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For traders hip to seasonal trends, buying precious metal miners during the summer months of July and August and holding until early in the next year is a trade that has historically had a very high ratio of success.

If you are seeking out potential mining plays to ride while the seasonal winds are at your back, I suggest you consider looking East.

Today, I will present 2 China precious metal mining plays to consider for a seasonal swing trade and 2 that are probably best to avoid. But first, let’s take a look at why buying precious metal miners with operations in China makes sense from a macro standpoint.

An Inflationary Environment

Last week (7/11/2011) it was announced that inflation in China had risen to 6.4 percent in June, a three year high. China Premier Wen Jiabao subsequently declared tackling inflation the Chinese government’s top policy priority.

Precious Metals are the “anti-inflation” and the Chinese government knows this. Unlike intrinsically worthless paper, gold and silver are limited in supply, useful, and fungible. They represent the ultimate form of protection against those pesky extra strokes at the federal reserve money-printing keyboard. While China has effectively won the fiat currency hording game with it's gargantuan $3 trillion in dollar reserves, it is still severely lagging in the gold reserve game. With only 1054 tonnes of Gold in its reserve as of its most recent reporting, representing 1.7% of its forex reserves, China is well behind France, Italy, and Germany and abysmally behind the United States by a factor of more than 8. Li Yinling, a prominent professor at Peking University and government official, publicly stated the obvious in March, that China needs more gold. With a bullish demand fundamental that may take decades to play out, China mining plays may hold an extra advantage over miners in other regions.

With a favorable geography and plentiful low-cost labor, cash-costs per ounce in China are often significantly lower than average. The concerns with China as a mining jurisdiction have always stemmed from outsiders attempting to open a mine in China finding themselves stuck in a lengthy, bureaucratic process involving co-operation with state-owned agencies. However, with entry into the “in crowd” being exclusive, companies that have found a way through these hoops find themselves with far less competition to compete with for resources and exploration targets.

Going from the big picture back to the immediate, let's now take a look at which Mining companies with operations in China are best positioned to outperform over the next 6 months.

RECOMMENDED

El Dorado Gold (EGO)

With a 9.73 billion dollar market cap, El Dorado Gold is the premier US-traded gold miner with a foothold in China. With El-Dorado Gold you get China exposure, scale, growth, and the wisdom of an experienced Canadian management team. El Dorado currently has 3 of its 6 primary mines in China with the other 3 being in Turkey, Brazil, and Greece. Its current combined cash cost is below industry average at just over $400 per ounce and it is looking to increase production to 770,000 this year and 1.5 million ounces by 2015 while reducing the cash cost to under $400 per ounce. With Gold nearing 1600, this puts El Dorado in a great position to reap profits near-term

El Dorado has consistently been expanding margins and looks to be ramping up at the ideal time to fully take advantage of high gold-prices. 46% of El Dorado’s 2011 $54 million exploration budget is delegated for China, giving it plenty of exposure and leverage to the region.

While possibly slightly overbought in the near-term, we would be looking to buy El Dorado Gold on a pullback to hold through Gold’s strong season.

SilverCorp (SVM)

SilverCorp is the largest China-based Silver producer with a current production profile of 6.2 million ounces per year. What makes SilverCorp unique is its industry-leading negative cash cost of $7.61 per ounce as a result of its base metal byproducts. Silvercorp is so efficient that its gross profit margin actually exceeds that of Silver Wheaton (SLW), a silver-streaming royalty company. (75% vs 67% based on SVM's 2011 fiscal year)

While production of 6.2 million ounces of silver per year is relatively low output compared with peers of similar valuation such as Hecla (HL) and First Majestic Silver (AG), I am a fan of the industry-leading margin, 206 million in cash reserves, and recent expansion in resources. In addition, SilverCorp has announced an aggressive stock buyback program and will be growing production to over 10 million ounces by 2014.

SilverCorp tends to trade in a volatile fashion with a high beta to peers. This makes for an ideal candidate for a seasonal swing trade.

BEST TO AVOID

China Gold International (JINFF.PK)

China Gold International is a China-based gold mining play with a ~1.58 billion market cap. For the past three years, China Gold has been steadily increasing production at its flagship CSH mine and is on track to produce approximately 120,000 ounces of Gold in 2011.

As an entity that is 40% controlled by state-owned China National Gold, China Gold's recent actions appear questionable when it comes to adding shareholder value. These include:

  • Choosing to focus a high proportion of growth efforts in Copper as opposed to Gold
  • Expanding exploration into Africa, defeating the purpose of a pure China Gold play and adding exposure to a politically unstable region.
  • Not pursuing a listing on a respected American Exchange, and thus making itself unavailable to several institutional market participants

While China Gold International may end up working out a multi-year investment, we do not recommend the company for a seasonal swing trade.

Minco Gold (MGH)

Minco Gold is an exploration-stage company engaged in the exploration of gold properties throughout China. Along with more than a dozen early stage properties, Minco Gold’s most prominent holding is its 13 million share holding of sister-company, Minco Silver. At a market cap of less than 100 million, Minco Gold appears at first glance to be a steal.

However, I do not recommend Minco Gold as a seasonal swing trade for the following reasons

  • Construction for Minco Silver's Fuwan mining project is now over a year behind schedule (per Minco's 2009 investor presentation) and with a 20-24 month construction period, both Minco Gold and Silver are years away from any significant cash flow or profitability
  • Minco Silver has a history of private placements at unusually large discounts to the market price. On Sept 24, 2009, Minco Silver announced a private placement of $20 million Canadian at 1.70 per unit. On this same day Minco Silver was trading at 2.14 (more than a 20% discount).
  • Minco Gold and Silver have a history of questionable management decisions, including lending money to a nearly bankrupt Sterling Mining, trying to leverage their creditor status in foreclosure to acquire the Sunshine Mine from Sterling, and then failing to acquire the mine in a court ordered auction by being outbid by a private consortium “Silver Opportunity Partners."
  • I believe that given that construction has not even started on the Minco Silver mine, and with a ~2 year construction timeline, Minco Silver is a high risk for further dilution, reducing the percentage of Minco Gold's stake.

SEASONAL TRADING CONSIDERATIONS

Considerations for what makes for a high quality seasonal mining trade may be different than those for a long-term investment. For a successful seasonal precious metals mining swing trade, I always look for:

  • A highly liquid equity that is traded by institutions and has shown strength among peers, but is off its 2011 highs, leaving plenty of upside for the strong season
  • Equities with actively producing mines that will likely exceed earnings estimates that were based on more conservative gold and silver price projections
  • A strong growth profile with an aggressive ramp up in production under way
  • Healthy margins and low cash cost per ounce for downside protection

Until next time, happy trails navigating the Wild East.

Disclosure: I am long SVM.

Source: 2 China Precious Metals Mining Plays to Consider; 2 to Avoid