I'm looking at investing in a couple of junior gold miners to augment my gold miner portfolio. When I make an investment I perform a top-down, bottom-up approach. I ask the following three questions:
1) Is the industry a good industry to invest in?
2) Is the company within this industry a good investment?
3) Is the company’s stock fairly valued or undervalued?
Is the Industry A Good Industry To Invest In?
To summarize, yes I believe the gold mining industry is a good industry to invest in. Gold is in a secular 10 year bull market and has recently pulled back slightly. Central banks continue to maintain low interest rates (e.g. U.S., Canada, U.K.) and/or reduce interest rates or reserve requirements (e.g. EU, China, Brazil). This makes the opportunity cost of holding gold low. In addition many central banks are employing various forms of quantitative easing (or for the non-Bernanke's ... printing money), which over time devalues fiat currencies, which is bullish for commodities in general and especially gold.
Gold miners’ shares have diverged in price from the price of gold over the past three years and are currently lagging the appreciation of gold. These types of ratios have a tendency to return to their long-term averages over time. In my previous article I mention some of the large hedge funds which are actively increasing their investments in the gold miners. Additionally, according to the latest numbers, inflation concerns are receding in China, Germany and other countries. A slow down in inflation should be good for the miners in general as it helps to control costs.
An excellent resource that illustrates various gold ratios including gold to gold miners’ index, gold to silver, and gold to Dow, among others, is InvestmentTools.com (note I am not affiliated with this site in any way).
Is the Company a Good Investment?
Fundamental analysis is difficult to perform on an exploration company as it will have little to no revenue at this stage of its development. Still it is worth looking at a company’s balance sheet to determine its current assets and change in common shares outstanding, both of which can be used to assess the probability of your investment being diluted in the near term by additional share issues. Several other qualitative and quantitative factors are also important: Geographic region of operations, quality of management, partnerships with larger corporations and proven reserves.
NovaGold Resources Inc. (NG), which trades on both the NYSE and Toronto Stock Exchange, is an interesting candidate. With a market cap of over $2B it is one of the larger pre-production miners. Geographically all of its core projects are located in the U.S. and Canada which affords it lower political risks than operating in many other countries. In the most recent Fraser Institute Survey of Mining Companies, seven of the top 10 jurisdictions were located in North America.
In November, NG announced that the president of Barrick Gold’s North America operations, Gregory Lang, would take over the top spot at NovaGold, adding additional depth to the management team. The company also has partnerships with two giants in Barrick Gold and Teck Resources and has actively engaged Native (First Nations) communities that are in the vicinities of its leases.
At the end of Q3 2011, the company had over $100M in current assets on its balance sheet which is equivalent to approximately six months of operating expenses. With a debt to equity ratio of 0.5, they still have room to increase the debt load before issuing additional shares in a capital raise. Shares issued and outstanding are 240M with an additional 50M in options and warrants outstanding. However, since production will not start until 2015 or later, it is highly probable that additional shares will be issued prior to 2015. One strategy would be to wait until after the next share issue, but in doing this you risk missing a rise in the stock price.
Is the Stock Undervalued?
Again, generally a fundamental analysis involving some type of discounted cash flow calculation is used to compare the "fair" share price versus where the stock is trading in the market. However, in a pre-revenue stage company cash flows are difficult to predict. Over the past 52 weeks it has traded as high as $15.14 and as low as $5.93, today it trades toward the lower half of the range at $8.97. More recently the stock has exhibited support around $8 and resistance at the $9.20 level. I am waiting to see if it breaks out of the $8 to $9.20 range. If it moves above $9.20 I will establish a position in the stock. If it falls below $8, I will look for a lower entry point.
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NovaGold has a current Proven and Probable reserve base of 19.7 Mozs gold, 3.4B Blbs copper and 51 Mozs silver (Source). Proven and Probable reserves are the most conservative estimate of a company’s reserves. Simply dividing the market capitalization by the Proven and Probable reserves, we can calculate that the market is valuing its gold reserves at $112/oz. With gold currently trading above $1,500/oz this provides a potential large upside to investors. As the company approaches production this valuation should rise as future cash flows are discounted over a shorter duration. The main risks to this assessment are the following: Gold price declines, production costs appreciate substantially or something specific to NovaGold or its properties affect its future negatively, such as fraudulent activity, environmental issues, loss of key personnel, large dilution of shares, etc.
I believe that the gold mining sector is currently undervalued compared to the price of gold. NovaGold is a large pre-production gold mining company that has a strong management team, partnerships with two large established players, properties in a stable geographic area and large proven reserves. I will be long NovaGold if the stock moves above $9.20 and will reassess my options if the price falls below $8.
Disclosure: I am long ABX. I am looking to enter an equally weighted long position in NEM and smaller position in the more speculative junior mining company, NG.