Maximize Your Gold Exposure: Buy Junior Miners That Trade Like Mispriced Call Options

Jul.29.14 | About: Allied Nevada (ANV)

Summary

Gold mining stocks have fallen precipitously over the past couple of years, and with good reason: many projects are uneconomical at $1,300/oz. gold.

For gold bulls, this has generated incredible opportunities in undervalued miners, which are trading like mis-priced out of the money call options on gold.

Gold bulls are encouraged to exploit these opportunities: buy companies with cheap gold in the ground with minimal additional risks for dirt cheap optionality to the gold price.

If you're like me then you believe that gold price is going to rise substantially over the next several years. I go into the details in a previous article so I won't delve too deeply here, but some of the basic fundamental drivers include:

  • A massive increase in the money supply that will at some point lead to a massive decline in the purchasing power of the dollar.
  • A decline in the importance of the USD in international trade which will further weaken the dollar's value.
  • An influx of demand coming from central banks that have until recently eschewed gold in lieu of USDs and related assets (i.e. Treasuries).
  • An influx of demand from citizens in countries with burgeoning middle classes (e.g. China, India).
  • A potential short squeeze coming from central banks and bullion banks, as they scramble to buy back massive amounts of gold that they have leased and pushed into the market over the past 20 years (an issue I discuss in depth here).

There are a myriad of ways that investors can profit from the coming rise in gold prices, although one that I find particularly compelling is highly leveraged mining stocks.

How do mining companies leverage the gold price?

If you were to simply buy gold and the price rises 10% then your gain is 10% (excluding fees, taxes... etc.). But suppose the cost of mining gold is half the price of gold. If the gold price rises 10% but production costs remain the same, then the mining company in question will see a 20% gain in profits.

Higher cost producers offer more leverage. Furthermore, companies that aren't in production and that have pre-production costs (e.g. mine construction, permitting, resource analysis) can offer substantial leverage in that the market will value their stocks as a percentage of their projects' NPVs. So, for instance, a company that owns a mine that requires $200 million in pre production costs and that will generate $50 million/year at current gold prices, might double or triple in value if the gold price rises to the point that the mine can generate $60 million or $70 million per year, with the specifics dependent upon how long the mine will produce for and the discount rate used to value future cash-flow.

Strategy - Treating Gold Mining Shares As Call Options

With this principle in mind, investors who are bullish of gold are encouraged to find companies that can maximize this leverage while minimizing risk.

With respect to the former, your strategy should be to calculate the value of a particular company's assets at a substantially higher gold price - say $2,500/oz. - and compare their value to the current market capitalization of the company.

A large differential can mean big upside potential. But keep in mind that the best opportunities are going to be found in companies that own mines that aren't economical, or are barely economical at the current gold price, and in fact this is likely the reason that their stocks are so inexpensive in this market environment.

With this in mind, you should be acutely aware of the fact that you are treating these gold miners as options, and you should incorporate them into your portfolio strategy as such (i.e. you should take small positions, use limit orders, and develop an exit strategy; you should also only play with money that you can afford to lose).

With respect to the latter, you need to keep in mind that your goal is to leverage your gold exposure. With this in mind, you want to mitigate other risks. Two in particular include permitting and political risk. There are many companies with great deposits located in areas that make it very difficult for these deposits to move into production, and you may find incredible leverage opportunities among them. Now these may be risks worth taking, but they require further evaluation beyond the scope of what I lay out here.

In general, you should look for the following:

  • The project should be in a low risk jurisdiction. It is in a place such as Canada, Mexico, Scandinavia, Australia... etc. It should also not be located in the middle of nowhere given the risk that infrastructure costs in these regions will exceed expectations.
  • Look for companies that are inexpensive relative to the amount of resources they own. In this market, it isn't too difficult to find companies that trade at $5 - $10 per ounce of gold in the ground. At $2,500/oz. gold, they could easily be worth $50 - $100 per ounce of gold in the ground or more.
  • Look for pure gold miners. A lot of gold deposits contain a lot of copper. This may be fine if you are bullish of copper, but this copper exposure can seriously dampen the gold leverage that I am interested in. Copper exposure isn't something to avoid necessarily, but it is something to be aware of.

Some Examples

Given the recent weakness we've seen in the gold market there are plenty of opportunities that fit the above criteria. Here are two that I find interesting.

1--Allied Nevada Gold (ANV)

Allied Nevada's Hycroft Mine in Nevada contains one of the biggest gold deposits in the world with 45 million ounces of gold equivalents (gold and silver). Furthermore, the company is valued at just $340 million, making it worth just $7.50/oz. of gold.

The mine is currently in production and it is about to undergo an expansion assuming the market allows this. Right now the mine is breaking even given the company's large financing obligations. If the gold price moves higher to, say, $2,000/oz, the mine can generate nearly $200 million in annual cash-flow, and at 10-times cash-flow the company would be worth $2 billion (a 500% increase). It gets even better if we price in the expansion.

Of course, given the company's financing needs ($1.8 billion for the mine expansion) and its $570 million in debt outstanding, this is a high risk investment, and if the gold price falls Allied Nevada will lose money and have trouble meeting its obligations.

Allied Nevada's Hycroft Project meets the above criteria that I put forth for a gold miner to buy for gold optionality. It is located in a good location (Nevada). It is cheap relative to the number of ounces of gold it has ($7.5/oz.). It has some silver exposure, but at current prices more than 90% of revenues come from gold.

Finally, the company has the added benefit of generating current revenue, and it can feasibly generate cash-flow at a higher gold price, especially if it can continue to pay down its debt. One red flag is that it needs $1.8 billion to expand the project, and there have been rumors that management is looking to sell part of the mine, which would eliminate a significant amount of the optionality that makes the shares so appealing.

2--Chesapeake Gold (OTCQX:CHPGF)

Chesapeake Gold owns the Metates Project in Mexico. It has the potential to produce over 1 million ounces of gold per year for 15 years once in production. It has 18 million ounces of gold reserves and another 9 million or so in equivalents in the form of silver. With a market capitalization of just $160 million, its valuation is around $6/oz, and this doesn't take the company's $35 million cash position into consideration.

Given the massive amount of gold that Chesapeake Gold can produce, it should come as no surprise that its valuation can skyrocket if the gold price rises. For instance, the project can generate over $800 million in cash-flow at $2,000/oz. gold, although we have to keep in mind that the project will cost more than $4 billion to build. Nevertheless, as the gold price rises, the odds rise that management can secure financing. Furthermore, as the gold price rises, Chesapeake Gold shares will rise in value as well, which would make dilution less punitive. So right now the company's gold is valued at about 0.4% of the gold price. At $2,000/oz. gold or higher, it is conceivable that this figure can rise to 2% - 5%, or even higher.

With this in mind, we see that the leverage opportunity is enormous. Furthermore, it meets my above criteria. It is located in Mexico, which is a low-risk mining jurisdiction. It is cheap on a price to gold-in-the-ground basis. Finally, while the mine contains some silver and silver often trades with gold, and if you are bullish of gold you are probably bullish of silver.

With this in mind I think Chesapeake Gold is an excellent gold option proxy.

Conclusion

There are a myriad of other companies in this market that have this optionality appeal, and if you are bullish of gold you should hunt them down and incorporate them into your portfolio to a small extent.

To summarize what you are looking for:

  • Look for companies that have projects that can multiply in value as the gold price rises.
  • Look for companies that minimize the various other risks that come with mining, especially permitting and political risk.
  • Look for companies that are cheap relative to the number of ounces of gold they have in the ground.

To summarize your strategy:

  • Bet small in the same way you would when buying any other out of the money calls. Only bet with money you can afford to lose.
  • Have an exit plan. Your math may tell you that you can make thousands of percent on a position, but that doesn't mean you should hold it until then.

If you follow these guidelines you should do very well. There are a lot of dirt cheap "gold options" in the market that offer asymmetric risk/reward, and now is the time to take advantage.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in ANV, CHPGF over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.