The Issues That Can Torpedo A Gold Miner Investment: Rule, Rickards, And Reik

Includes: GDX, GLD, SGDJ, SGDM
by: Sprott U.S. Media, Inc.

Investing in individual gold miners requires understanding significant nuances to avoid taking on unnecessary risk.

A key factor when investing in a gold miner is understanding their cost structure and how leveraged they are relative to gold.

Understanding geopolitical risk and geological risk is also vital to understanding which gold miners to own.

Even if a miner has great assets, great management and the right cost structure, their ability or inability to replenish their reserve can make or break an investment.

By Albert Lu, CEO of Sprott US Media

Investing in companies requires a study of a given industry and company's nuances. If you are investing in social media companies, understanding the pros and cons of a desktop versus a mobile platform is important. In a similar way, the age range of the audience is important when coming up with the revenue projections and valuations for the company. For an auto company, understanding if the company is more focused on SUVs or small cars, the premium market or the mass market business is crucial. In addition to this, understanding if the company has a unionized workforce or not will materially impact your ability to estimate cash flows and expectations for the company.

Gold and precious metal companies, like each of the above examples, have their own peculiarities that are important to understand when valuing the firms. If an investor cannot grasp these issues, then investing in the individual gold miners as opposed to investing in the VanEck Vectors Gold Miners ETF (GDX), VanEck Vectors Junior Gold Miners ETF (GDXJ), Sprott Junior Gold Miners ETF (SGDJ), Sprott Gold Miners ETF (SGDM) or even the SPDR Gold Trust (NYSEARCA:GLD) or iShares Gold Trust ETF (IAU) can mean taking on unnecessary risk.

Sprott US Media recently hosted a discussion titled "Will Gold Trump Politics in 2017?" with Rick Rule, Trey Reik and me, Albert Lu, from Sprott, along with James Rickards, a New York Times bestselling author. One of the key topics discussed was: 'what are the key factors to look at when investing in gold miners?'

When investing in gold miners, key factors investors need to understand include the leverage to the gold price, the quality of management, the geological quality of the reserves, the geopolitical risk of the deposit, and the company's ability to replenish their reserves.

Below are excerpts of the discussion I'd like to underscore with some added insights:

Gold miners are a levered play on gold

James Rickards:"…In general, a gold stock is a leverage bet on physical gold. So, because of …the difference between fixed cost and variable cost…there comes a time when you recovered your fixed cost and then all of the incremental cost goes straight to the bottom line and the stock market applies a multiple to that.

So, gold miners generally go up faster than the price of gold in a bull market and they go down faster than the price of gold in a bear market which is what leverage does, so they're kind of a leverage bet."

Leverage to the gold price may be welcomed by the investor who is bullish on gold. However, there is a downside.

Rick Rule:"…Now, asking companies to exhibit leverage is an interesting challenge because in one sense, the most marginal companies…exhibit the best leverage. We've asked the gold mining companies for the last 40 years to be marginal. And sadly, they've complied. So, it's very important that in the next 10 years…[for] the gold mining companies to be very selective in capturing that leverage."

But evaluating mining companies takes more than an opinion on the price direction of gold. The careful investor seeks to understand a miner's cost structure, particularly the relative proportion of fixed to variable costs, to understand the company's value at different gold prices. These factors are especially important when investing in high-beta, small-capitalization gold companies such as those in the Sprott Junior Gold Miners ETF (NYSEARCA:SGDJ).

Management quality, qualification and alignment are key drivers of a mining investment

As discussed in a recent Seeking Alpha article, a second important consideration when evaluating a gold miner investment relates to management quality. This is especially important when dealing with mining companies because of the nuances involved.

It is essential to invest only in solid management teams with proven track records. However, it is also important that the team's experience is consistent with its current role. Furthermore, the investor should validate that the management team's financial interests are aligned with those of the equity holders.

Geography and Geology - The two Gs have a major impact on investment risk and reward

Trey Reik:"…stability packs, stable government, good communications, that type of thing are very important…there is a lot of concern that in a place like the Congo there's an appropriation risk…

Grade is also a very important factor these days because peak oil is nothing like peak gold. We really haven't had a major deposit in a couple of decades of world class value and most of the gold mines that the majors are looking at these days are sub-1 gram per ton which obviously brings capital cost into more of a microscope. So, I think another very, very important variable in the next 10 years will be grade..."

Gold mining involves extracting natural resources. As an extractive industry, gold mining has more exposure to national governments than many other industries. The government view on the owner of the natural resources, and the enforceability of contracts can have huge impacts on the risk and potential upside of a mining investment. This is one of the important factors that impact which companies chosen for the SGDM from the entire GDX universe.

The size of a company's reserves is not the only measure of the opportunity. As Trey highlights, the quality of the reserves is of vital importance. Lower quality reserves demand higher investment to extract, which impacts profitability.

Mining Lifecycle - The success of reserve replacement can change an investment horizon

Rick Rule:"… You look at the company historically and you look at something called the 'recycle ratio', that is, from the cash flow they produce how many ounces, how much net present value in ounces are they able to establish either through exploration or acquisition."

Trey Reik:"…I mean the Barricks and the Gold Fields and Anglos of the world, who are larger companies, have a much more difficult time replacing their reserves. Their mines are generally more aged and they're forced into decisions of development and acquisition that don't always work because, quite frankly, gold mining is extremely difficult scratching the earth's crust for something that appears at 3 parts per billion in inherently difficult (places) and the best laid plans sometimes hit hurdles which are not foreseen."

Mines have a finite life. Hence, the company's ability to replace its assets influences the expected duration of cash flows. Even strong assets deplete over time which changes the dynamic of the investment going forward. Extending the mining life cycle translates to an investment that creates value for much longer than would otherwise be expected.

Successful investing necessitates a thorough understanding of industry and company specific nuances. In gold mining, those drivers tend to be very industry specific and pose a unique challenge to investors when contrasted with other equity investment opportunities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: Sprott U.S. Media is an affiliate of Sprott U.S. Holdings Inc., which is under common control with Sprott Asset Management LP. Sprott Asset Management LP offers both SGDM and SGDJ mentioned herein.

Additional disclosure: Past performance is no indication of future returns. The views and opinions expressed herein are those of the author’s as of the date of this commentary, and are subject to change without notice. This information is for information purposes only and is not intended to be an offer or solicitation for the sale of any financial product or service or a recommendation or determination by Sprott Global Resource Investments Ltd. or any affiliated entity that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the objectives of the investor, financial situation, investment horizon, and their particular needs. This information is not intended to provide financial, tax, legal, accounting or other professional advice since such advice always requires consideration of individual circumstances. The products discussed herein are not insured by the FDIC or any other governmental agency, are subject to risks, including a possible loss of the principal amount invested.
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