How to Pick Gold Miners

With gold miners, in general, so attractively valued relative to the gold bullion price, the question becomes: Which stocks are the most compelling and have the best leverage to robust precious metals prices?

First, an investor could begin the process through elimination. FINRA highlighted some of the key warning signs when analyzing gold stocks, such as claims of being a “buyout target,” or speculative claims about reserve growth, and grandiose predictions of exponential growth, to name a few. FINRA says investors should be wary of “free lunch” programs that claim profits in gold are “easy,” and we agree.

Research from geologist Robert Sibthorpe shows that only one in 2,000 (0.05 percent) companies would ever find 1 million ounces of gold, and that only a third of those would be able to turn that find into production. In addition, research from Barry Cooper at CIBC shows that these discoveries are becoming even more difficult. There were 51 gold/copper porphyry discoveries of +3 million ounces during the 1990s, but only 24 of such discoveries occurred during the 2000s.

In order to find the diamonds in the rough, I use what I call “The Five M’s” for mining stocks. I discussed this process thoroughly in The Goldwatcher: Demystifying Gold Investing, an investor’s guidebook to gold investing I co-authored with John Katz a couple of years ago.

The Five M’s are: Market cap, Management, Money, Minerals and Mine life cycle.

1) Market Cap

Market cap is simply the number of shares outstanding multiplied by the stock price. The gold sector is broken down into three sectors by market cap: Seniors (market caps >$10 billion), intermediates (between $2 and $10 billion) and juniors (<$2 billion).

If a gold company has 10 million shares outstanding at $1 per share, the company is valued at $10 million. The question any investor should ask is, “Is this company really worth $10 million?” If the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (1 million ounces in reserves X $25 an ounce). If the company’s market cap is only $10 million, it may look undervalued. Accordingly, if the company’s market cap is $50 million, it may appear to be overvalued.

For larger gold companies, an investor can measure a company’s market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation. For junior mining companies—an area of focus for our World Precious Minerals Fund (UNWPX)—we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.

2) Management

Essentially, management of mining companies must have both explicit and tacit knowledge to be successful. Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?

Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?

Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors. Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.

Some of the most successful company builders in the gold-mining industry are what I call the “financial engineers” – people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.

3) Money

Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow. A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis.

We call this the “burn rate”—how long will the company’s current cash levels last before it has to return for additional financing. If a junior exploration company has $15 million in cash reserves and is spending $3 million a month, it has five months to deliver enough reserves per share to convince capital markets it is worth the risk.

This calculation can be done quickly. Exploration reserves are generally valued at one-third the reserve values of a producing mine—if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce.

The gold-equities market is generally efficient at judging reserves per share, so if the exploration company doesn’t come up with the results necessary to get an evaluation—find gold for less than $50 an ounce—investors quickly lose confidence. There is an old rule when it comes to exploration companies: don’t pay more than two times cash per share if there are no proven assets in the ground.

4) Minerals

Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share.

Companies operating mines that produce gold as well as industrial metals tend to have lower valuation multiples. For example, the current price-to-earnings ratio for Freeport-McMoRan (FCX), is 8x-times forward earnings. This is considerably lower than Yamana (20x), Goldcorp (21x) and Agnico-Eagle (36x). Investors can use the low relative valuations of copper/gold producers to increase their margin of safety in anticipation of an upward move in gold prices.

5) Mine Lifecycle

There are many delays and disappointments during the development and operation of a gold mine. Input costs can rise out of control (such as what happened in 2008 when oil hit $140 per barrel), labor workers can strike, and political/environmental policy shifts such as higher taxes or stricter environmental regulations can shrink margins.

Assuming the company continues down the path to development, its share price drifts sideways until around six months before the first ounce of gold is expected to be produced. At this point, the stock begins a strong new leg up when a more sophisticated set of shareholders come into the market. Eventually the price drops off and then levels as the speculative money moves on to the next hot opportunity and the company transitions from explorer to producer.