Smaller gold miners offer the prospect of strong growth but are less diversified than their larger rivals. This exposes stockholders to the operational risks that could affect one or more of the producing mines. Such has been the case for investors in Jaguar Mining as the group's Turmalina mine in Brazil has produced weaker gold grades than expected.
 

Looking at the weekly chart of Jaguar Mining we can see that the stock sold off sharply once it broke below its uptrend and the horizontal support around the $9 mark. This selling pressure has taken the share price back below its 200 week moving average and is currently testing horizontal support around the $6 level.

Taking a closer look at the daily chart of JAG we can see that the recent selling looks to have found support at the confluence of the lower bound of the downward channel and the $6 horizontal support level. The daily RSI has turned higher from oversold territory and has formed a bullish divergence with the price action, forming a higher low while the price formed a lower low. This increases the odds of the $6 support level holding. Should the share price hold this support there is little overhead resistance until the $8 mark.

As a reminder to members, Jaguar Mining is focused on Brazil and has two key mining locations at Turmalina and Paciencia. A third mining site, Caete, is expected to achieve commercial production in the fourth quarter of this year. There is also one development project and two exploration projects and all of the group's operations are in Brazil.

Since our last write-up on the group the stock has fallen by almost 50% and thus the market cap is currently around $500m. When we last wrote about the stock in mid-April it was trading at around C$11 and then fell down to about C$8 before the second quarter update. The Q2 update then saw the stock fall to just above C$6 where it is currently trading.

This is disappointing to say the least but it should be remembered that small cap stocks are inherently volatile and that Jaguar Mining's stock price was as low as C$2.80 in December 2008. Thus in this area investors must stomach big stock price moves. The main focus of investor disappointment has been the second quarter results although disenchantment was clearly starting to creep in before then.

When we last wrote about Jaguar Mining we noted that it was inexpensive on the basis of ore in the ground compared to peers. However, we also reflected that this was due to the lower current production than peers which meant more risks on extracting ore from the ground.

In the event Jaguar has been hit from lower ore grades than expected principally from its Turmalina mine. This has pushed up cash costs and therefore hit profitability hard. The way to improve things according to the group is to adopt different mining techniques.

For investors a key concern is clearly whether these lower ore grades will continue and make the mine less valuable. Jaguar Mining argues that following a review it has established that there is no change in the overall geology i.e. no decrease in the in-situ grades. Whether Jaguar is correct on this point remains to be seen but we remain optimistic.

Furthermore, gold mining is always going to be an unpredictable affair filled with either positive or negative surprises. The lower ore grades found are disappointing but this should be possible to turn around. This is not expected to occur before the end of the year when the new mining techniques are adopted.

Turning to the financials and the second quarter saw a net loss of $5.9m which compares to a profit of $9.7m a year ago. Gold sales decreased to 30,646 ounces against 35,561 ounces a year ago. However, the average selling price rose to $1,203 which compares to $922 in Q2 2009.

Cash costs rose to $746 per ounce in Q2 against $447 in 2009. This was caused by the average feed grade falling to 3.17 grams per tonne (g/t) against 4.18 g/t a year ago. However, grades should start to recover in 2011 as the group changes its approach.

The change over in mining method is from stoping to cut-and-fill but this is taking longer than expected due to delays in developing an access ramp. The Paciencia mines already use the cut-and-fill method.

In our view this appears simply to be a waiting game and Jaguar should have enough expertise to ensure the new method does improve grades. It is worth remembering that as the group operates underground mines operational issues can be complex and problems can be costly.

Turning to cashflow in the second quarter cash from operating activities was $4.5m while investment in growth projects was $36.5m. Set against this cash holdings were $65.4m at the end of June and so the group should be able to get through until the end of the year. In 2011 cashflow should improve significantly as the new mining methods are adopted.

Output will clearly be weak in 2010 due to the lower grades and this may run over into part of 2011. However, with the new Caete operation coming on stream for the whole of 2011 Jaguar Mining anticipates that output should rise by 40% over 2010.

The group is also conducting a review of technologies to reduce capex requirements and operating costs which should be completed in the next few months. Once this is done production forecasts and capex figures will be updated.

Jaguar Mining appears to be a perfect example of how the stock market can overreact to short-term issues. Investors simply don't appear to be giving the company the benefit of the doubt that it can get on top of cost issues. By contrast, we believe improvements will be made going forward and that the long-term growth prospects and the strong outlook for gold bode well for the group.

Accordingly, Jaguar Mining will remain firmly held in the Fat Prophets portfolio.