Will Mania Strike Gold Explorers Or Producers?

by: Simit Patel

For many of us gold bugs on Seeking Alpha, a forthcoming mania in gold and gold stocks, reminiscent of what occurred in the '70s (but likely bigger), is all but a foregone conclusion. While there are no certainties in the market as few if any of us can honestly claim to know the future, a higher gold price based on supply demand factors and the psychology of markets seems like a high probability. Gold is underowned by institutions - demand is strong due to negative real interest rates in the world's foremost currency, the US dollar, and the gold discoveries are increasingly difficult to come by.

Of course a forthcoming mania does not guarantee profits. To ensure the profit opportunity is maximized, there are a number of issues that need to be considered. One of the most pressing one is whether the mania will strike all gold stocks equally, or if there will be a bias towards explorers - those searching for new gold mines - or producers (those operating existing mines that have already crossed the threshold and are actually producing gold).

The Case for Producers

The obvious argument behind producers is that they already produce and have earnings. In this regard, they can be seen as a safer bet. Related to this is the fact that as these firms are larger, they are more inclined to have a share price above $5 - often a minimum price for many institutional funds before they will consider investing. Pension funds, the kind of fund that will be attracted to investing in larger, more stable companies, have trillions of dollars that need to go somewhere. They may be attracted to companies that can pay dividends and have relatively low P/E ratios - attributes characteristic of gold producers. As the gold price rises, many gold producers will likely increase their dividends. Companies like Newmont Mining (NYSE:NEM) already have established a policy of linking their dividends to the price of gold. If these big funds step into gold producers, a bubble may emerge.

Put another way, expecting a bubble to come in gold producers is a bet on fear. It's a bet that the safety of dividends and gold production will be so high in demand that it leads to a bubble.

The Case for Explorers

On the flip side, the case for explorers - and against many producers - is that gold discoveries are increasingly difficult to find. And so, as the rush into gold intensifies, producers will have no choice but to shell out big money for explorers that can find those mines. Indeed, depending on how the market shapes up and where investors decide to put their money, producers may need to pay so much in shares and capital that their upside is limited, while it is the explorers that hold on to the promising properties that are the big winners.

In my opinion, a bet on exploration is more akin to a bet on greed. It is a bet that the market will become so gold hungry that they will take the risk of betting on explorers that currently don't have much besides a dream. It's also worth noting that the market for explorers is incredibly tiny. The market cap of the entire TSX Venture Exchange, where most explorers are listed, was just $43.5 billion as of May 2012. To put that in perspective, the market cap of Barrick Gold (NYSE:ABX), the world's largest gold producer, is currently $38.73 billion. If companies like Barrick, Newmont, and Goldcorp (NYSE:GG) - three of the largest gold producers that collectively have a market capitalization of greater than $94 billion, more than twice the entire TSX Venture Exchange - spend even a fraction of their market cap on explorers, the valuations could explode to the upside.

Of course, the catch with the explorers is that most of them are worthless; they don't have any gold and never will. The few that do, though, are capable of generating phenomenal returns. But if a full-blown mania emerges in this sector, even those that have nothing could soar.

The Solution: Low Cost Producers and Royalty Stocks

Getting back to the question posed in the title of this post, I think the solution is a combination of producers and explorers. Personally, I currently have about 10X the amount of capital I have reserved for stocks in producers rather than explorers, although I'll be tightening that ratio significantly as I'm focused wholly on explorers now (featuring the most promising explorers I invest in our premium newsletter). For those who are fairly new to this sector, one strategy I think is a great way of playing this is to focus on low-cost producers - meaning producers with very low mining costs - and royalty stocks. Royalty stocks are like investment funds, in that they invest in a number of mines in exchange for an ongoing stream of revenue from the mine's production. Shareholders in royalty stocks are a bit like limited partners in a venture capital firm, in that they hire the royalty stock's management team to find the promising opportunities out there. Royalty stocks have done remarkably well in this bull market; see my previous write-up on them.

Based on this strategy, Goldcorp is the low cost producer to focus on, while Franco Nevada (NYSE:FNV), Eurasian Minerals, (NYSEMKT:EMXX) and Sandstorm Gold (SNDXF.PK) are royalty firms I think are worth focusing on.

Disclosure: I am long FNV, GG, EMXX, NEM, ABX.

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