Back in February, I wrote an in depth guide to precious metals investing in which I gave reasons for owning precious metals and some mining stock selections. I was, however, somewhat vague in my portfolio strategy with respect to investing in mining stocks and basically just gave investors a laundry list of stocks to buy and classified them into essentially large and small companies.
Looking back this is a rather unsophisticated approach and I've since realized that I should put forth a portfolio strategy for mining investors to follow. What I've come up with is a diversification across four different kinds of mining companies that should be represented in your portfolio. While the proportions should vary according to your risk tolerance each kind of company has something to offer every portfolio. They are:
- Royalty/Streaming Companies
- Optionality Plays
- Project Development Plays
- Growth and Cash-Flow Focused Companies
While these companies are all in or near to the mining space they have very different functions in your portfolio. Let's go through them one by one.
Royalty and streaming companies (just "royalty companies" hereon) stand out above the rest of the sector because they have performed astonishingly well. The leader of the pack is probably Royal Gold (NASDAQ:RGLD), which has gained nearly 40-fold in value since the turn of the century. The other major players such as Franco Nevada (NYSE:FNV) and Silver Wheaton (NYSE:SLW) don't have the longevity to make a comparison, but since they began trading they have outperformed the prices of the underlying metals and pretty much every major global stock market.
I won't go too much into royalty companies here because I have written about them in depth. The basic idea of a royalty company is that it is a bank for a mining company. The royalty company makes an upfront payment to a mining company for a royalty or a stream on a mine, a part of a mine, or even a group of mines. There are many kinds of royalties but the most common is the net smelter return royalty, which basically means that the royalty company will get the value of the metal produced minus the smelting cost, which is usually about 1% of the metal's value. A stream gives the company the right to buy a certain amount of metal from the mining company at an agreed upon price.
While each agreement is different they are similar in that the royalty company winds up with a cash-flow stream that is correlated to the price of the underlying asset. The fundamental appeal of a royalty company relative to a mining company is that its costs are essentially fixed. For instance if a stream entitles the company to buy 5% of a mining company's silver production at $4/oz. then it doesn't matter what the price of silver is or what the cost to the mining company is, the streaming company pays $4/oz.
This certainty is extremely valuable, and in essence it makes royalty companies akin to gold and silver bond funds. From a quantitative standpoint, because we are more certain of the company's future costs we can discount future cash flow at a much slower pace than we would a mining company, which has fluctuating costs.
Royalty companies are essential to a precious metals portfolio given their profitability through virtually any market environment and their strong, consistent cash flow. The big three royalty companies also pay dividends, although they are more symbolic than substantive.
That's the good news. The bad news is that the royalty companies have already been discovered by the market, and they aren't cheap. For instance I recommended Royal Gold at the beginning of the year at $46/share, and it now trades at nearly $80/share while the gold price is less than 10% higher.
The strategy, then, is to buy these companies' stocks on weakness. The only one of the major three right now that is even close to offering relatively good value is Silver Wheaton. Silver Wheaton is the largest of the royalty companies, and it is the only one that focuses exclusively on streaming deals. It is probably worth about 15% - 20% less than the current price of $27/share on a DCF basis.
Investors may also wish to look under the radar. Osisko Gold Royalties (OTC:OKSKF) is a relatively new royalty company with a 5% net smelter return royalty on the Canadian Malartic Mine owned by Yamana Gold (NYSE:AUY) and Agnico Eagle Mines (NYSE:AEM). It is overvalued relative to the value of this royalty when it is evaluated conservatively, but the company is also exploring its massive Guerrero land package in Mexico, and the Canadian Malartic Royalty could be worth more than my conservative estimate if the mine life is extended.
Ultimately, however, while these companies are technically overvalued their managements have essentially all been successful at making prescient investments in big projects early on, and I expect that these teams will continue to grow attributable production on a fairly regular basis, which means that DCF analysis may be an inappropriate way to value them.
Again I won't go too deep into this because I have covered the topic in a previous article. With optionality plays your goal is to buy gold or silver in the ground at a dirt cheap price in a quality mining jurisdiction. What you're looking for are companies with projects that aren't so attractive in the current market environment, but which become enormously attractive at higher metal prices. The goal, essentially, is to find mining companies that are similar to out of the money call options. Here are just a couple of examples:
- Chesapeake Gold (OTCPK:CHPGF): This company owns the Metates Project that contains over 25 million ounces of gold equivalents, but because the project is so expensive to develop you're buying the gold/gold equivalents for about $6/oz., or less than 0.5% of the gold price. As the gold price rises the project's value will climb exponentially and so will the value that the market gives this gold in the ground.
- Silver Bull Resources (NYSEMKT:SVBL): This company owns the Sierra Mojada Project in Mexico and it contains 160 million ounces of silver and over 200 million ounces of silver equivalents. With its $40 million valuation you're paying less than $0.20 per silver equivalent ounce in the ground. The project is unappealing now but if the silver price rises the project's value jumps exponentially.
The list goes on and there are even variations on this principle. For instance Silver Standard Resources (NASDAQ:SSRI) and Allied Nevada Gold (NYSEMKT:ANV) are producing companies that cannot tap most of their resources economically at current prices. At higher prices their values rise exponentially. The point is that you aren't so much interested in cash flow, growth or project development. You are looking for a substantial resource that is assigned virtually no value because it has no value in today's market but which has incredible value in a higher metal price environment.
This is the riskiest of the four categories, and it is the one that is going to frustrate the most if metal prices remain depressed. Keep this in mind when you are allocating your assets to this part of your precious metals mining portfolio. For most of you reading this, this class of miners should probably make up the smallest amount of your portfolio.
Project Development Plays
This is the trading part of your portfolio. What you are looking for are companies that have a project at some point in its development and it is preparing to move to a point of further development. Your goal is to hold the stock as the development takes place after determining that it is going to generate value, or at least has a relatively high probability of doing so. You sell shortly after the development (you want to sell after the late-comers start to pile in) or when your price target is reached.
The most typical of these is going to be the development of a mine. Take Asanko Gold (NYSEMKT:AKG) as an example. The company just made the decision to go ahead and construct its Asanko Gold Mine in Ghana. It should reach production in about a year and change. When it does I expect that the shares will trade for at least the project's NPV at an 8% discount rate at whatever the gold price is at the time, so if it is $1,250/oz. this figure is $585 million (according to my January calculation). This is my upside target, although given that the company has a line of credit and more than enough cash on hand this target could easily be higher. Right now the company is valued at $423 million, and so the stock has upside of about 40% at $1,250/oz. gold. Naturally I will adjust my target with the gold price. If it hits my target before production starts then I will reevaluate and consider selling. Finally if something interferes with the thesis I will have to reevaluate. Something to this effect has happened with Asanko Gold, which recently found a new deposit that will likely increase the value of the mine, and when this data is released I will reevaluate my target.
Generally these sorts of plays are shorter term and investors need to take this into consideration. This means that you need to take a trading mentality. It also means that you need to be less concerned about where you think the gold price is going and more concerned about where it actually is, and then shave a few dollars off. Since I am bullish longer term I am hoping that the gold price rises in the year that I plan on holding Asanko Gold because this raises my valuation estimate of the company, but my general goal here is to benefit from some sort of accretive activity.
This is in stark opposition to the optionality stocks. For those I want a rising gold price to increase the value of the deposit, and I am not really interested in management's value creation plans.
Growth and Cash-Flow Focused Companies
With these sorts of investments I am less concerned about how much metal the company has in the ground or what the values of the company's mines are relative to the market capitalization of the company. Here I am concerned with the following:
- Is the company cheap on a price to cash-flow basis?
- Is the company growing its resources on a regular basis?
- Is management obsessive about containing costs?
There aren't too many companies that are like this, although there are companies that certainly try. Fortuna Silver (NYSE:FSM) is like this. Management is doing an excellent job of growing resources and production, but it isn't cheap on a price to cash-flow basis and management hasn't really been containing costs ($17/oz of silver mined before taxes).
Looking at the companies on my radar there is only one that has been successful, and that is Mandalay Resources (OTC:MNDJF). Mandalay Resources is trading at just 12 times earnings and yet it is growing production and resources at its two producing mines. It just bought a third mine--Bjorkdal in Sweden--that will help the company grow assuming that management can bring costs down (and why else would they have bought it). Furthermore it bought a deposit in Chile from Silver Standard last year and it is rapidly analyzing it in order to bring it into production by 2017.
Despite the fact that metal prices are down recently this stock is within 15% of its all time high. It is up over 500% in the past 10 years or so, and it pays a dividend that is correlated to its sales.
The one red flag is that the company doesn't have a lot of resources and it is expensive on a price to DCF basis unless you assume that the company's resources will not run out (all of its mines' lives are 6 years or less based on current reserves).
Honorable mention here should be given to GoGold Resources (OTC:GLGDF), which got its Parral Tailings Project in Mexico into production on time and on a budget of just $35 million. It also bought the San Gertrudis Project late last year and is rapidly developing that historically producing mine. That project should also be a low cost producer with low initial capex. The company also has a huge early stage exploration project called San Diego that has enormous potential. The problem is that this stock is simply too expensive with a valuation of nearly $200 million and only one project with discounted cash-flow worth less than $100 million. I think eventually this will be a strong buy once again (I recommended it in December at just under $1/share and it now trades at $1.40/share) but I would hold back for the time being.
Each of the kinds of companies I mention here generates value in a different fashion. Two are cash-flow focused and the other two are catalyst driven (gold price appreciation or project development). Depending on your style of investing you can favor one or two of these styles over another, but in general I think investors who are serious about owning gold miners need to own something from each category. If you do you will own companies that are able to withstand a stagnant gold price while owning others that offer substantial leverage.
Most importantly if you diversify in this manner you can rebalance should the market go one way or another. If the gold price soars and favors optionality plays you can take profits here and re-allocate them into a company that just issued a lot of stock in order to build a mine in hopes that as production nears the stock's value will rise even if the gold price doesn't. If the gold price falls the royalty companies and your Mandalays will outperform and give you dry powder to load up on the collapsing optionality plays that will be the winners on the upside.
More aggressive investors and especially those who are particularly bullish of gold and silver will want to overweight the optionality plays. If you are more conservative then you will want to overweight growth and cash-flow focused companies such as Mandalay. Even if you aren't especially bullish of gold but want some exposure as a "hedge" against calamity or whatever else you can do very well in royalty companies: for instance Franco Nevada is near an all-time high even though gold is not (although I think the stock is overvalued)
Disclosure: The author is long MNDJF, SSRI, AKG, SVBL, RGLD, SLW. 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.
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