Researching Gold/Silver Mining Companies III

Includes: GDX, GDXJ, GLD, SLV
by: Jeff Nielson

In Part I of this series, I introduced novice investors to this sector to some of the basic metrics we use to do a preliminary evaluation of these companies. This was followed-up by our Mining Coordinator, Brian Boutilier explaining how he uses similar criteria in his initial screening process with these companies.

In Part II, I delved more deeply into the data on these companies, focusing on the producers and near-term producers. In Part III, I will move even further back up the food chain of these companies, to the earliest stages of development, to explain to readers the differences in how such companies are evaluated (and valued). This will be complimented by Brian Boutilier’s hands-on tutorial, where he applies this methodology in doing a real-life evaluation of one of these companies.

As investors saw in the previous installment, valuing producers and near-term producers is a relatively straightforward process. The producers can be evaluated through operational data, while the near-term producers (by definition) have already engaged in some sort of feasability study – which is a detailed, scientific analysis of how a particular miner will extract and process the resource, along with a detailed estimate of profitability/return on investment.

With earlier-stage mining companies, such simple and straightforward evaluations are not possible, which is why these companies are geared for investors who have already acquired a significant amount of experience/expertise in evaluating these miners. In fact, before we can attempt to evaluate such companies, we must engage in more detailed categorization – which involves ascertaining the objective of a mining company regarding a particular project(s).

Why should we bother to take the time (and added risk) to evaluate and invest in such companies? Buy one of these earlier-stage companies at the right time, and you can obtain a return on your investment in weeks which might take years to duplicate through holding a producer/near-producer.

Sensing visions of dollar signs dancing before the eyes of readers, I will pause at this point to provide a cautionary note to those who are suddenly thinking get rich quick. As the old adage goes, markets have a habit of ensuring that pigs get slaughtered. Those who think they can waltz into these companies figuring they will make quick trades for fabulous profits almost always manage to destroy themselves.

They buy into a promising company, and (as is usually the case) it does not immediately explode higher. Instead, it drifts sideways, or perhaps even lower. The greedy investors, expecting quick profits become impatient. Inevitably they succumb to the oldest and most fatal of investor diseases: “the grass is always greener on the other side of the fence”-itis. These impatient, overly-aggressive dolts see other companies doing what their company was supposed to do. They sell what they are holding for no gain (or a loss), in order to buy something else which has already had a run.

This is otherwise known as selling low and buying high – and is not the way to make money investing. Investors buying into the earlier-stage companies (if anything) need more patience with these companes than with the further-advanced miners.

There is another very important reason why even experienced investors don’t simply load up with nothing but early-stage companies. As we saw in the Crash of ’08, equities of companies which don’t produce earnings got massacred. The mining sector was especially hard-hit.

The producers were (relatively) lightly damaged. The near-term producers (which were fully financed) also were only semi-annihilated. All of the earlier-stage companies (without revenue-generating capacity) were absolutely crushed. On a personal note, not being able to exit before the equities-meltdown in 2008, I simply sat and held.

I saw my entire portfolio decline by approximately 90%...and two years later, I have gotten that all back, plus I’m now seeing some very nice net-profits on those investments. This illustrates the crucial difference between volatility and risk (a distinction which is misunderstood by the vast majority of financial advisors).

The commodity-producers, and commodities in general, are very volatile. It’s always been that way, and it likely always will. In today’s manipulated markets, that volatility is only being amplified. However, commodities also represent hard assets, unlike the $10’s of trillions in banker-paper floating around in markets – and not counting the $1.5 quadrillion of derivatives in the banksters’ private casino.

Naturally, all of this paper is very heavily leveraged and totally dependent for its value on the fiat-currencies bankers have foisted upon it. If the U.S. dollar goes to zero, a gold mining company is not only as valuable as ever, but more valuable – since it produces the world’s best money. Conversely, if the U.S. dollar goes to zero, every dollar of U.S. bonds is also worth $0 – along with almost all the rest of those $trillions in banker-paper. And those investments can never regain their value.

That is risk. Given the choice, I will accept volatility over risk any day – as an investor with a medium- to long-term investment horizon. Obviously older investors need to be somewhat more cautious – which is why God invented bullion. Now back to the miners.

Moving backward, chronologically, from the near-term producers, the next echelon of miners are the advanced-stage exploration projects. Since we mining investors are simple folk, these labels tend to be rather self-explanatory. So the question is what separates an advanced-stage exploration project from a near-term producer?

First, the advanced-stage miner will generally be in the process of undertaking a feasability/economic assessment to determine whether its project is commercially viable as a mine. The near-term producer will have already completed such an assessment and usually be financed to go into production – or in the process of obtaining that financing, and thus will tend to have a greater cash-position than the advanced-stage explorer, although this is not always the case.

An explorer which is still actively drilling may need (and have) much more working capital than a near-term producer which is not yet fully-financed. This is why we need to always stay on top of the cash/burn-rate of these companies – so that we don’t buy-in days before a costly financing (and dilution) takes place.

The other huge difference between companies at these different stages of development is their objective. With near-term producers, the company’s strategy is clear: they want to build and operate a profitable mine. While many near-term producers allow larger partners to buy-in, to expedite financing and development (and bring in expertise which is often critically needed), these companies are still bona fide miners.

Conversely, with many mining companies with advanced-stage exploration projects, these companies never intend to be owners and operators of a mine (and nurse a project along through those many years of development). In other words, these companies are not miners per se, but rather exploration companies in the mining sector. This is not a bad thing.

With a shortage of mining engineers, and even miners themselves, there simply isn’t enough talent for all of these mining companies to start-and-finish all the projects they initiate. Indeed, the larger miners (rather lazily) rely upon such exploration companies to find-and-develop deposits – and then swoop-in, cheque-books in hand.

Does this mean it’s the larger miners which provide the most value for investors? Hardly. Good projects are very expensive – in a world dealing with peak gold (and perhaps peak silver?). After spending big-bucks to buy into these projects, the larger miners then get to write an even bigger cheque: to finance construction of the mine.

With the junior miners now having fully recovered from the commodities take-down of 2008, they are now demonstrating what analysts of these companies (including myself) have predicted all along: gains in share price which dwarf the gains of the larger miners. Indeed, subtract a dozen or so of the best-performing mid-cap miners, and the return for investors on these larger miners has been nothing less than pathetic. A basket of juniors is vastly superior to owning a handful of seniors.

Mining companies which want to drill-out a particular deposit, but not take the project all the way to full development (i.e. a mine) are (naturally) referred to either as advancers or project developers. With such companies, investors must keep track of two aspects of the company’s operations in addition to the drilling/exploration taking place with its premier project: a buyer for the current project, and other projects/properties for the explorer to move onto once this property is farmed-out.

First of all, investors must remember these companies are either on the look-out for a major partner, or simply a buyer for this project. This means that investors must gauge how attractive this property appears to an outsider, and more particularly, a much larger company – which needs to be able to produce ample long-term profits on the deposit, sufficient to pay for the property, pay for mine-construction, and still yield enough profits to give investors some net-return on the project.

This means that before such earlier-stage companies have completed a formal feasability study, investors must informally do such an evaluation themselves (to whatever degree is possible). Is the ore high-grade or low-grade? Is it near the surface, or relatively deep? Is the ore comprised of one or more wide intercepts, conducive to larger-scale commercial mining, or is the ore comprised of harder-to-mine narrow veins?

If the ore is near-surface and comprised of relatively wide veins, then often such a deposit will be deemed suitable for open-pit mining. This form of strip-mining is obviously not especially appealing for the more environmentally-minded investor, however, modern reclamation techniques mean that responsible companies could/should/will restore these areas once mineral extraction is completed.

After evaluating the ore deposit, next we must focus on location. Is the geography relatively amenable to such industrial development? Are their potential issues regarding land claims or environmental factors? Is there any pre-existing infrastructure (which can dramatically reduce capital costs for constructing a mine)? Properties which were previously mined, or contained in mining districts are much less likely to be tripped-up by environmental/permitting issues.

Is the mine very close or adjacent to any large mines, currently in operation? Obviously, if a junior miner can find and prove-up a sizable mineral resource which is close to existing operations of an established miner, then there are tremendous synergies available for the larger company – meaning they can afford to pay more for such a deposit.

The less favorable the geography, and other location issues, the better the ore-deposit which is required in order for it to ever become a mine. Finding a deposit with billions of dollars in metal contained in it means very little if the billions which can be required to finance such projects don’t leave enough excess profits available to justify such an enormous capital investment.

After evaluating the company’s flagship project, what else does the exploration company have in its pipeline in the way of projects? With some of the more aggressive exploration companies, they may engage in the exploration/development of several projects simultaneously.

While such companies can appear very sexy to investors (since they tend to generate a steady stream of drill-results and other news), we must also appreciate the logistical (and financial) issues facing these more aggressive miners. Drilling-out a single property to the stage where a resource estimate can be calculated (the first step in moving toward a mine) is a very expensive, capital-intensive proposition. Conducting drilling on several properties at once devours capital.

Many of these exploration companies accumulate wonderful inventories of promising projects, and make the mistake of trying to develop too many at once. The problem with such companies is that even though they are finding lots of potentially minable ore, they are unable to generate value (i.e. a rise in the share price) at a greater speed than they are diluting the share structure through financings.

Typically, once such a strategic mistake is made, what we is see an under-capitalized company – with hundreds of millions of shares issued. And the typical fate of such miners is that their projects are gradually ‘cannibalized’ by their more fiscally-prudent peers, with the result that the shareholders of such companies, with their wonderful properties never make a dime (and may end up with very large losses).

This is not to say that all companies who adopt such multi-project strategies suffer this fate. Just keep in mind that here we are dealing with definite risk which increases relative to how much a company tries to do at once. Regular readers know I believe in the KISS principle (“Keep It Simple Stupid”), and so I personally favor the exploration companies who work one project at a time.

With the gaps in our knowledge gradually being filled-in, it’s now time to graduate to looking at the babies: “early-stage exploration companies” (otherwise known as lottery tickets). Obviously, the earliest stage exploration company is one which has not even started drilling on a property. The more challenging question is what is the transition point between an early-stage and an advanced-stage exploration project?

The most-obvious dividing-line is the resource estimate. Those readers who have read the previous installments already know that this is a scientific calculation of the amount of ore contained in a particular mineral deposit. Such a calculation can only be completed after extensive drilling has been conducted – in order to create a three-dimensional picture of the deposit for analysis.

Thus, when the early-stage explorer approaches an accumulation of drilling results so that a resource estimate is imminent, this is when they make the transition from early-stage to advanced-stage. While such labels may be seen as mere semantics by some investors, they are not to be disregarded lightly – since (generally speaking) each time a project advances to the next level, it results in an upgrade in the valuation of the company by the market.

Such revaluations do not proceed like clockwork. In other words, usually when an early-stage explorer announces a first resource estimate for a property, there is a significant advance in the share price – but not always. There are many factors which influence the share price of a mining company, including exogenous factors totally beyond the control of the miner.

Do not get discouraged, and automatically bail-out of a company simply because it doesn’t jump higher on the day that important news comes out. Decisions on selling your shares should be based on fundamentals – not market-reaction. If a company’s operational results are meeting one’s expectations, and if such results are being obtained in a reasonably cost-effective manner, then patience is the operative word with such companies.

Completing our reverse-chronology, what factors should we look at when evaluating an early-stage explorer with little-or-no previous drilling results to guide us? Here we fall back on the mantra of all real-estate buyers: “location, location, location.” On the one hand, evaluation is simple in that we have so little data. Conversely, this makes such companies by far the most-speculative investments among all mining companies.

There are, however, factors which can reduce the odds on such companies considerably. Exploration companies which start with a property in an established mining district have a leg-up on companies which are exploring in ‘virgin territory’. While modern imaging techniques provide better ‘clues’ in such unexplored areas, such data does not pass the point of educated guesses.

The other advantage of exploring in an established mining district is that many “exploration” properties of today were, in fact, former mines – decades or even centuries earlier. Where mining has taken place relatively recently, there may be some historical data of the ore deposit to guide investors (and the mining company, itself). This could be just crude data on the amount of metal extracted (and the approximate grade), or it could be detailed information including drilling results and the location of various zones of ore.

What investors must be aware of with such historical data is that in our modern regulatory environment, all such numbers are unofficial. To provide investors with a higher degree of certainty on the data presented to them by mining companies, the Canadian government instituted a new “code” which all such mining data had to satisfy – known as the NI 43-101 code of mining reporting.

Given that Canadian or Canadian-listed mining companies dominate global mineral exploration, these are the data standards which are of the most relevance to investors. Because historical data obviously cannot retroactively comply with such standards, such data will either not be priced into the share price of the exploration company, or (if the data is seen as very credible) it may be partially priced-in by the market. Thus, simply issuing the same data, but which satisfies NI 43-101 requirements translates (generally) into a higher share price.

The last factor to evaluate is one which applies to all mining companies, but which is most difficult to evaluate for new investors: management. How can a new investor (who doesn’t know any of the names in this industry) separate good management from bad management – with a pure exploration company?

Past history is obviously a partial guide – if an investor knows what members of management have done previously (often with different companies). However, this doesn’t tell investors whether perhaps other individuals (not part of this team) were more responsible for such past success – or maybe management simply got lucky?

In other words, the way in which we really get to know management is through osmosis: holding shares in these companies, and observing for ourselves how a particular management team executes its strategy. This is yet another reason to enter these companies cautiously: nibble on some shares, and if you like the management (and results justify it) continue to add to your position(s).

All investing is a series of decisions based upon probabilities. For disciplined investors, mining companies offer a relatively structured, relatively straightforward business model – at a time when the global scarcity of commodities means that the future for such companies has never been brighter.

Choose carefully, buy slowly, don’t get greedy, and always maintain diversification through holding a basket of such companies. Follow these principles, and you can invest in such companies – and still sleep well at night.

Disclosure: None