# By the Numbers, Mining Stocks are Undervalued

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by: Daniel Gschwend

How can I say mining stocks are over- or undervalued? I’d have to do the math for all the listed companies, which is more or less impossible.

But there is a more convenient and possibly even more accurate way to argue that a market sector is trading with a significant discount.

In mining, the most important value driver is the value of the underlying asset, e.g. gold. If gold rises shouldn’t gold stocks rise too? In the recent months, particularly junior mining stocks did not rise even though gold saw a spectacular performance.

On the other hand, big cap mining stocks did benefit from the rising gold price but nevertheless were underperforming.

There are many reasons behind this divergence. But the most important was, that investors were explicitly not willing to take risk. But once risk appetite returns, investors will find out that many mining stocks are trading at considerable discounts to their implied value.

In the next paragraphs I will show you my considerations and give you some investment ideas to participate.

So why do I believe that mining stocks are undervalued? I calculated the theoretical value of the AMEX Gold Miners Index (GDM, which is composed mainly of big cap mining stocks) by using a linear regression model. So how does a linear regression work? A linear regression analyzes the relationship between two variables, x and y (in this case between the AMEX Gold Miners Index and gold). For each variable you know both x and y values and you want to find the best straight line through the data. The degree of this relationship between two variables is expressed by the correlation coefficient. R2, the so-called coefficient of determination is also important in the context of the correlation coefficient since R2 illustrates the linear dependency of y to x (or in this case the AMEX Gold Miners Index to gold). The correlation coefficient is by definition between +1 und -1 (+1 means a perfect positive correlation and -1 means a perfect negative correlation).

In this case the model does only work if mining stocks have a strong positive correlation to gold. I calculated the correlation over a 5 year period with weekly closing data. The AMEX Gold Miners Index has a correlation of approx. +0.96 to gold (and R2 +0.922 which is very significant). The correlation got weaker during the last couple of months due to some kind of decoupling of mining stocks because of the sub-prime market turmoils. This created the current discount in mining stocks. The following graph shows the various number of observations between gold and the AMEX Gold Miners Index at specific dates.

click to enlarge images

By using the formula provided by this model, I came up with a potential value, based on the current gold price and historical correlations, of around 1’357 points for the AMEX Gold Miners Index. Currently, the AMEX Gold Miners Index is trading at around 1’187 points which means more or less a discount to its calculated value of 14%.

If you believe that gold will hold its current price level or rise even more – as I do, than the mining stocks will eventually catch up.

The correlation coefficient between the TSX Venture Index (TSX-V, which is composed mainly of junior mining stocks) and gold is also significant with +0.78 (5 year, weekly closing data). Taking the recent sell-off in the junior mining sector (represented in the TSX Venture Index) into consideration, it is not very surprising that small caps are trading with an even bigger discount to their applied value. The TSX Venture Index is trading with an approx. 18% discount to its applied value. Even though the TSX Venture Index is not only composed of mining stocks and many of the mining stocks don’t even have gold resources (e.g. early stage exploration companies), the statistical analysis is still significant and clearly points to a causality.

In summary, investors can currently buy big cap mining stocks and junior mining stocks with fairly attractive discounts which I believe will eventually be balanced.

I will show you now the case for approx. \$ 1’000/oz gold at the end of 2008: I found that the highest correlation to gold occurs with the following input variables – which also makes sense from an macro-economical approach:

• EUR/USD to Gold  +0.86
• USD/CNY to Gold  -0.97
• WTI Oil to Gold  +0.89
• US Dollar Index to Gold -0.85

These correlations are all significant and allow to build up a model to forecast the price of gold. In the following matrix you can see where the price of gold should be at the end of 2008. There are single targets based on each input variable and an equally weighted forecast. I therefore predict a year-end target of gold at \$ 972/oz or approx. +12% from current levels.

If I summarize the following considerations and apply the same approach to forecast the AMEX Gold Miners Index [GDM] year-end target with the forecasted gold year-end target of \$ 972/oz, the GDM target will be 1’510 (currently at 1’187) or approx. +27%. The year-end target for the TSX Venture Index is even approx. +30% from the current level.

Now, let’s put these forecasts into investment ideas. From an investor’s point of view, it is very important to diversify and therefore have some exposure to physical gold, big/mid caps and small caps. A very liquid way to gain exposure to gold is to buy the SPDR Gold Shares (NYSE: GLD). The objective of this ETF is for the shares to reflect the performance of the gold bullion. Buying big/mid caps can also been done in a cost efficient way. The Market Vectors Gold Miners ETF (AMEX: GDX) does reflect the performance of publicly traded equity securities of gold and silver mining companies, as represented by the AMEX Gold Miners Index [GDM]. The advantage of buying the SPDR Gold Shares (NYSE: GLD) and the Market Vectors Gold Miners ETF (AMEX: GDX) is to have one product which reflects a basket of stocks or gold instead of buying a bunch of single shares. If you don’t like the idea of buying an ETF than you might want to buy BHP Billiton (NYSE: BHP) to gain exposure to base metals and Barrick Gold (NYSE: ABX) to gain exposure to precious metals. These two big cap companies are rather representative of their sector.

The much more challenging undertaking is to gain exposure to small cap companies. There are no ETF’s around that reflect junior mining companies. I would therefore recommend to investors to buy a selection of junior mining stocks or a mining fund with exposure to small cap companies. For a non professional investor the choices are pretty big and the risk is considerable. Consecutively, I will give you a selection of junior mining stocks, which I like and which offer excellent entry points for long term orientated investors. In the current market it is very important to only invest into junior mining stocks which have NI 43-101 compliant resources/reserves, established production or near term production prospect, management with a proven track record and located in politically stable countries. Therefore, I like the following companies:

• Central Sun Mining (AMEX: SMC) [TSX: CSM]: Central Sun Mining has a market cap of \$ 125 million and is located in Nicaragua with one operating mine with approx. 50’000 ounces production p.a. and one mine which right now is being converted from heap leaching to conventional milling. The company expects to produce approx. 125’000 ounces of gold from two operating mines in 2009 with cash costs of approx. \$ 380 per ounce. While we see some significant production growth, we also expect the company to be able to boost the existing resources of approx. 1.7 million ounces of gold. Cash is no problem since they had \$ 12.2 million at hand as of March 31, 2008 with only 61 million shares outstanding. The stock is highly undervalued to peers and offers production and exploration upside.
• Largo Resources (Nasdaq OTC: LGORF.PK) [TSX-V: LGO]: Largo has a pre-feasibility stage vanadium project in Brazil and an advanced stage tungsten-moly project in Yukon, Canada. The vanadium project already has a scoping study at hand with a base case of \$ 192 million NPV (using really conservative numbers). Largo plans to go into production in early 2010. This makes the company a near term producer with a market cap of only \$ 150 million. Largo’s management team has also an impressive track record, most are from Desert Sun Mining, a company that was acquired by Yamana Gold. Just recently, Largo entered into an off-take agreement for the Maracas vanadium project with Glencore International AG. This outlines the very strong project fundamentals since Glencore is one of the world’s largest suppliers of a wide range of commodities to industrial consumers. The stock recently had a stellar rise but remains significantly undervalued to its NPV and exploration upside is considerable (including PGM potential).
• Excellon Resources (Nasdaq OTC: EXLLF.PK) [TSX: EXN]: Excellon Resources is a silver, lead and zinc producer operating in Durango State, Mexico. For fiscal year 2007 Excellon produced 2.3 million ounces of silver, 10.3 million pounds of lead and 8.9 million pounds of zinc. Excellon is one of the highest grade silver producers in Mexico and intends to double production by the end of 2009. The company is lead by a very experienced management team and board of directors. The Platosa project still has considerable exploration upside. Excellon therefore offers investors cash flow through production and exploration fantasy. The stock offers upside on future production expansion and further exploration success.
• U.S. Silver Corporation (Nasdaq OTC: CYLPF.PK), [TSX-V: USA] U.S. Silver is a silver, copper and lead producer located in the USA. The company has 48 million ounces of silver equivalents as resources/reserves and two operating mines in addition to other advanced stage or exploration projects. U.S. Silver is attractively valued based on market cap / oz Ag resources & reserves and on P/CF (price to cash flow multiple) compared to peer group companies. Management is technically experienced and should be able to unlock the hidden value in the company. Current market cap is approx. \$ 100 million with around 212 million shares outstanding. The stock is undervalued to peers and should benefit from future production expansion.
• Petaquilla Mineral (Nasdaq OTC: PTQMF.OB) [TSX: PTQ]: Petaquilla Mineral is an emerging junior gold producer in Panama with a production target of approx. 100’000 ounces of gold p.a. starting at the end of 2008. The company has the capacity to expand production from 2’200 tpd to 5’000 tpd in the following years. Petaquilla Mineral additionally has an ownership of approx. 13% of Petaquilla Copper. Petaquilla Copper is developing a world-class copper deposit and has teamed up with Inmet Mining and Teck Cominco. Because of financing concerns, Petaquilla Copper recently had some pressure on its share price. Petaquilla Mineral is slightly undervalued on the gold project and offers considerable upside on future production expansion and especially on the copper part with its share in Petaquilla Copper.

In summary, I’m still very bullish on gold based on strong fundamentals. I also believe mining stocks in general are trading at attractive levels. But the biggest potential for long term orientated and risk aware investors definitely lies in selected junior mining companies.

Disclosure: The author is fund manager at a mining & metals fund. The author’s view reflects explicitly his personal opinion. The fund has a position in BHP Billiton, Barrick Gold, Central Sun Mining, Largo Resources, Excellon Resources, U.S. Silver Corporation and Petaquilla Mineral.