice comments, including this one from Mike:

it’s $3.50 per gallon at the pump here in San Jose. anyone figured out yet if their profits made in oil related investments actually get eroded in the high prices paid at the pump? sheesh….

While the question itself may be a little facetious, it serves well as a launching pad for two points I want to make. Oh, btw, I drive about 12k miles a year. At 24 mpg and $2.50/gal for regular around here, it’s just over $100 a month. Even if you assume my wife’s car consumes twice that, it’s still more than covered by the nice dividends from my CanRoys.

Sector allocation
The first point I want to bring up is on asset allocation. When one is trying to cover living expenses with capital gains or more commonly dividend income from one’s portfolio, it makes sense to have the sectors match. In the example I gave, dividends from the oil/gas sector covers our actual energy expenses. The same guideline can be applied to utilities, food, etc. Consequently, the sector allocation is determined by one’s actual expenses and dividend rates rather than the sector weighting in some index which is what one gets by buying an index fund. This is an excellent way to hedge the inflation as experienced by each individual.

Crude/gasoline price disparity
The second thing I want to point out is the faster appreciation of gasoline ($GASO) over crude ($WTIC) in the last couple month, which can be seen from the following two charts. Specifically, $GASO has seen 10 consecutive weeks of increases. Obviously, it means the consumer’s pocket book is being hit a lot harder than the headline oil price is suggesting.

A while back, I wrote Sweet and Sour on different grades of crude and petroleum products. It was a primer written by a layman for laymen, if you will. In it, I mentioned the 3-2-1 crack spread which is a very rough approximation of an oil refiner’s profit margin. Basically, 3 barrels of crude is assumed to produce 2 barrels of gasoline and 1 barrel of heating oil. Below is a chart of the crack spread along with crude prices courtesy of Chris Puplava from Financial Sense. Obviously, the refiners are minting money lately. It’s too bad I didn’t pay attention to the names that I mentioned myself. Tesoro (TSO) especially, has gone from $53 to $100 in 6 months.

Although I believe there is considerable political risk from a Democratic congress, I’m looking to increase exposure to refiners. Our energy needs depend on refining capacity as much as crude supply. As the supply of Arab light wanes (due to maturation of the Saudi Abqaiq and Berri fields), refiners geared towards processing heavier and sourer grades of crude will see their margins increase.

More about supply capacity
I cannot overemphasize the importance of refining capacity or petroleum extraction capacity in general. The Canadian oil sands which contain trillions of barrels of oil is being billed to be the savior of world’s energy problem. However, the mining and in situ extraction required are daunting tasks. The oil sand (bitumen) needs to be upgraded into a synthetic crude. The largest oil sands operator, Syncrude, has been expanding capacity in order to increase their production to 350,000 barrels per day (bpd) in 2007. According to this report (pdf, section 3.5) from the National Energy Board of Canada, even if all oil sand projects currently planned move forward, by 2010 total output will amount to little more than 3 MMbpd. Keep in mind that world energy needs are ~85 MMbpd currently and growth is projected to be 1.4-1.5 MMbpd for 2007-2008. Those number should put the promise of oil sands into perspective.

For now, the EIA is forecasting a world surplus production of 2 MMbpd. So even if you think it’s not consistent with the forecast of inventory reduction, there is no need to rush and get your own 1,000 gal tank. I showed that chart on declining Saudi production in the last post. It is entirely possible that they were shutting down wells voluntarily to rest those fields. For now, I’m still expecting oil prices to decline following detente of the Iranian situation coupled with normal seasonality effects. The real test for Saudi production will come this summer when demand picks up again.