In my last article, I explained why I thought the Basel III Agreement would be one of the fundamental catalysts that will push the price of gold a lot higher. There are a lot of ways to take advantage of this, but one of the best ways is to buy into undervalued stocks in an investment sector that has just been through a severe price/valuation correction.
I have some key fundamentals factors I use in assessing whether or not to invest in a mining stock: the company must be operating in a politically "safe" country (relatively, that is); management should have a meaningful ownership of the stock; with smaller companies, there should be a larger mining company with a strategic ownership interest (potential funding source and investor exit strategy); the company should have a strategy for increasing its resource base in excess and of what is being produced; and the stock should be significantly undervalued relative to the current market cap AND have a catalyst which will trigger the stock price/market cap to increase significantly.
One stock that fits all of these criteria and that I find particularly compelling is Gold Resource Corporation (GORO). GORO has 5 properties in the State of Oaxaca in southern Mexico, one of which was put into commercial operation in July 2010. Several companies are discovering rich deposits in Oaxaca, including Fortuna Silver which commissioned a gold and silver mine in September 2011. GORO is a "story" stock, meaning it requires some detailed explanation of what happened and why the market is wrong about the stock. I've found in over 20 years of fundamental investing that "story" stocks require a lot of investigation and analysis beyond typical Wall Street research and offer the best risk/return payoff.
If you want to familiarize yourself with GORO, here's the company website. I will provide a quick summary of GORO's fundamentals, explain why the stock suffered big price-drops on mid-July and mid-November and outline why I believe that GORO is currently one of the most undervalued mining stock plays. My view is based on my own research and fundamental analysis, including a long phone conversation with Greg Patterson, GORO's head of Corporate Development and Investor Relations.
GORO's producing property is the El Aguila project, which is currently producing 85,000 - 100,000 ozs. of gold (and gold equivalent) on an annualized basis. Their current goal is to ramp this up to 150,000 ozs by the end of 2015. GORO is one of the lowest cost producers in the industry, with cash costs currently at $396/oz. vs. an industry average of $727/oz (Thompson Reuters GFMS 2012 survey). The company has only 58.9 million fully diluted shares outstanding, an $850 million market cap and it pays a 4.5% cash dividend - by far the highest dividend yield of any of its peers: (Link Pg. 31). Management owns 14% of the stock and Hochschild Mining plc (HCHDY,PK) owns 28%. For last two quarters, GORO has been free cash flow positive before dividends.
For starters, high short interest in the stock
One issue with GORO's stock is the enormous short-interest. As of November 30, the short interest was 17% of the float and the short ratio was 12.2 - both extremely high for a stock with only 58 million fully-diluted shares, of which only 32 million is publicly traded. When this situation exists, the shorts are usually either very right - and eventually the stock goes to zero - or they are really wrong - and the stock soars on good news as they scramble to cover.
The history of the short-interest in GORO is actually interesting. When GORO was developing the El Aguila property, the management strongly believed that they had a home-run deposit and decided to build a mine and commence production without having first prepared a 43-101 resource statement OR spending the money for a formalized economic assessment. Not only is this unconventional, I have never heard of developing a mine prior to releasing 43-101 statements and a preliminary economic analysis. Usually the latter is required for financing the mine. Because this was so outside the "norm," a massive short-interest in the stock developed over time which reflected extreme skepticism of the company and the validity of its property.
When I observe this type of situation with a stock, my antennae go up because it often means there's a significant degree of mispricing in a stock, either to the upside or the downside. With this particular situation, my view is that the price of the stock is way too low. The company's overall operating results since the mine became operational proves out management's strategy of saving money on the typical preliminary reports and going straight to mining. The fact that management owns 14% of the equity confirms, at least for me, that they are managing the company in line with the best interests of all shareholders.
Recent stock price woes
GORO's stock was hit in July when the company announced disappointing production results for Q2 and had to revise lower its full year 2012 production estimates. The lower production was due to the fact that the company had to address some underground and infrastructural needs like expanding ventilation and upgrading electrical power. They also had focus on prep work which would enable the company to expand into some higher grade zones. Both issues reduced both the amount and grading of the ore mined during Q2, which caused mining production to fall short of expectations.
This type of quarterly operational issue is not uncommon in the mining industry and GORO's management has presented a fairly detailed analysis and remedy of the problem. In fact, the company demonstrated its ability to address these types of operational issues by increasing production 54% in Q3 over Q2.
However another issue surfaced which caused the second "cliff dive" in mid-November. GORO announced a pending restatement of earnings for the Q1 and Q2 due to a dispute with a buyer in Mexico of GORO's precious metals concentrate. GORO management believes that the situation resulted from concentrate tampering sometime after the concentrates left the mine site, and prior to the concentrates being sampled while at the buyer's warehouse. GORO and the buyer resolved the dispute, but it resulted in lower net revenues for GORO in Q1 and Q2 and necessitated a re-statement of those quarters.
This was the event that prompted my conversation with management. As explained to me, the discrepancy in the amount of metal contained in the concentrate sold to the buyer was raised with the management of GORO's Mexican operations group in early spring 2012, but the group failed to alert Corporate headquarters of the situation. You can read the details here: LINK.
The company addressed the issue by implementing stronger controls over internal reporting and additional security to prevent any potential tampering with the metals concentrate while its being delivered to the buyer. The company also replaced the general manager of the Oaxaca mining unit in order to fix the management control problems: LINK. Since taking these measures, there have not been any more problems with settling the final terms of the sale of metal concentrate with this buyer.
The issue which caused the stock drop in July is a common problem in precious metals mining. Several of the largest gold mining companies have experienced production issues this year. It's part of the business risk embedded in gold/silver mining. The November issue is a managerial oversight issue which is common with any smaller business in which management is focused on creating high growth and outgrows its existing management structure. This is one of the inherent short term risks with investing in smaller companies. I believe GORO has taken effective measures to address this particular issue.
The bottom line
The "inefficiency" with respect to the degree that the "market" is incorrectly valuing GORO's stock presents an opportunity to take of advantage of this "mispricing," given that my analysis and instinct tells me that the market is wrong here.
GORO's stock hit an all-time high of $30 - $1.7 billion market cap (fully diluted) - in April 2011, shortly after listing on the NYSE and in correlation with the run-up in the price of gold during that time frame. Since then, GORO has achieved impressive production growth and continued expansion of the potential size of the resource base at El Aguila.
It is my contention that the stock has been excessively oversold in response to the negative news events of Q2/Q3 and represents compelling investment value. This the inability of the market accurately value GORO is due to 1) the overall context of a price correction in all mining stocks; 2) concentrated and aggressive short-selling; and 3) the lack of understanding by the market of GORO's specific problems and the success with which management has addressed those problems.
I believe GORO's stock will outperform the mining stock sector as a whole for at least the next year as investors see continued operational success and begin to focus on the current market cap of GORO relative to its peak in April 2011 and relative to the inherent value of its asset base and high dividend yield. The easiest money made was the bounce from its recent low $12.67 to its current price of $15.50. I actually put on a core position in my fund around the $13 level and continue to add to it on any price weakness. You can short out-month, in-the-money puts for some downside protection in the event that the mining sector trends sideways for awhile. I have also utilized this strategy in my fund.
On the assumption that the current gold/silver/mining stock correction has largely run its course - and barring any unforeseen stock market disasters - I think GORO can move back over $20 before June and has the potential to double from here before the end of 2013. If you refer to the chart above, you'll see GORO left a huge "gap" at $20 in October and that gap should at least get filled, assuming all markets remain at least flat.
Two other significant factors that could propel the stock a lot higher are the potential for aggressive short-covering on any unexpected positive news and the possibility of a takeover by Hochschild. With today's (Dec 17) announced acquisition of Orko Silver (OKOFF.PK) by First Majestic (AG) at a 66% premium to Orko's previous closing price, rate of return money will be looking for undervalued mining stock opportunities with takeover potential and GORO is set up for that possibility.
Assuming gold continues in its bull market trend, the mining stocks should start to get a lot of significant investor attention in 2013. It is this dynamic that I believe gives GORO the potential to double from its current level by the end of 2013.