Picking Gold Mining Stocks

By: Scott Wright | Fri, Jul 28, 2006
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Slowly but surely, a shift of capital continues in the financial markets. As investors diversify away from the underperforming general stock and bond markets, commodities are quickly becoming one of the go-to investment classes.

Investors are finally starting to heed attention to the historically-low correlation commodities provide to the conventional stock/bond portfolio mix. And with inflation fears gripping the markets, the commodities hedge provides refuge for the sensible.

But protectionism only provides peace of mind, if that. For bold and daring investors and speculators, commodities take on an entirely different look. Not one of protection, but one of opportunity. If one knows history and can read the fundamental writing on the wall in today's global economy, bold and daring should be rendered smart and prudent.

There are many different ways investors and speculators can take part in this great commodities bull market. Not only are institutional funds and hedge funds increasing their exposure to commodities, individual investors are able to join the party through now easy-to-open individual futures trading accounts and growingly popular ETFs.

And commodities-specific ETFs are really starting to attract attention. With metals and energy leading the way, various ETFs that track an underlying commodity or an index of stocks that explore for, develop and produce these commodities are taking center stage.

One of the newest ETFs to hit the street is designed to take advantage of one of the hottest sectors in the entire financial markets the last five years, gold stocks. In May the long-anticipated gold-miners ETF was launched allowing investors the opportunity to attain diversified exposure in the gold mining sector. Van Eck Global manages the Market Vectors-Gold Miners ETF (GDX) which is designed to track the performance of the Amex Gold Miners Index.

The Amex Gold Miners Index, which was created in 2004, is comprised of 45 publicly traded mining stocks of various weight and size. For investors who are not up to the task of individual stock picking but want to take part in the amazing run in gold stocks, GDX indeed provides good market exposure to the gold mining sector.

As mentioned, gold stocks have been hot. Take the venerable HUI gold-stock index for example. The HUI is comprised of 15 of the best gold-producing companies in the world and has risen an astonishing 996% in the last five years to its recent bull-to-date high. It's hard for investors and speculators at any level to ignore these massive gains, and it is only logical for anyone with a pulse to want a piece of this action.

As you can see in the chart above, gold stocks as measured by the HUI have been in a league of their own. To illustrate, let's say on January 1, 2001 you had put $10,000 each into the S&P 500 Index (SPY), physical gold and split among the weighted HUI components. If you had held through the end of Q2 2006, you'd be sitting on $9,900 in the S&P, $22,700 in physical gold and $80,400 in gold stocks.

Gold stocks are of rare breed on the commodities front and have had amazing success for a variety of reasons. First, the fundamentals of the metal they mine are unique and unequal to any other commodity. And second, they embody a neat little characteristic called leverage.

To loosely illustrate leverage, first consider that as compared to the HUI's 996% gain, gold is only up 183% to its recent bull-to-date high. So just looking at the numbers, gold stocks provide positive leverage to gold of 5.4 to 1. Therefore up to this point, every 1% rise in gold has led to a 5.4% rise in gold stocks. The reason for this is as the price of gold continues to rise, so do gold miners' profits.

Theoretically, the cost to pull an ounce of gold from the ground remains relatively the same, allowing for various inflationary increases. So every $1 rise in the price of gold is likely to lead directly to a $1 rise in profits for the miners assuming their costs are lower than the market price of gold and that they have not sold forward, or hedged, their future gold production.

So in this still young secular bull market in gold, it has proved quite profitable for stock investors to have positions in the companies leveraging gold's gains. And since up until recently there hasn't been a way for investors to directly invest in the HUI or any other gold-stock index, individual stock picking has been the way to go.

Now with this gold-miners ETF, investors can obtain broad market exposure to the red-hot gold mining stocks. There are several advantages and disadvantages in going this route. One advantage is the diversification over a whole gamut of stocks limits individual company risk. Inversely though, this diversification can also limit the upside potential of a gold stock portfolio.

Not all gold stocks are created equal, as well-researched high-potential individual stocks have the true propensity for legendary gains as this gold bull marches on. A prudent investor who is able to identify these elite stocks can capture far better gains than an index may provide.

Another disadvantage to index investing is the criteria it may have in place for the stocks it chooses. In the Amex Gold Miners Index, each component must have a market capitalization of greater than $100 million and an average daily trading volume of at least 50,000 shares over the last six months. So this limits exposure for some of the promising junior gold explorers.

In addition to this, the Amex Gold Miners Index only tracks stocks that are traded on U.S. stock exchanges. For the cross-borders investor, this drowns exposure to some of the very promising stocks that are traded solely on the resource-friendly Canadian exchanges.

And the weighting of this index can also limit upside potential. The Amex Gold Miners Index is very top-heavy with the top 6 companies comprising nearly half of the weighting and the top 15 comprising over 75% of the weighting.

To illustrate the difference in the quality of stocks that are in the Amex Gold Miners Index, which is essentially comprised of every major gold and silver mining stock that qualifies, and the HUI gold-stock index, which is comprised of only 15 of the best of best gold stocks, look at the performance. Since 2002, the performance of the Amex Gold Miners Index would have seen a trough-to-peak gain of 264%, whereas the HUI had a gain of 419%. This is a big difference.

Indexes do serve their purpose in the markets, but safety in numbers allows for the bad to mix in with the good. Unfortunately indexes tend not to concern themselves as much with deep fundamental analysis into each of their individual components.

In-depth research is invaluable in stock picking. Each stock needs to be stripped down in order for its true inner-self to be revealed. This is very important to us at Zeal as one of the key services we provide for our newsletter subscribers is identifying stocks that have a high potential for swift appreciation and then subsequently recommending them as market forces dictate opportune entry points.

But most people don't get to witness or experience the process of researching a stock or what goes into the analysis. Each sector is different and requires various methods of analysis, and this includes mining stocks. Because it is hard for us to pack in-depth fundamental discussions on our favorite stocks into our newsletters, we provide periodic supplemental reports that detail our favorite stocks in a given sector.

And in our recently released gold stocks report, we discuss some of the stocks we are most looking forward to adding new positions in whenever the next major interim bottom is reached. With gold mining stocks piquing mass investor interest, I'd like to share some of the research and analysis that we think is important so it can perhaps guide you in your own decisions.

In identifying the gold stocks with the best potential for appreciation, there are a number of key factors that need to be considered before getting to the decision-making stage. It is very important to consider each step in this process, as each step alone can make or break a stock.

Portfolio: Just as an individual investor diversifies his own holdings, gold mining companies tend to do the same. Gold miners typically have a diversified portfolio of land holdings between exploration projects, development projects and operations if they indeed produce.

Portfolio diversification is very important for gold companies and needs to be seriously considered in the analysis stage for a variety of reasons we will discuss in more detail. There are very few exceptions to this rule, as if your eggs are all in one basket you can get burned if something goes wrong.

Having a diversified portfolio of projects serves many purposes. It hedges against a lot of the big risks gold miners are faced with in this tough business. Examples of such risks are geopolitical, environmental, legal, market, and of course the risk that a given land holding just does not have the mineral content as originally thought, or even hoped, and that it would likely never be economically viable to mine. In this industry, assets are constantly revalued and charged to the books if they don't work out.

A prime example of portfolio risk occurred in recent weeks as a very promising silver explorer got the carpet pulled out from underneath it causing its stock to fall over 80% in a single trading day. This company had only one single project to its name, and though very promising with amazing resources, a court ruling stripped it of its property rights effectively rendering this explorer assetless and perhaps soon to be insolvent barring a miracle.

So when looking at gold companies, or any mining company, give those with small portfolios a very close examination. And if a company is banking its future on a single asset, then perform some due diligence on this asset to make sure there are no strings attached and that it has future viability.

Resources: Resources are the bread and butter of a gold miner. Gold mining stocks attract investors in large part based on their resources or resource potential. The reason for this is resources can paint a picture, sometimes not always clear, of the future potential of a gold company. Whether a full-blown major producer or a highly speculative junior explorer, resources are the key to their existence.

The best form of a mineralized resource is classified as a reserve. Most gold producers have actual proven or probable reserves that have been assessed through extensive feasibility studies. Reserve gold has been deemed economically recoverable considering the ore grade, mining method, capital expenditures and current market conditions.

Usually when a project has a portion of its resources classified as reserves, it has reached the development stage and should be ready to move forward to its ultimate goal of being an actual producing mine. But not all gold companies have mature projects with reserves. Most smaller gold companies and even the major producers have projects in the infancy stage where initial exploration or pre-feasibility work has only yielded resource potential.

By definition, a resource ounce has not yet proven to be economically recoverable. The majority of gold companies have some measure of resources on various projects through either pre-feasibility studies, core samples from drilling or surface samples. But since resources are not yet proven to be economically recoverable, the asset or company comes with greater risk.

Some gold companies act as arbitrageurs with their resources and will either pawn their discoveries/resources off to larger companies or look for a senior partner with deep pockets to finance the project. Yet others look to take their resources to the development stage themselves and profit from them in the future. Both of these methods are acceptable and normal in this industry.

When analyzing the strength of a company's resources, it is important to consider the extent of the work being done on each project and whether or not it has a strategic plan for future exploration and development of each project. How active is a company being with its resources?

Financial Strength: Perusing through a company's financials can be a tedious yet revealing undertaking. When I examine a given company, I use both its latest quarterly and annual reports. These reports can typically be found in the investor relations section of a company's website or through the SEC website for U.S. filers or the Sedar website for Canadian filers.

The first thing I look for is a strong balance sheet. I always do a quick calculation of the current ratio to see how the company stands in its ability to meet short-term obligations. Then I take a look at its debt-to-equity ratio to gather an idea of its financial leverage to see how it is financing its assets.

Cash is king in running a business, and it is always important to know how much there is and where it comes from. If a gold company is a producer, then some of its cash will come from revenue-generating activities. But if a company is not yet a producer, it does not have a revenue stream that provides cash for future spending.

You will likely find that non-producers almost always get their cash from equity offerings. Therefore long-term debt is a rarity for the smaller explorers. Large banks and financiers that provide credit facilities to mining companies usually won't look their direction unless they have completed a bankable feasibility study and have had their environmental permits approved for a given project.

And even with the producers, you typically don't see significant long-term debt like you do in most other sectors, especially in technology and energy. Some of our favorite producing gold miners proudly tout a goose egg in the long-term debt section of their balance sheets.

Another big tell when looking at financial statements for gold companies, especially for the juniors, is where they are spending their money and how much of it they have left. Unfortunately there is a very fine line between many of the junior explorers in the gold industry and some of the internet spoofs of the tech bubble. Since the gold industry is so hot right now, the emergence of fly-by-nighters, aka dot-juniors, has come to surface.

Sometimes when you look at the financial statements of some of these companies you will find they are spending more money on marketing and salaries than they are on the exploration of their land holdings. A big red flag should pop up if this is the case.

For the legitimate explorers, their current cash position mixed with the progress of their explorations should give you a loose budget that can be used to project their future longevity. And since non-revenue-generating companies can't live forever, it may be prudent to check out their financing history as to the frequency of stock offerings/private placements. This could reveal their potential strength or weakness months and years down the road.

Longevity: A very important piece of information you need to consider when analyzing a gold producer is longevity. Since gold producers have revenue-generating activities from economically recoverable gold, they need to be measured differently than the explorers. Explorer stocks should be reserved for speculative capital as they are much more risky than producers.

But since producers draw in investment capital, they need to be compared to each other, not explorers, in a more conservative manner. One measure of doing so is through longevity. In other words, how long of a life does a company's mine or mines have remaining. This is measured by looking at existing or future production rates scrubbed up against existing reserves.

So if a particular mine is producing 100,000 ounces of gold per year at full commercial production and it has 1 million ounces of reserves, it has roughly a 10-year mine life remaining. This can also be calculated for mines in development and construction as usually the feasibility studies have extensive mine-life projections.

This is ever-important as the business of bringing natural resources to market is unlike any other in the world. There is a finite supply of gold that each miner has claim to. And once a producer's resources are depleted, if there is nothing else left in the pipeline, they are done. It is not like widget production where an unlimited supply can be produced based on demand.

The top gold producers usually average about 7 to 12 years of production with their combined assets. And because longevity is an important measure for investors, the producers that are able to boast the longest lives tend to perform better in the markets. It is not easy though maintaining longevity, as it is a constant battle renewing and growing the reserves necessary to prolong mining life. This is why the next area of focus is so important for gold miners.

Exploration: Bringing gold from mine to market has never been an easy task. It takes significant time and capital to discover, explore, develop and construct a gold mine. Similar to an old-time 49er patiently prospecting for gold in the American River, 21st century exploration requires some of the same painstaking meticulousness.

Gold is one of the rarest minerals in the earth's crust and it is becoming increasingly difficult to discover sizeable deposits. Gold companies need to constantly be exploring for their next gold mine in order to stay ahead of the curve and maintain longevity.

Outside of mine construction, exploration should be one of the biggest expenditures mining companies make. For producing gold miners, successful exploration is what will be the key to extending their lives and renewing reserves, acquisitions aside. And for junior explorers, successful exploration is what is going to lead to them eventually becoming a producer themselves or becoming attractive enough to sell their assets for huge gains via divestitures or company buyouts.

In addition to discovering new deposits, a large part of the exploration budget for gold miners involves the further exploration of existing deposits. When initial discoveries are made, the true depth and breadth of the deposit is not fully realized until well after initial feasibility studies. In fact, many times it is not fully realized until after the mine has been operational.

Operating mines have expensive infrastructure in place that makes it a no-brainer to exploit the existing deposit and the surrounding area, also known as brownfields exploration. Often times a mature mine that has been in production for many years and is close to the end of its life has extensive exploration occurring so as not to lose the infrastructure. Processing plants, onsite smelters and refineries, and waste ponds are the biggest expenses in constructing a mine. Once a mine is closed, this infrastructure usually becomes obsolete.

Many times expanded exploration programs show already discovered deposits may extend farther out or down than originally projected. Or there might be another mineable deposit within close proximity of an existing one. It is financially prudent to maximize the use of expensive infrastructure.

A healthy gold company, whether producer or non-producer, should have active exploration activities at existing mines, through brownfields exploration, or at newly targeted deposits, also know as greenfields exploration. And only through sizeable capital expenditures are exploration activities ever going to bear fruit.

Geopolitics: Oh the joys of geopolitical travails! Today more than ever geopolitics have an impact on global commerce. When examining gold stocks, one of the most important things to look at is the whereabouts of their projects. Unfortunately gold deposits don't always reveal themselves in first-world countries next to a metropolis with unlimited and cheap energy and labor resources.

In fact, many times gold deposits come to surface in desolate, unstable and remote parts of the world. Some of the biggest and best gold mines reside within the borders of countries that are less than receptive to free markets, international trade and profitable resource mining.

One of the most important reasons for portfolio diversification is geopolitics. If a gold company has most or all of its projects within the borders of a historically safe country such as the U.S., Canada or Australia, then this shouldn't pose a problem. But when a project or projects are within the borders of a country or even a region that is the least bit unstable, the company risk rises dramatically.

A couple of my favorite junior explorers and hopefully soon-to-be producers have their prospective gold mines in areas of great instability. One in particular is in the heart of Venezuela. The deposit this company has put tens of millions of dollars into the exploration and development of is amazing. It has the capability of becoming a massive, long-lasting and ultra-profitable gold mine. But the gold company that wants to bring this mine to life happens to be an international explorer based in North America.

When it originally obtained rights to and began exploration on this deposit, things weren't as bad. But since Marxist president Hugo Chavez has made life difficult for international natural-resources companies of late, there is a big risk this mine may never come to life. If this deposit was in a geopolitically safe country, I would be throwing all kinds of capital into it, but because of its current geopolitical situation it becomes a highly speculative investment.

Geopolitics are always very important to consider for each gold stock. You must look at each project and the possible risks its location may have. What kind of government is in place? Have they historically been friendly with international businesses? What kind of currency exchange or tax issues might there be? These are just a few of the questions you should be asking about the projects within a given gold company's project portfolio.

Leverage: I briefly discussed the concept of leverage above. Leverage is very important in being a profitable gold miner, and even more so in capturing the legendary gains available in a secular bull. Leverage must be carefully and thoroughly examined for gold companies that produce gold and those that are in the development and construction stage of bringing their deposits online.

Many commodities markets have the common practice of forward selling. In short, the buyer and seller agree on a fixed price that a commodity will exchange hands for in the future. These forward contracts are typically designed to hedge future volatility risk so the supplier, especially those with low margins, can better manage their production and cash flows and so buyers can better manage their expenses and forecasting. This basic concept was the initial catalyst in creating the futures markets.

In gold mining forward selling, also known as hedging, has become a red flag for producers in this secular bull market. There is a huge opportunity cost in selling forward future gold production in a secular uptrending market. Forward contracts that have average prices well below spot gold prices can really lead to significant losses that ultimately penalize shareholders. Many of the gold producing hedgers today have forward contracts several hundred dollars per ounce lower than spot, and their shareholders are getting raked over the coals.

Unfortunately two of the top three weighted companies within the Amex Gold Miners Index are two of the most notorious hedgers in the entire gold mining industry. The chronic underperformance of their stocks compared to the non-hedgers reflects this phenomenon. In fact, one of the reasons the HUI has been so successful is its criteria for selecting its components. The HUI is comprised of gold producers that are unhedged.

There are a couple of circumstances where moderate hedging is acceptable as a criterion for buying a stock. First is if a company has moderate hedging as a result of a merger or acquisition. And second is if a company has minor hedging due to project financing obligations.

Often gold producers are forced to debt-finance the construction of a gold mine. Because of the nature and volatility of the commodities markets, the banks and financiers lending the money take on what they deem to be a greater-than-average risk. And as a condition of the loan or credit facility, the lender typically requires a percentage of future gold production to be sold forward so they can ensure payment of the loan. If indeed a miner's only hedging is a direct result of a financing requirement, this can be acceptable as long as it is a small portion of its annual production and reserves.

Now on the leverage front, whether a miner is hedged or not, it is very important to understand its overall stance on forward selling future gold production. Most companies make this clear in their mission and value statements.

I believe in order to run a truly successful gold miner, the executive team has to be bullish on gold. When I see a company voluntarily hedging their future gold production, this tells me they are not bullish on gold's strategic trend, and will likely get burned in the end. I tend to shy away from companies that perform such deeds as in the long run it will penalize their shareholders.

Cost Management: Cost management takes on a whole new meaning in the gold mining industry. Ultimately, as in every business regardless of the sector, the better you manage your expenses the more profitable your business is going to be.

Gold mining costs are measured by the ounce commonly referred to as cash-cost-per-ounce or operating-cost-per-ounce. The lower the cost per ounce of gold produced, the higher the profits. Cost management and leverage go together hand-in-hand. So theoretically it is in the best interest of a gold miner to keep costs as low as possible. Here lies an interesting paradox among gold miners.

Many of the chief areas of focus I've discussed come into play when analyzing cost management. Longevity is of great importance to the success and survival of a gold miner. As discussed, prolonging the life of a miner's assets is key to this concept. And successful exploration mixed with rising gold plays a big part in this.

With this in mind, the optimal gold mining stocks to invest in are those with no hedging and very low cash costs. These producers do exist, but they are few and far between. Interestingly, operating costs have been rising abnormally fast in the gold mining industry in the last couple years, at a much faster rate than rising energy and labor costs would dictate.

The valuation of gold stocks tells the story. But interestingly, one of the big reasons for these rising costs is intentional on the miners' part. This happens through shifting operations to mine a higher percentage of low-grade ores. Initially this doesn't make any sense, but from the eyes of a gold mine operator it becomes clearer.

First we need to understand the key measure of a reserve versus a resource, which is economic viability. If an ounce of gold costs less to produce than what it sells for at market, among other factors, it can be classified as a reserve ounce. So as the price of gold continues to rise, lower-grade ore, or ore with a lower mineralized content of gold, becomes profitable to mine whereas it may not have been before.

While we investors want to see big profits when gold rises, mine operators are more concerned with maximizing the lives of their mines. So while the markets can support miners running a higher percentage of low-grade ore through their mills, enough so that the miners can still cover their costs and perhaps still turn a small profit, they will take advantage of this. Ultimately this extends the life of a mine as it conserves high-grade reserves.

I call this stealth cost management, with increased longevity being the end-game for gold miners. But even with this going on in many of the open-pit gold mines, there are those companies that stand out in their ability to manage costs which indeed pleases shareholders.

Other: There are also a few other things I like to look at in the analysis phase of picking my favorite gold stocks. First it is always important to glance at the history of a company. What roots came together to form the company you see today? To what extent did it service its projects in the past? Was it ever involved in any serious environmental problems? Does the management team have a history, good or bad?

And not only is it prudent to get an idea of the corporate history but also the history of its stock performance, which could lead into another critical stage of analysis involving valuation comparison. Even though gold stocks are not pure value plays, there are individual gold stocks out there that are undervalued compared to their peers. Some of these stocks deserve to be undervalued for various fundamental reasons, but some stocks can be obtained at bargain levels. And how has their stock performed in previous uplegs and corrections?

If your goal in researching a gold stock is to truly understand the ins and outs of it by getting to know the company, then the tactics I outlined above should really help in refining your picks. A well-researched stock in an uptrending market can lead to legendary gains. There are many good gold stocks out there, but very few great gold stocks. As with any investment, you have to sift through the ordinary to get the extraordinary.

In our latest Gold Stocks Report, we dive into in-depth analysis as guided by the above methodology. Our purpose is to try to find the best of the best gold mining stocks to ride in the next upleg of this secular bull market for the Ancient Metal of Kings. We expect the stocks in this report to perform very well in a continuing gold bull market.

And as the great commodities bull of the 00's marches forward, we will continue to deploy capital not only into gold stocks, but into various precious metals and base metals stocks. The supplemental reports we publish identify and detail some of the elite stocks we will be trading, but our newsletters focus on tactical trading technicals to better time our entry and exit points.

If cutting-edge commodities market analysis is something you've been looking for, please subscribe today to our acclaimed Zeal Intelligence monthly newsletter or our popular Zeal Speculator alert service.

The bottom line is gold mining stocks offer investors excellent exposure and leverage to gold through many different avenues. The new gold-miners ETF not only offers investors the opportunity to invest in a broad diversification of gold-mining stocks, but it gives excellent overall exposure to a still small market.

This exposure should only help the gold mining stocks. And for investors and speculators who want to capture the truly legendary gains through individual stock picking, down-and-dirty research should reward the diligent.

 


 

Scott Wright

Author: Scott Wright

Scott Wright
Zeal LLC.com

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at ... www.zealllc.com/subscribe.htm.

Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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