In the following I'll try to lay out the case for why I'm long the gold and silver sector in general, and Gold Resource Corp. (GORO) in particular. I'll begin by outlining my positive medium-term outlook for the metals and then turn to some specifics that might allow GORO to outperform in a rising market.
Gold and Silver Sector
Since part of my argument relates to historical trading patterns, let me begin this with a confession of sorts: I started my trading life as a gold bug. As far back as the Compuserve forums (for anyone old enough to remember those) when stocks like Arizona Star Resources and Bre-X were huge movers, I was trading gold and silver stocks; convinced that they were the ultimate protection against inflation and monetary debasement.
And indeed, over the long term, gold and silver have performed well, as the twenty-year charts below illustrate.
Gold chart source.
(click to enlarge)
Silver chart source.
But just because precious metals prices have generally risen, doesn't mean that investing in miners has been easy or foolproof. The next figure is a 25-year chart of the XAU (which is a "capitalization-weighted index composed of companies involved in the gold or silver mining industry").
XAU chart source.
If metal prices are up by a factor of 3 or 4 over the time frame in question, one might wonder: why do miners, which are leveraged to the price of gold/silver at any point in time, not have gains at multiples of the metals themselves? (Miners are leveraged because mining costs are relatively fixed, so if the total cost to mine an ounce of gold is say $1,000, then at a gold price of $1,200 the profits are $200, but if the price of gold rises 20% to $1,440, profits go up by more than 100% to $440.)
The answer is threefold. First, the leverage is based on a static analysis, but in reality companies and markets are never static. For example, as metal prices go up, it becomes economical to develop higher cost mines, such that the overall profitability of the mining sector over the long term reverts back to the mean. But this supply adjustment takes years, so there can be - and are - huge swings in profitability over the short term, i.e. whenever metal prices move sharply, but the leverage to metal prices doesn't persist over time.
Second there are problems specific to the sector itself. One is often labeled "political risk," but I think it has more to do with the fact that ore bodies are immovable, so if a company finds and proves one up, it becomes a target to anyone in power seeking free handouts, often labeled "windfall" taxes and royalties. (See my favorite book, Atlas Shrugged for a penetrating analysis of this phenomenon.)
Third there have been two significant events that have marked the sector, the biggest being the massive fraud at Bre-X. As one scholarly paper summarizes:
During the spring of 1997, Bre-X's failure destroyed nearly 6 billion Canadian dollars in paper wealth. However, the losses incurred by Bre-X shareholders proved to be just the tip of the iceberg. Our event study suggests that the Bre-X scandal triggered a collapse in confidence in the whole mining sector, with smaller, exploration-type companies being hit particularly badly. Perceptions, and sector valuations, plummeted almost overnight and financing possibilities dried up in the wake of the Bre-X fraud. The collapse of the junior mining stocks serves as a reminder that a whole sector can be brought down by a single, precipitating event.
The gold/silver market also collapsed in 2008, but it was part of a global meltdown in many asset classes, so wasn't as noticeable on a relative scale.
2009 marked a new bull phase in the gold market, with many people blindly following guru's such as John Paulson and Eric Sprott. This rush to follow, in my opinion, set up a host of weak hands who propped the sector to 25-year highs but were unaware of the risks they were taking. So when the sector began to reverse, the move was exaggerated. See the following one-year charts for a graphical depiction of the fallout.
Now the fact that metal prices and the miners have plunged is not in itself a reason to be bullish. Prices could continue to fall. But several factors suggest a bounce may be forthcoming.
As the price of gold and silver fall below the cost of production, the marginal producers begin to drop out. The process is slow however, since there are costs to shuttering a mine, thus producers tend to wait to see if metal prices will rebound. Only when they're convinced that a new price level has been established do they typically bite the bullet and shut down production. Despite a year long drop in prices, we're only now starting to see this process unfold. As evidence consider:
A June 28 CNBC report:
"What I believe is that the official costs, the costs in reality, are significantly higher than $1,000. So we've had quite a few gold mines close in Australia," Su said on Friday. "We've had some companies actually go bust and we've also got significant job cuts by big miners like Newcrest, Barrick, and Silver Lake Resources."
And a June 21 press release:
Golden Minerals Company (NYSE MKT: AUMN); (AUM.TO) ("Golden Minerals" or "the Company") announced that it has suspended operations at its Velardena mine as of June 21, 2013, in order to conserve the asset until operating plans and prices for silver and gold indicate a sustainable cash margin for operations. The employees at the Velardena mine were informed of the Company's decision in the afternoon of June 21, 2013. In February 2013 the Company anticipated the Velardena operations would achieve operating cash neutrality during the third quarter 2013, assuming gold and silver prices of $1,600 per ounce and $30 per ounce, respectively. In May 2013 the Company projected a $5 million negative margin from the operations for the remaining three quarters of 2013 at prices of $1,500 gold and $25 silver. Metals prices have continued to decline and remain below these levels.
Some recent reports suggest that insider buying in the sector is strong:
"TGR: Did you notice a significant change in insider buying or selling in the gold sector when gold had that significant selloff in April?
TD: Absolutely. When gold sold off in April, our indicator for the gold group jumped substantially. It got as high as 10:1, meaning 10 gold companies had key insider buying for every one that was selling. That is an astronomically high level of buying. We had another test of that in early June when we saw renewed weakness in the gold stock indices and the gold price. Buying picked up. Insiders seem to be suggesting that they are very interested as the S&P/TSX Gold Composite Index toys with the 1,500 level."
In the whole time I've followed the gold sector, I've never seen sentiment as weak as it's been this year (getting worse as the year has gone on). This is borne out by many sentiment indicators, e.g. the Gold Miners Bullish Percent Index:
Bullish Percent Index source.
On a more personal / anecdotal level (but one which I weigh heavily), all the gold boards I follow are dead (and these typically are populated by the most vociferous people). In the past, even when the price of gold has moved against them, the boards have been active, discussing how the downdraft is surely a short-term move due to "manipulation by the powers that be." Yet now, crickets. Similarly, nobody believes any market bounces.
Put all these factors together and we have what I consider decent odds for a medium term (6 to 12 month) bounce in the metals and miners.
To play this, I've bought the following ETFs in varying amounts: iShares Silver (SLV), SPDR Gold (GLD), Market Vectors Gold Miners (GDX) and Market Vectors Junior Gold Miners (GDXJ). But I've also decided to put a small percentage of my silver/gold bet into a much more speculative individual name:
Gold Resource Corp.
(Update, over the weekend the company sadly announced a fatality at its underground mine, so it's best to watch the stock for a week or two to see how much it falls as a result. Depending on how it reacts, there might be much better buying points in the near future.)
GORO is a silver/gold mine with one producing property, the El Aguila Project. It also has several exploration properties, but I'm going to ignore those in what follows (consider it a bonus if any of them pan out). Here's a quick yahoo finance summary of the company to help everyone get situated (ratios with the stock trading at $8.15).
Now, though I'm long the stock, I don't want to sugarcoat anything here; my reasons for choosing GORO as a speculative name is because I believe that, while the company has some flaws, the market has overreacted to them. So in presenting my case I may seem less gushingly supportive than other bull cases you may read.
Indeed, I was first introduced to GORO through a short seller's report, and for a few years I was short (trading it on the short side from high 20's to mid teens). But at a stock price of $8 and some operating history, I think the short story is largely played out, and in my experience, such stocks often bounce substantially.
Let's then briefly review some of the original short criticisms (since short-sellers often do the best research, their arguments should always be considered).
We can dismiss a few criticisms as inappropriate or irrelevant: the comparisons to senior producers and the idea that GORO isn't a pure gold producer. But what about heavy insider sales? While it might have been true at some point, here's the recent insider transaction summary:
Next there's the question of production. The figure below shows the historical quarterly sales of concentrate. This doesn't prove that they will produce in the future, but it, together with the data on the various veins on the property plus the on-going mill expansion, dispel the short argument as it was put forth.
Two red flags remain however. They are, in ascending order of concern:
- The company claims that there have been two storms, which have materially affected production; a claim, which seems to stretch credibility.
- Some of the insiders are related (the Reids)
These are significant potential warning signs, and for the conservative investor, reason enough to avoid the stock. I however have taken a small speculative position, as the risks seem to be priced in. Moreover, the fact that the company has paid a monthly dividend for a few years now suggests to me that it is legitimate and has shareholders' interests at heart.
Finally, let's take up the biggest criticism leveled at the company: it has no "proven or probable reserves." This is no trivial matter. After the Bre-X fraud, there was a big push to make the process of establishing such reserves more rigorous and independent, in order to protect investors. Moreover, there are other benefits to firmly establishing reserves. When companies delineate ore bodies ahead of time, they can develop the best plan to exploit the resource (where best means highest NPV over the entire mine life). Without knowing what you have, it's impossible to optimize throughputs, mining plan (i.e. in which order to mine the ore), etc. This is particularly true of distributed massive oxide and sulphide deposits.
Gaining such knowledge however isn't without cost. It means doing a lot of the work - and spending a lot of money - before there are any revenues to show for it. Yet on an NPV basis, it's still probably the best way to proceed, assuming one can procure the capital necessary. As I noted above however, one of the sector specific risks is that as soon as a company proves up a resource, vultures descend to get an unearned piece of it.
In such an environment, GORO's weakness may actually be a strength. (This is particularly true because its mineralogy is of a vein type, not the more common distributed resource.) It has acquired enough information to plan a few years ahead, but it doesn't trumpet its reserves, nor does it need years of preparatory downtime or capital expenditures necessary to enact a maximized mining operation. Cash flow from operations funds the program; indeed the process has historically allowed the company to return a third of its cash flow to shareholders. Finally, not having so much time and capital invested makes the company more flexible, and therefore better able to adjust to changing gold prices.
Moreover, while it may not have SEC sanctioned proven and probable reserves, the company does have an independent resource report, and has on-going drilling by which it is adding future mineable targets. (For a graphical summary, see pages 15 to 28 of their corporate presentation.) The pattern of development is one shown by the discovery of a parallel vein structure called "Splay 5."
From an earlier drilling press release we learned:
"The step-out drilling that discovered and continues to define Splay 5 speaks to the growth potential of the Arista deposit and epithermal vein system," stated Gold Resource Corporation's President, Mr. Jason Reid. "Continued drilling is defining more vein swarms and as we connect the intercepts we are optimistic many of these splays, like splay 5, will grow and become viable ore shoots from which to mine from. Splay 5 is one of several new splays discovered at the Arista deposit which are expected to add substantial ounces to our El Aguila Project's production and mine life. We have always felt there were significant additional ounces yet to be discovered at Arista and we believe these splays move us in that direction."
Then in a subsequent release, the company announced that it "has preliminarily targeted Splay 5 to begin to contribute to production during the third or fourth quarter of 2013."
Thus the lack of a typical set of proven and probable reserves is not a concern in this case. Indeed, given that it allows more flexible mining with smaller time and capital commitments, as well as potentially deflecting calls for new "windfall" taxes, I argue that it's a positive in this situation.
- Recently a big holder of the stock, Hochschild Mining Holdings, sold 3.4 million shares of stock. I stand to be corrected, but at the moment I take this as a statement about the sector in general and the difficulty in raising capital, not anything specific about the company. As such I view the sales as a buying opportunity.
- In making my case, I noted that GORO's dividend policy was an indication of its legitimacy, helping to dispel arguments about it being a "Ponzi" scheme. However, if metal prices remain in the doldrums, it wouldn't surprise me to see the dividends cut, at least temporarily. Given that many shorts make this same point, I think such an eventuality is already baked in to the stock price.
It's my opinion that the gold/silver market is due for at least a medium term bounce. Several ETFs are available to play this and I have availed myself of these. But there's also a more speculative way to participate, viz. to buy Gold Resource Corp. on the idea that the criticisms leveled against the company have played out and been more or less diffused. Historically, companies, which have been beaten down by short-sellers, often bounce significantly in such situations.
(Update, over the weekend GORO sadly announced a fatality at its underground mine. So while it makes sense to look at the ETFs immediately, it's probably best to watch the stock for a week or two to see how much it falls as a result.)