Gold Mining Stocks: Cheap Or Good Value?

Apr. 21, 2013 9:40 AM ETAEM, AG, COLUF, NEM, GLD, LGCUF, RGRNF, SVLC, PPP, RIOM19 Comments

The tumble in the price of gold and silver back to the low thirteen-hundreds and twenty-twos per ounce respectively is history and precious metal investors need to adapt to the new normal. Understandably, some have walked away in disgust vowing never to return; and who could blame them. But for those who have followed our advice and have kept their powder dry, this is a good time to cast a line and start fishing for bargains in the sea of blood all around us.

As with all fishing, patience is a virtue. We don't particularly expect a sharp bounce and we expect ongoing volatility combined with a sell-in-May mentality. This mix should ensure opportunities to present themselves at least well into the summer months. The price of gold has remained below $1400 for the past week and a trend for the foreseeable future has not established itself just yet.

If you thought that the chart for the price of gold (GLD) is looking sickly, then consider the chart below which also shows the AMEX Gold Bugs Index (HUI). Now here is a sick puppy if ever there was one. Before making investment decisions in the gold mining sector investors should ask themselves whether this knife is done falling for the foreseeable future. If the answer is yes, then dry powder is a good commodity to have.

^HUI Chart

^HUI data by YCharts

Potentials buyers of gold mining shares should exercise caution, however, since boundary conditions have changed substantially. Not every gold and silver mining company that appears cheap at the moment is actually a bargain. Numerous precious metal miners will find it difficult to perform under the prevailing circumstances with production costs threatening to exceed the achievable spot price. To stick with the fishing analogy: the waters are muddy (rhymes with bloody) and care must be taken to pick the right catch of the day. The most visible fish under these conditions are the ones floating with their bellies up, and those are the ones that should be avoided.

Here are some criteria we follow in precious metal mining investing under present conditions in order to take advantage of low prices while minimizing the probability for future disappointment.

Low production cost. A potential buy for us must be able to produce profitably at present gold and silver price levels and even slightly below. Many primary precious metal miners are well stretched at the present point in time and some may not be able to keep their mines open for long. Especially many primary silver miners are in a precarious position right now.

Reserve grades. The sudden drop in precious metal prices will also affect the cut-off grades for reserve estimations. It is important to remember that reserves are ounces in the ground that can be economically mined. Present conditions will put pressure on reserve updates due towards the end of this year which typically translates into pressure on the share price. This article gives details on this particular issue.

Manageable debt. We don't like miners with high debt levels these days. The low spot price will lead to reduced revenues which in turn might impair the ability to service the debt. This news report mentions one candidate for possible down grading of the credit rating. We presume that others will be mentioned in due time.

Growth. The option of increasing profit due to rising gold and silver prices is no more, at least for the moment and probably for the remainder of this year. Solid growth in production can still make up for some of the profit reductions to be expected.

Ongoing exploration. Many precious metal miners will seek to cut costs by reducing or canceling exploration activities. While such a choice might provide a short-term fix it also creates a long-term disadvantage. Our outlook is long-term and we will be looking for companies that maintain their reserve and resource base throughout this testing period of time so they will come out bigger and stronger when times get better again.

Share dilution. The discrepancy between growth in market capitalisation versus declining share prices has been commented on in various places. We will be seeking investments in companies with a history of providing value per share, rather than increase in market capitalisation via expanding share registers.

Other risk factors. Spot price is causing some degree of financial stress for most mining companies at present. We therefore try to avoid additional risk factors that might exacerbate the stress. In our opinion the present situation calls for technical low-risk mines in safe jurisdictions.

Sustainable dividend. Dividend paying stocks offer some cushion in the event of further slides. Yield is traditionally not comparable to other sectors but has just become substantially more attractive. Sustainability of present dividend levels at "new normal" price levels needs to be assessed before making an investment.

Major gold miners typically do not offer aggressive growth opportunities but have advantages in other departments. They are geographically diversified, some of them offer compelling production cost profiles and most of them have enough financial substance to weather substantial storms. Most majors also pay dividends. We are presently keeping close watch on Agnico Eagle (AEM) and Goldcorp (GG) as our picks of this bunch. Goldcorp is the largest gold mining company by market capitalisation. Their operations carry moderate country risk and management have shown the ability to keep cost down. Agnico Eagle have a explicitly conservative business model emphasizing organic growth and have been paying a dividend for over 30 years. Their production cost is also reasonable. They have recently made investments in promising exploration and development stage companies, underpinning their long-term growth strategy.

Smaller cap mining companies typically accentuate growth over dividend yield. In our research we look for credible growth plans that are financed and achievable. Production costs vary considerably and different reporting conventions complicate cost comparison. There is a multitude of small to mid-cap precious mining companies competing for investment and only a few of them tick most of the boxes outlined above. We are currently closely following First Majestic Silver (AG), SilverCrest Mines (SVLC), Luna Gold (OTCPK:LGCUF), Regis Resources (OTCPK:RGRNF) and Brigus Gold (BRD) to name just a hand full.

Another aspect of the current situation is the possibility of takeovers of undervalued junior companies and especially development stage companies which could find themselves under pressure in coming months. Larger cap companies with adequate cash reserves are certainly watching carefully for opportunities. Near-term low-cost producers such as Sulliden Gold (SDDDF.PK) or Colossus Minerals (OTC:COLUF) are only two candidates that might fit this bill.

These are interesting times for gold investors and last week's price tumble can be viewed as a catastrophe as well as an opportunity. Not all is lost and we suggest that fellow investors in this sector keep an open mind to find the opportunities that such an event creates. Good fishing.

Disclosure: I am long AEM, AG, SVLC, OTCPK:RGRNF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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