Things are about to get a lot worse for small resource stocks…

The sector has already dropped 50% in the past 16 months. But more trouble could lie ahead for some of your favorite resource plays.

In today’s essay, I’ll show you how to avoid the losers… and find the winners.

Regular Growth Stock Wire readers know we monitor the TSX Venture Index for a read on the general trend in small resource stocks (like gold exploration firms, small oil companies, etc.). The TSX Venture is the “Dow Industrials of small resource firms.”

[ad#Google Adsense 336×280-IA]This index is down a huge 50% from its high in March 2011.

It’s down 26% since its recent high in February 2012.

We discussed the drop in this Growth Stock Wire essay from May 16.

In that essay, we warned that companies were running out of money… which could crater resource stock prices even more.

When it comes to evaluating the safety of a small resource firm, cash is a huge thing.

Cash is the lifeblood of small resource firms. They have no revenue… and everything they do costs money. Even the stuff they list as assets, like their projects, are actually liabilities. For example, land listed as an asset may or may not contain economic minerals… but the company must still pay rent every year to hold the land.

And if the company’s bank account isn’t large enough to cover its costs, these companies go under.

Of the 2,388 companies listed on the TSX Venture Exchange, 1,239 have less than 10% of their market value in cash. That means 52% of the Venture needs cash and will have to raise money. If you own stock in one of these companies, your shares will be worth less after the company raises the money. You’ll be diluted.

Just 13% of the companies have a relatively safe margin of at least 50% of their market value in cash. That means they are more likely to survive… and make it to the next bull market in junior mining stocks.

If you’re considering doing some contrarian buying in this beaten-up sector (or if you own some of these firms right now), make sure to avoid companies that are running low on cash. Check the company’s market cap… and then check its cash levels. If the company’s market cap is far above its cash levels, it’s likely going to fall even more this year. I expect many will fall 50% from here.

Another thing to keep in mind during this difficult period for resource stocks: Don’t pick through the trash and buy companies with no assets. As my friend Michael Kosowan, a broker for Sprott Global in Carlsbad, California told me yesterday: If you are buying junior mining companies right now, you better have a darn good reason.

The only companies worth buying today are the ones that have a great asset. We’ve discussed several such names here in the past, like Mirasol Resources (MRZ.V), Almaden Minerals (AAU), and Kaminak Gold (KAM.V).

These companies made significant discoveries in the past two years. The value of those discoveries should put a bottom on those stocks, a price where long-term investors will step in and buy. But nobody is going to buy a stock with just “hopes and dreams.”

In summary, things are bad in the resource sector. But for companies running low on cash (and there are a lot of them), they’re going to get worse. That’s why it’s best to buy only proven assets right now

Good investing,

Matt Badiali

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Source: The Growth Stock Wire