Seeking Alpha
Gold & precious metals, macro, research analyst, deep value
Profile| Send Message| ()  

This article continues Buying and Owning Gold Part 1: Arguments for Gold Ownership. In it I present specific ways to buy gold, the reasons for which I outlined in the first part of this article. Each of these options will appeal to investors with varying appetites for risk.

Gold Itself

The option with the lowest risk would simply to buy gold itself. This in itself sounds simpler than it really is. There are various coins, bars, bullion vaults, ETFs and CEFs available to investors. Each varies in terms of their relative availability to investors, their tax consequences, and their counter-party risks. Unfortunately none of these is risk free, and consequently diversification is the best option.

The safest way to buy gold is probably to buy bullion coins (American Gold Eagles, Canadian Gold Maple Leaves … etc.) or bars (Pamp Suisse, Credit Suisse, Perth Mint … etc.) and to store them in a safe place such as an at home safe. The primary risks here are theft and government confiscation. Some places to buy physical gold are APMEX, Gainesville Coins, or you can support your local coin shop and avoid shipping hassles. For those readers who live in or near Chicago like myself Harlan J. Berk is an excellent establishment. If one wants to hold gold bullion coins or bars in a bullion vault, they can be stored in a bullion vault in an account that allows its clients to take delivery of their gold (absence of such an option should be viewed with suspicion). The Perth Mint in Australia is viewed by many to be a safe place to store gold.

For those who want the convenience of gold traded on American exchanges there are numerous options. The most common by far is GLD, however I would recommend the Sprott Physical Gold Trust: PHYS. There are two reasons for this. First, PHYS has a tax advantage over GLD. The former shares are treated like any ordinary shares of stock, and are taxed at the normal capital gains rate, whereas GLD is taxed as a collectible, that is, at 28%. Second, I became skeptical of the integrity of GLD in the summer of 2009 when David Einhorn elected to sell his GLD shares in lieu of physical gold. Why would one of the world's most well-respected money managers take on the burden of holding and storing physical gold when he could have the convenience of the highly liquid GLD? While this move doesn't prove anything, it certainly does not help the case for holding GLD. Sprott Inc., who manages PHYS, claims to have their gold holdings audited by an independent auditor. Furthermore, PHYS sells at roughly a 2.5% premium over its NAV, suggesting that investors are willing to pay extra for the perceived safety of PHYS.

One interesting fact to point out here is that there is a closed end fund--GTU--which has been around for significantly longer than PHYS--which also trades at a similar premium to gold. During the equity and commodity market meltdown during mid-late 2008, the premium investors were paying for shares of GTU exceeded 30%. I would recommend GTU as well as PHYS except that holders of PHYS are allowed to take delivery of their gold (400 ounce minimum).

Mining Shares

Buying gold mining shares can offer substantial leverage to the gold price. The HUI Gold Bugs Index bottomed in 2000 at 38 and currently trades at just under 400 today, while gold has "only" risen from about $275 to $1650 per ounce during the same time period. Mining shares can also pay dividends making the better companies suitable for retirees.

However, buying gold mining shares is not simply buying leveraged gold. Gold mining is like any other business: there are capital expenditures, political considerations, differences in the qualities of management teams…etc. There are also companies that are at various stages in developing their businesses. Some have diversified portfolios of producing mines in many countries, while some have only one producing mine, the failure of which would bankrupt the company. Still others are not yet producing gold and will need to raise capital to bring their projects to production, while still others are simply a team of entrepreneurs and geologists with land packages that may contain economically feasible mines (although most do not and will go bankrupt).

Consequently, like in any other sector, investors must carefully analyze each individual gold mining company. To illustrate this, consider the performance of Goldcorp (GG), which I recommend in this article, versus Harmony Gold Mining Co. (HMY). The former traded at under $3.00 per share in 2000 and is now trading well over $30.00 per share despite recent weakness. The latter has barely increased in price despite the six-fold increase in the price of gold. Goldcorp is extremely well managed, and has its mines in the Western Hemisphere in generally low-risk jurisdictions. HMY has had issues with costs and has its mines predominantly located in politically unstable South Africa.

Not only do management and location matter, but one must keep in mind that gold mining companies often have a lot of exposure to other metals such as copper, lead, silver, zinc…etc. Two of the worlds largest gold mining companies--Barrick Gold (ABX), and Newmont Mining (NEM), have significant exposure to copper. In fact, ABX bought Equinox Minerals, which primarily produced copper, back in 2011. Gold mining companies will often say something like: "We produced 100,000 ounces of gold at $800 per ounce with copper offsets." which really means that they produced 100,000 ounces of gold and for each ounce of gold they produced they produced 60 pounds of copper at $1,000 per combination of 1 ounce of gold and 60 pounds of copper. Furthermore,in describing a mine, they might say that they have 1 million "gold-equivalent" ounces of reserves, which includes their copper, silver, zinc…etc. priced in terms of gold.

With these considerations in mind, the shares of gold mining companies have fallen considerably from their highs in the past couple of years, and some (including those I discuss below) are cheaper than they were back in 2007, when gold prices were less than half of what they are today. Confirming this bearish sentiment is the fact that gold mining shares have been overly punished when they fail to perform. Take for example the case of Agnico Eagle Mines (AEM). AEM had to shut down their Goldex mine, losing less than 20% of production. While this is bad it is not catastrophic. Yet the market took shares from about $71 to $32 over the following months, during which time gold prices fell only slightly. This bearish sentiment and extreme investor behavior appears frightening, but it has lead to enormous opportunities.

I discuss two of these opportunities here that provide options on two opposite sides of the risk spectrum: Goldcorp , which I believe to be one of the safest gold mining companies, and Timberline Resource Corporation (TLR), which carries with it extremely high risk, but which also may prove to make fortunes for investors.

1 -- Goldcorp

Goldcorp is currently valued at $28 billion. They own or are a partner in 12 producing mines giving them almost 3 million ounces of annual production taking into account the commencement of their most recent project Pueblo Viejo, a joint venture with Barrick Gold of which they own 50%. They have extremely low costs of just $300 per ounce, which will cushion them from losses should gold prices correct further. They also have eight development projects which will bring their gold production to well over 4 million ounces by 2016. Their projects are primarily gold focused, although they do have some silver and copper, and to a lesser extent some lead and zinc.

Admittedly Goldcorp is not the cheapest gold miner among the other major producing companies. Although their share price is down to $34.00 per share from its 2011 high of $56.00, they have a higher P/E ratio, a higher price to sales ratio, a higher price to cash flow, and a lower dividend yield compared to many of their peers. However Goldcorp's management has demonstrated an ability to grow rapidly and consistently. Over the past 10 years or so Goldcorp has increased their revenue, cash flow, and profits over 20 times, while they have increased their stated book value over 10 times. They have been paying regular monthly dividends since 2004, and while the yield is currently small at about 1.7% they seem to be committed to raising their dividend annually in the post-financial crisis era. Since I first bought the stock in 2009 the annual dividend has increased from $0.18 annually to $0.60 annually taking into account their most recent 11% dividend increase in January.

Furthermore, Goldcorp's management has avoided operating in geopolitical hot spots and regions fraught with social unrest. All of their properties are in the Western Hemisphere; most of them are in Canada, the United States, and Mexico, all of which are considered to be good places to mine given their relative political stability.

Goldcorp is a solid growth company with limited downside risk that is committed to returning capital to shareholders. In an era of high volatility in asset prices--especially in fiat currencies--few investments can offer this sort of consistency, making GG a cornerstone of most portfolios and a must-own investment for retirement.

2 -- Timberline Resource Corp.

Timberline Resource Corp. is the polar opposite of Goldcorp as a risk/reward proposition. It is an enormously risky investment, but it can realistically provide investors with potentially life-changing returns, especially in an environment of rising gold prices.

TLR holds several properties in the northwest United States. Since their peak in August, 2007, TLR shares have tumbled from over $5.00 per share to under $0.20 per share, losing over 96% of their value. In terms of gold prices TLR shares have lost over 98% of their value over this time period. This means that TLR, after its recent secondary offering in December, has a fully diluted market capitalization of about $14.5 million.

Among junior mining equities TLR is unique. On the one hand, like many of its peers, TLR will not see cash flow from its flagship Lookout Mountain project for several years--probably not until 2017 at the earliest. However, unlike many of their peers, they will likely begin to see cash flow in the second half of 2013 from their small, yet not insignificant, joint venture property--Butte Highlands. The Butte Highlands project is a joint venture with Highland Mining, LLC. TLR will receive 20% of the proceeds from Butte Highlands until Highland Mining, LLC has recouped its initial investment. At that point, which should be before the end of 2014 given the $24 million price tag of developing the Butte Highlands project, TLR will receive 50% of the proceeds. If all goes well TLR will not have to dilute existing shareholders nearly as much as other junior mining companies, if any dilution is necessary at all.

Given that the risks one assumes in owning this stock are so high I will spell them out clearly before I discuss the enormous upside potential.

Risk

TLR shares the same risks that all gold mining companies are subject to: (1) stricter environmental regulations, (2) higher taxes, (3) higher energy and labor costs, and (4) share dilution.

The primary risk unique to TLR is that they may lose the aforementioned advantage they have over their peers. In their most recent 10-Q they claim that no feasibility study has been completed on the Butte Highlands project, and so there is a higher risk that the mine is not economically feasible. If we assume the worst case scenario--that the Butte Highlands project is abandoned due to excessive cash costs--then TLR loses their relative advantage over their peers, and investors can expect: (1) share dilution, (2) the assumption of debt, (3) a sale of part of its South Eureka property (on which lies the Lookout Mountain project) to a JV partner, or (4) any combination of the above. Despite this risk unique to TLR, the company is still a relatively good value at its current price given the merits of the Lookout Mountain project alone.

Reward

If, however, the Butte Highlands project is economically feasible, and if it is able to reach its potential as stated in TLR's most recent corporate presentation, then the project will produce approximately 50,000 ounces of gold per year. In this scenario TLR will control 50% of this production, or 25,000 ounces per year for 4-5 years. Given that there is no NI 43-101 filed for the Butte Highlands project, cash costs per ounce are difficult to predict. When I contacted the company asking them to shed light on what future cash costs might be, I was informed that they should be similar to other small underground mines, which is roughly $800 per ounce. If we assume conservatively that cash costs will be $1,000 per ounce, and that gold prices will be $1,500, TLR will have $12.5 million in cash flow annually (after Highland Mining, LLC recoups its initial investment) to fund: (1) the development and further exploration of its South Eureka projects (Lookout Mountain and Windfall), and (2) further exploration on its Snowstorm and Spencer properties.

The NI 43-101 for its Lookout Mountain project states that there are 390,000 ounces of gold measured and indicated, and 221,000 ounces of gold inferred. Conservatively assuming 500,000 ounces of gold produced at a rate of 50,000 ounces over 10 years, and $1000 of cash flow per ounce, the company is currently trading at less than one third of its future cash flow of $50 million annually from just its Lookout Mountain project. Furthermore, the Windfall project is projected to have 200,000 ounces of gold.

If TLR ends up trading at 5 times the annual cash flow from just its Lookout Mountain project then this stock can appreciate more than 1,500% to over $3.00 per share. This figure does not take into consideration the following realistic possibilities: (1) either one of TLR's exploration properties yields an economically feasible mine, (2) additional resources are discovered at its Butte Highlands and Lookout Mountain projects, (3) a NI 43-101 is released for the Windfall project revealing that it is economically feasible, (4) a larger appreciation in the price of gold than assumed, (5) a mania in gold mining shares that lifts prices to higher multiples of cash flow than the 5X assumed above. If any of these events occur, then the aforementioned $3.00 price target might end up being extremely conservative.

TLR is a high risk investment that is meant for extremely patient investors. There is a good possibility that they will lose most of their value, or that the above price projection is not reached. Nevertheless, if you are going to speculate in small gold miners, this is one of your better choices.

Source: Buying And Owning Gold Part 2: Specific Investments In Gold