I have been investing in gold mining companies for a number of years and although this sector can offer spectacular returns it also has quite a number of challenges.
First of all, gold mining is a very tough business. It is capital and energy intensive, it requires large upfront investments, and there are a vast number of environmental laws and regulations that companies must comply with.
Furthermore, most companies in this industry are in a constant need for capital to fund new mining projects, and needless to say the biggest risk to investors is dilution.
As result, gold mining stocks are subject very high volatility with huge price swings. This of course adds both risk and creates opportunities.
Here is a list of guidelines that may prove to be helpful…
Bet on the Jockey not the Resource
The first question you want to ask is who is running the company and who are the majority stake holders? Some management teams are better than others, so make sure you look at their track record. For example, Rob McEwen and Pierre Lassonde are two persons that have solid track record of building up successful mining companies, and betting on talent like this certainly eliminates risk. This sort of information is available from a variety of sources, including company websites and other publication like King World News and Casey Research.
Make sure that management have a significant stake in the company. Management needs to be financially aligned with shareholders. Rob McEwen for example has a 22% stake in US Gold, the company he runs, and he does not take a salary as the CEO. He has stated that he plans to make all his money in stock appreciation just like all other investors.
Consider that more than 90% of all the properties controlled by mining companies will never actually become mines. This is because finding a mineral deposit with the potential to host an economically viable resource is both time consuming and expensive. Building a new mine requires serious research, commitment and tens or even hundreds of millions of dollar in capital just to get started, so it’s essential that the company do its due diligence and get it right.
Before you consider putting money into a new project make sure that the company has hard facts and drilling results to back up claims of mineralization in a prospective property. Ignore all claims made by company executives that are not derived from hard facts. A common stunt made by mining executives is telling the public that they have identified a resource with potential but lack hard data to back it up.
A large and growing number of gold deposits found today are located in backwater third world countries. This is why it is so important to understand the political situation in the country where the property is located. For example, are there rebel groups or kidnap gangs operating around your mine site? Is there a likely danger that the country will nationalize foreign assets during troublesome times? How easy or hard is it to get permitting and is there a lot of red tape? The process of getting permitting is usually slow and can take many years, especially in western nations. These are all good questions to ask company executives. Do your due diligence and remember that political risk is perhaps on for the biggest risks to mines in today’s society.
Gold mining stocks have different characteristics from general equities and traditional measures such as P/E ratios don’t do well in assessing the true value of the company. Other factors such as company cost, production rates, and development trends are more important. The model below was developed by Bud Conrad at Casey Research and it analyzes gold mining stocks based on 8 different factors:
· – Proven and Probable Reserves – Total amount the mine is expected to produce.
· – Cash Cost per Ounce – The cost per ounce the company expects to pay for labor, equipment, etc to take the reserves out of the ground and to the market place.
· – Mine Asset Value – The difference of the price of gold today and the production cost per ounce multiplied by total reserves.
· – Debt – Total debt of the mine. Mines are very expensive and most borrow to start production.
· – Hedge Liability – An obligation the mine has to deliver gold at a future price that is below the market price.
· – Mine Asset Value – The Mine Asset value minus Debt and minus Hedge Liability.
· – Market Cap – The total amount of shares outstanding multiplied by its share price.
· –Valuation Ratio – The market cap divided by Net Asset Value.
The purpose of Bud Conrad’s model is to compare the gold reserves in the ground against the stock price to see whether the price is low enough to be attractive. The table below compares the value of different gold mining companies. The far right column shows the valuation ratio. A ratio of 1.0 indicates that a company’s stock may be expensive compared to its assets and a value of closer to zero indicates a bargain.
The company’s ability get financing is critical. It will define the scope of the operation and the success of the project. Questions to ask is where are they going to get the money from? Are they going to get a traditional loan from a bank, are they going to issue bonds, or perhaps issue new shares to pay for the new project. Also, is the amount of capital raised sufficient to carry out operations or will they require additional financing later on?
Remember, one key reason for poor stock performance for many companies over the last couple of years has been dilution of shares. Many companies have successfully grown profits but because of constant dilution of shares the stock has been flat.
We are in the midst of a secular bull market in gold and chances are good that it will end in a mania. During the last gold bull market of the 1970s and early 1980’s many companies literally went from a few pennies to hundreds of dollars. And chances are good that a few companies will delivery equally high returns this time around, perhaps 100%, 1,000% or maybe even 10,000%. But remember that many other companies don’t deserve your capital and some others aren’t even worth the paper the stock is printed on. So make sure you do your due diligence.
To learn more about investing in gold mining companies I highly recommend subscribing to a news letter that is able to sort out the good companies from the bad and provide that data to help you with key decision making. I say this because investing in gold mining stocks, especially junior minors is not the same as investing in blue caps or technology, and the professionals in this particular industry typically have much better track record than the average investor.
I personally prefer Casey Research’s publications. The international speculator is tailored for junior mining companies and they have “boots on the ground” to physically check out the properties, and putting them through an intensive examination before making a recommendation. In addition, BIG GOLD is another subscription dealing with mid to large-cap precious metals stocks, gold and silver ETFs, and mutual funds.