Managing Expectations - Part III
Part III of III: Picking Mining Stocks in a Bear Market
In the first part of this three-part series, I discussed the importance of cycles such as four-year presidential elections and the life of a gold mine, and how they play into our investment strategy here at U.S. Global Investors. Part II dealt with statistical diagnostic tools, in which I strived to simplify the definitions of standard deviation and mean reversion and explain how they're applied.
The third part of this series on managing expectations is devoted to fundamental resource stock evaluation. I'll discuss some of the statistical tools we use to pick quality stocks during a treacherous bear market, such as what we've seen in gold stocks the last three years.
Let it be known, however, that, though our approach might vary slightly depending on the condition of the market, we fervently seek to pick the best stocks at the best price and execution.
How I Learned to Respect the Bear
The traditional definition of a bear market is when broad stock market indices fall more than 20 percent from a previous high--which sounds like a catastrophe, but is in fact "normal" market behavior. According to self-professed "investing nut" Ryan Barnes, a contributor for Investopedia, "bear markets... are a natural way to regulate the occasional imbalances that sprout up between corporate earnings, consumer demand and combined legislative and regulatory changes in the marketplace."
Think of bear markets, then, as the gradual transition from warm summers into frozen winters. Trees lose their leaves, snow and ice blanket the ground, many animals--the bear the most notable--hibernate for the season. All life seems to take a breather. But just as you can always count on spring to emerge and, with it, new life, you as an investor can count on the market to rebound with fresh vigor.
As you might have known, the tail end of "winter" is when you want to take part in the inevitable recovery. If the market never had a winter season, if it were perpetually trapped in an endless summer, investors would be hard-pressed to find an ideal entry point.
It's easy to determine when winter becomes spring. But what about the end of a bear market? How do you know when it's bottomed and the optimal buying time has been reached?
CLSA consultant Russell Napier, in his now-classic 2009 book Anatomy of the Bear, describes the determinants of the end of a bear market:
"The bottom is preceded by a period in which the market declines on low volumes and rises on high volumes. The end of a bear market is characterized by a final slump of prices on low trading volumes. Confirmation that the bear trend is over will be rising volumes at the new higher levels after the first rebound in equity prices."
Look at the chart below. You'll see that, in three decades, the Philadelphia Gold & Silver Index (XAU) has never had a losing streak for more than three years.
Historical precedent suggests that gold stocks were due for a jump in 2014, and just as expected, the XAU has returned close to 20 percent year-to-date (YTD) after an abysmal 2013, the "final slump of prices on low trading volumes."
The following line graph illustrates just how dramatically gold and silver stock performance has rebounded. As you might remember from our discussion last week, what we see here is an example of mean reversion, which occurs when the price of a security reverts back to its historic average.
These data exemplify the notion that you should remain patient during downturns, avoid getting discouraged and allow the security--in this case, precious metal stocks--to revert back to its long-term mean. When it does, you'll find that the wind is suddenly at your back instead of in your face.
Spencer Johnson, author of the 2009 book Peaks and Valleys: Making Good And Bad Times Work For You--At Work And In Life, writes, "You cannot always control external events, but you can control your personal peaks and valleys by what you believe and what you do." Likewise, we might not have any control over how the market behaves, but we can control how we respond to it: with grace, intelligence and levelheadedness.
Value Drivers for Superior Performance
One of the tools we use to navigate around volatility, regulate emotion and focus on facts and fundamentals is an invaluable model we call the portfolio manager's cube. It helps us separate the weak from the strong, evaluate a company's attractiveness and pick the best GARP-y stocks. "GARP" stands for "growth at a reasonable price," which is an investment strategy that aims to identify companies with superior growth and value metrics.
The cube allows us to sift, sort and prioritize. It draws attention to the intersections among a resource company's production, cash flow and reserves (rows) and relative value, momentum and event drivers (columns). Using this model, we compare stocks on a relative basis in production per share to find attractive opportunities and overpriced risks. We also identify events that could increase reserves and/or production per share over the next 12 months.
More than anything else, the cube affords us the framework for conducting relative valuation of a stock. Relative valuation is a method that compares a security's value to that of others to determine its financial worth.
For example, we evaluate mining stocks in the same way you or I might compare cars on multiple metrics before making a purchase. On this topic, I urge you to check out one of my favorite websites, Dennis Boyko's GoldMinerPulse, for a look at the type of fundamental analysis and relative evaluation that goes into comparing and contrasting mining stocks.
The following is an example of how we might use the cube. Suppose a young mining company has just discovered a gold deposit. This event might excite potential investors and compel them to enter when the stock is undervalued, expecting it to skyrocket. But it's important to conduct a cross-sectional analysis of this discovery in terms of production, cash flow and reserves. How much gold does the company expect to produce in relation to others? The average concentration of gold in the earth's crust is 0.005 parts per million, making a substantial yield very rare. About one in 2,000 companies is lucky enough to stumble across at least a one-million-ounce deposit.
Other questions might include: Does the company have ample cash flow to finance the costly yet necessary infrastructure, equipment, geological analyses and manpower to extract the metal, not to mention pay dividends? Has it kept up with its cash reserves to remain solvent during development of the mine and subsequent excavation? Many years, after all, typically go by before ounce one is plucked from the ground.
Besides using models such as the portfolio manager's cube to determine a mining company's or asset's relative value, we also rely on "boots on the ground" experience. Members of our investment team and I routinely visit domestic and global projects to gain tacit knowledge and ensure that operations are running smoothly and management is knowledgeable and has a firm handle on things.
To see photos of what these visits look like, check out our most recent slideshow, On a Quest for Copper.
The Five Ms
A mine's lifecycle is the perfect segue into what I call the five Ms to picking the best mines. Most of what follows can be found in the 2008 book I co-wrote with London-based financial writer John Katz, The Goldwatcher: Demystifying Gold Investment.
One of the five Ms is Mine Lifecycle, which I cover at length in Part I of this series along with other cycles such as weather patterns, gold seasonality trends and four-year presidential cycles.
The other four Ms are Market Cap, Management, Money and Minerals, detailed below.
Market cap is simply the number of shares outstanding multiplied by the stock price. The gold sector is broken down into three sectors by market cap: seniors (market caps >$10 billion), intermediates (between $2 and $10 billion) and juniors ($2 billion).
If a gold company has 10 million shares outstanding at $1 per share, the company is valued at $10 million. The question any investor should ask is, "Is this company really worth $10 million?" If the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (one million ounces in reserves X $25 an ounce). If the company's market cap is only $10 million, it may look undervalued. Accordingly, if the company's market cap is $50 million, it may appear to be overvalued.
For larger gold companies, an investor can measure a company's market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation. For junior mining companies--an area of focus for our World Precious Minerals Fund (UNWPX)--we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.
Essentially, management of mining companies must have both explicit and tacit knowledge to be successful. Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?
Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?
Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors. Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.
Some of the most successful company builders in the gold-mining industry are what I call the "financial engineers"--people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.
Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow. A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis.
We call this the "burn rate"--how long will the company's current cash levels last before it has to return for additional financing. If a junior exploration company has $15 million in cash reserves and is spending $3 million a month, it has five months to deliver enough reserves per share to convince capital markets it is worth the risk.
This calculation can be done quickly. Exploration reserves are generally valued at one-third the reserve values of a producing mine--if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce.
The gold-equities market is generally efficient at judging reserves per share, so if the exploration company doesn't come up with the results necessary to get an evaluation--find gold for less than $50 an ounce--investors quickly lose confidence. There is an old rule when it comes to exploration companies: don't pay more than two times cash per share if there are no proven assets in the ground.
Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share.
Companies operating mines that produce gold as well as industrial metals tend to have lower valuation multiples. For example, the current price-to-earnings ratio for Freeport-McMoRan, is 8x-times forward earnings. Investors can use the low relative valuations of copper/gold producers to increase their margin of safety in anticipation of an upward move in gold prices.
I must stress once again that these relative valuation techniques apply whether we're in a bull or bear market. In Peaks and Valleys, Spencer writes, "Have you ever noticed that your life is filled with ups and downs? It is never all ups or downs."
Similarly, the market is never all ups and downs. As active money managers, we have learned to adapt to an ever-changing climate--from "summer" to "winter"--to select what we believe are the best, most reasonably-priced mining stocks for our investors.
Next week, look out for my discussion on how our investment team trades uses statistical tools to make trades around core positions.