Strategy #1 - Build a Portfolio (Long-term Approach).
Strategy #2 - Pick Winners / Trade (Annual Returns Approach).
Strategy #3 - Chase Momentum / Speculate (Short-term Approach).
Here are three investment strategies that can be used for investing in gold/silver mining stocks. Most people who invest in gold/silver mining stocks often use a combination of these strategies. Moreover, many gold/silver mining stock investors use all three strategies to a certain extent. These strategies are my opinion and were categorized from years of experience.
Strategy #1 - Build a Portfolio (Long-term Approach)
This is the strategy that I use. It is based on the premise that gold prices are going to explode in value at some point. It is a positioning approach for a big return. The key is to get positioned and then wait.
There is very little, if any, focus on annual returns. Instead, the focus is on constantly building your portfolio so that it is ready for the big move up in gold/silver prices. When that big move comes, it is recommended to steadily sell shares and take profits on the way up.
For this strategy, the number of stocks you own is not relevant, although I tend to keep my cost-basis low for each stock and thereby own a lot of stocks. It is rare for me to have my cost-basis above 2% for a single stock, unless it is a mutual fund/ETF.
This strategy is not concerned with volatility because it is dependent on waiting for the big move up. The only reason to sell a stock is if the story changed for a stock since you bought it. Most stocks are simply held until the big move comes. This will create potentially large paper losses for stocks that fall in value, but the strategy remains in place - waiting.
This is a passive investing strategy. There is some watching of the portfolio, but mostly it is a passive buy-and-hold approach. The active part of this strategy is to constantly build your portfolio. What you are trying to do is add more stocks to your portfolio so that you have a better chance of big returns when gold/silver prices break out.
What you are not trying to do is re-balance your portfolio by trading. If a stock takes off, let it ride, or even add to it. If a stock drops, ignore it - unless the story changed. This strategy is all about positioning and waiting. You want to have positions in as many quality miners as you can. Those positions should be chosen carefully. You want good entry prices so that the stock has good upside potential.
Entry prices are very important. I try to pick stocks with at least 5 bagger potential at higher gold/silver prices, although sometimes I'll go down to a 3 bagger potential for quality producers. The reason for picking 3 baggers is that quality producers could easily outperform.
I value companies based on 5x to 15x future free cash flow. For instance, if annual future cash flow for a miner is estimated to be $100 million, then my expected future valuation would be somewhere between $500 million to $1.5 billion, depending on various criteria (management, location, costs, deposit size, etc.). I think this is a valid approach for future valuations.
Cisco traded at 280x free cash flow in the late 1990s. If gold/silver miners become the hot stocks to own, we could easily see miners valued at 30x to 50x free cash flow. In fact, some royalty stocks are already valued that high today.
This strategy is all about constantly building a portfolio and positioning for an event that pushes gold/silver prices much higher. I think the event most likely to cause gold/silver prices to rise substantially will be the popping of the debt bubble and a bond market collapse. But it could be something else that pushes gold prices higher.
My price targets for gold are $3,000 to $10,000 and $100 to $300 for silver. If we get anywhere close to my expected targets, then my strategy will have worked.
The key to this strategy is building a good portfolio and being positioned for higher gold/silver prices. In my book (How to Invest in Gold and Silver), I describe a pyramid approach to building your portfolio (below is the pyramid from the book). The bottom of the pyramid is lower risked assets, such as physical gold/silver, gold mutual funds, and ETFs.
You want your portfolio to be weighted much like this pyramid if you are going to use this strategy. Most investors ignore the bottom of the pyramid. Not me. My portfolio is pretty much weighted like this pyramid. My largest cost-basis positioning are physical silver, bullion ETFs, gold mutual funds, and miner ETFs. That is followed by mid-tier producers, development stocks, and explorers.
I think the best way to make this buy and hold strategy work is to be overweight quality producers. Because my main strategy is to chase future cash flow based on higher gold/silver prices, then producers are the companies that should perform best. I remember not owning enough quality producers during the last gold bull market in 2010-2011. I kept watching the share price of several producers going straight up and learned my lesson. I told myself to make sure to own enough quality producers for the next bull market.
I have come to learn from years of experience that development stocks and explorers are mostly bad risk/reward stocks for buy and hold, long-term investing. I started out as a big believer in development stocks. However, experience has shown me that most of these are just money eaters over the long term. These companies often either dilute shareholders into the ground, or they sell them for low premiums. I would say this happens at least 80% of the time.
I still own several exploration and development stocks, but I keep my cost-basis down for each one. My expected outcome for these stocks is what I wrote in the previous paragraph. I treat these as very high-risk speculation stocks.
The risk/reward for exploration stocks are worse than development stocks, especially as long-term investments. You should consider exploration stocks as lottery picks as a long-term investments. Moreover, you should only buy exploration stocks that have a discovery that appears to be potential large mine. It is very, very difficult to find a large mine (> 3 million oz.). If you own an exploration stock that does not have a potential big discovery, then you are just playing the lottery.
Strategy #2 - Pick Winners / Trade (Annual Returns Approach).
Some personalities are not conducive to passive long-term investing as described in Strategy #1. Some people have a hard time with paper losses and believing that the strategy will eventually pay off. Because gold/silver mining stocks are highly volatile, it is not unusual for stocks to be down more than 50%, or even for portfolios to be down 50% or more.
If you have difficulty with paper losses, then you will likely use a more active approach. This strategy is all about picking winners and then actively managing your picks to ensure they are winners. This means constant re-balancing and trading, and limiting your losses.
This strategy is actually the most widely used and is considered the best way to invest. Most successful investors use an active strategy of managing their portfolio and limiting their losses. In fact, the only reason to use Strategy #1 is because of the likelihood for very high returns. It’s a “sit tight and be right” approach.
Most active gold/silver investors do not want to manage a lot of stocks, so they invariably have a small portfolio of 10 to 30 stocks. They are looking for annual returns and tend to cut losers that can impact returns. They either use automatic trading stops or keep a constant vigil over the performance of each stock.
The key to this strategy is to cut losses and to take profits. Also, it is quite common to add to winners. If a stock jumps 25% or more, then they might buy more shares to leverage more returns.
Active investors are constantly tinkering with their portfolio. By tinkering, I mean trading. Selling a few shares here and buying a few share there. Also, they like short-term trades to increase their returns very quickly.
The other aspect to this strategy is to utilize large weightings on stock favorites. It is not uncommon for a single stock to have a 10% or 20% weighting in their portfolio. Also, because they don't have a lot of stocks in their portfolio, they tend to have a lot of stocks with portfolio weightings of 5% of more. By using heaving weightings, they can have large annual returns.
Active investors have one primary goal and that is to obtain large returns using a proactive approach. To achieve this goal, they want to be in control. Passive investing is a stupid approach from their perspective. They want to pick winners and let them ride to a certain extent, and then take their profits. However, in tandem with picking winners, they want to cut their losses and keep their losses under control.
A typical stop-loss for an active investor is around 10%. Any loss beyond this is quickly sold. Some active investors with a higher risk threshold might sell at a loss around 20%.
A good active investor should always outperform a passive investor. However, to be an active investor requires the skill of picking winners, plus the emotional makeup that allows you to constantly trade your portfolio. When you have those high weightings in volatile gold/silver miners, you have to be nimble and ready to trade on a moment's notice. For instance, if you are stopped out, what is your next trade? How long do you let your cash sit?
I am not a good trader, and this is why I use a passive approach. Also, I have a large portfolio and I don't have the emotional makeup to have high cost-basis weightings for individual mining stocks. The volatility is too high for my comfort level to use high cost-basis weightings for stocks.
Being both an active investor and well positioned for the big move up in gold/silver prices will not be easy to pull off. Why? Because you will be constantly managing your portfolio for annual returns while waiting for a long-term payoff. When the big move up in gold/silver prices comes, it will be too late to buy quality stocks which will be the first stocks to move higher. In other words, you won't own them after the initial move.
What is likely to happen is that active investors will have a small number of stocks when the breakout occurs. If they have the right ones, then they will do exceedingly well. Thus, you have to be a very good stock picker. It is very difficult to pick 10 or 20 stocks and get all of the right ones. It’s almost impossible to know which ones will be the big winners.
Strategy #3 - Chase Momentum / Speculate (Short-term Approach).
This last strategy is used by investors for quick returns. Strategy #1 is for long-term investing. Strategy #2 is for annual returns. This final strategy is for big returns in a short period of time. This period can be a single day, a week, a month, or perhaps longer.
As I stated at the beginning, many gold/silver mining investors use all of these strategies. Anyone can see a near-term investment opportunity and jump in. This is quite common with exploration stocks. One discovery drill hole can signal a potential discovery. It is not uncommon for junior explorers to make quick runs based on drill results.
These quick returns draw speculators into the mining sector. Often they sit on the sidelines and wait for drilling news. They are like gamblers who want a quick return. They know it is coming, so they sit and wait for the news.
I call these momentum investors, and that is what they are doing - chasing momentum. There is nothing wrong with this and it works. In fact, it is a smart way to invest if you pick your spots well. The risk is that many of these initial drill results can lead to a quick move up followed by a sharp decline. For this reason, it is wise to use a trailing stop to lock-in gains or prevent big losses.
A trailing stop is a trade that gets automatically triggered when a stock drops to a certain level. As the stock rises in value, you cancel the trade and move it higher, thus trailing the trend up.
The key to making money chasing momentum is information. You need to understand why a stock is trending and if the odds are good that it will continue to trend. Plus, you should learn to read technical charts to get an edge for when to get in/out. Chasing momentum is trading and all traders should know how to read technical charts.
It should be mentioned that when you are chasing momentum the fundamentals of the market usually don't matter - unless the entire mining sector is trading on momentum. The only thing that matters are the drill results and the buzz around the stock. The tricky part is knowing when to get out, or how much to let ride. Do you let all ride or take some profits? When do you take profits, and how much? These are lessons you will have to learn.
I have found that if a small explorer makes a significant discovery, it will trend higher until the ultimate size of the discovery is determined. After that it tends to plateau until it is sold. Riding the share price up to the plateau can be very rewarding if you have a good entry price.
Most discoveries make their initial explosion in price from the first drill holes. However, that discovery still needs to be confirmed or expanded with follow up drill holes. This is where speculation comes in. We don't know if those follow up holes will confirm the discovery, or how big the deposit will become. In essence, it's just a bet that the drill holes will continue to be good.
Today, the big momentum trades are usually chasing drill results, such as Great Bear. However, when gold/silver prices takeoff there will be another momentum trade, which is to chase cash flow. An example of this type of trade is what happened to Kirkland Lake Gold. As their free cash flow steadily increased, so did their share price, which jumped from around $4 to $47.
This same rise in free cash flow is going to happen to many producers if gold/silver prices rise. If this occurs, you will be able to trade these big moves. You can take a position for a company that you think is going to have a large increase in free cash flow, and then trade it with a trailing stop. I think this type of momentum trade is going to become the norm as gold/silver prices rise.
In addition to momentum trading, there is speculating. For gold/silver mining stocks there are a variety of ways to speculate other than to chase drill results or cash flow. Sometimes these are for short-term gains, but often they are for longer than one year.
A typical speculation bet is liking the story of a company. They might not have a discovery yet, but the geology looks great. Or, they might have gold in the ground that is valued very cheap and the company thinks they can advance the project to production.
Speculation bets are usually when you are going after 20+ baggers, although sometimes speculation bets are for quick returns of less than one year. For example, if a stock is oversold, you can bet it is going to rebound. Or, if a stock seems undervalued and is likely to rise in the near-term, you can trade it for a quick return. These types of quick speculation bets will be very popular as gold/silver prices rise. It will be quite common for gold/silver stocks to rise 25% in a single month. Finding a mining stock that is ready to pop will be all the rage.
Disclosure: I am/we are long KL. 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.