A decent gold miner article issued today by one of the more respected asset management firms in NY.

Regards - VHF

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The Play

Lee Quaintance & Paul Brodsky - QB Asset Management

September 7, 2011

Though investing in them has been a tough row to hoe of late, we think gold miners are ridiculously, unsustainably cheap. First, they have historically been of dubious repute (i.e. “A gold mine is a hole in the ground with a liar on top”, not actually uttered by Mark Twain, as is usually credited, but poignant just the same.) Further, large investment banks influencing the majority of investment capital do not go out of their way to provide support to the gold industry. (Why would they?) One need only look at the absence of research coverage of precious metal miners and the very low official projected gold prices across Wall Street, which feeds directly into projected miner revenues and earnings for anyone looking to value them on a financial metric.

To make matters tougher, good and honest miners have generally been bad financial operators and unresponsive to shareholders, led by salt-of-the-earth geologists and their relatives struggling to answer irrelevant financial queries from urban money changers more concerned with stuffing unrecognized gains into the current calendar year to bonus-up for beach homes and Wii2s. Mining relatively small ore bodies is a laborious and unpredictable process. It does not translate well into a financial architecture.

A tree falling in the woods makes a sound even when no one hears it. The play in gold miners is not their management or even on-time delivery of surprisingly good earnings. It’s all about their gold inventories. There are cheap, independently-audited companies mining or able to mine proven reserves in politically stable, well-situated domains. The current monetary food fight that increases the value of gold increases the value of their inventories.

Gold mine output growth has actually decreased in recent years even as the gold price has risen. This implies true scarcity and the exhaustion of mature mines owned by very large miners also producing consumable commodities. (Gold production and revenues as a percentage of their total revenues is small.) If the largest miners of iron ore, copper and coal want to replace their gold inventory then the cheapest and quickest way to do this is through acquisition of smaller miners in control of quality mines. If they do not, then smaller miner intrinsic valuations will appreciate on their own in a very levered fashion. The critical metric is asset valuation of pure-play gold miners. Reserves on the balance sheet are the key, and we think they must and will be recognized.

As for producing revenues and earnings, we expect revenues generated by existing producing miners will rise substantially more than input costs. Established miners with permitted proven and probable reserves will gain from increasing gold prices, economies-of-scale related to energy and labor costs, and from new discoveries and ore-grade increases within already-permitted zones. Further, the cost of production per ounce mined and sold will diminish as by-product metals increase in price as well.

Unsophisticated financial operations, investor unfamiliarity, rising energy and labor costs and fears of government shakedowns do not mean that the upside for gold mining shares in developed economies is limited. In fact, we think the upside in pure gold (and silver) miners may be substantially higher than the underlying metal.

This has not been recognized yet. In fact, shares in gold miners have badly lagged the price appreciation of gold futures. The graph below shows the normalized spread separating Spot Gold from the NYSE Arca Gold Bugs Index (HUI) over the past five years. As you can see from the bottom panel, shares of precious metal miners have greatly underperformed spot gold since mid-2008 and this trend has been greatly exaggerated since March of this year. In fact, for 2011 spot gold appreciated 28.5% while the HUI Index rose only 4.4% through August 31.

click to enlarge: http://tinyurl.com/3t3hxvo

How might we explain this underperformance? We think there may be a few reasons. First, recent gold converts (or reluctant momentum players) may be fairly unfamiliar or unconcerned with value over time. They may simply want immediate exposure and the easiest way is through listed futures. The other alternative gold expression hindering miner sponsorship has been publicly traded gold ETFs. Gold ETFs have done a credible job of tracking the daily performance of gold futures. However, as we alluded to above, we think there is great room for investor disappointment in some of the more popular ones.

For example, the SPDR Gold Trust, which is reputed to have the sixth largest inventory of gold in the world, is a Grantor Trust contractually obligated to deliver to its shareholders a dollar-equivalent gold value in the form of each day’s closing share price. Doug Hornig of Casey Research recently researched GLD by scrutinizing its prospectus and interviewing its sponsor. He concluded that ownership in it, even among investors holding more than 100,000 shares pre-approved for share/gold conversion, does not practically constitute gold ownership for shareholders. Were there to be a sudden run on physical gold that would close gold futures trading, GLD’s sponsor would not be able to open the shares for trading. All credits and debits would be reconciled in dollars. In the US any long-term profits would be taxed at the 28% tax rate on collectibles. So we think there is considerable room for disappointment among ETF holders that believe they have adequate exposure to physical gold or the performance of physical gold if and when that exposure is most needed.

We view this as a potential powder keg that will lead to sudden sponsorship of gold miner shares, analogous with the bullish argument associated with large short interest in a stock (only better). ETF shareholders are already sold on the merits of having long gold exposure. What they lack currently is the knowledge that they own a vehicle that would not provide them the benefits of gold when they need it most. We expect re-allocation from ETFs to gold miner shares as this becomes known.

Given: 1) a $10k Shadow Gold Price and current macroeconomic fundamentals supporting further monetary inflation; 2) the maturation over the last five years of exploration, permitting, production, balance sheets, access to capital and stabilized energy and labor costs within the miner space; 3) ten years of “curing” (the benefits from survival bias for both miners and gold miner investors that has already occurred); 4) the vast underperformance of shares vs. spot more recently; and 5) the “high priority” of miners within the list of all potential gold expressions when monetary issues present themselves more obviously to the public; we conclude that this particular investment space will produce significant out-performance.

Over the last two months we have scaled out of our bullion plays and re-allocated towards miners we know and about which we are enthusiastic. Three of our precious metal miners were acquired in 2010. Last month, one of our miners, Northgate Minerals, a Canadian firm in which we built a decent stake over the last few years, agreed to be acquired at almost a 50% premium. Like many other miners we hold, NXG had been very profitable for the Fund even before that announcement.

We think the assets owned by certain miners will encourage more transactions or else they will be re-priced in step-shift fashion by the markets. (It is reminiscent to us of base metal miners in the spring of 2009.) Our only metric for staying long precious metal miners is that their inventories remain cheap to above-ground physical gold, which in turn remains cheap to past and future money and credit growth.