Trading, Speculating and Investing in North American Precious Metal Stocks

June 17, 2003

Trading Rules

All stock market sectors have their own unique criteria and set of rules for both valuation and for trading specific securities.

The perverse nature and continuously changing structure of the gold bullion market and gold stock markets precludes strict adherence to hard and fast rules. The following list provides the investor with numerous criteria and factors to consider when trading, speculating and investing in gold securities. There is no single "holy grail" for all stocks at all times, but rather a set of guidelines that vary over time as political, economic, demographic and technological changes affect the structure and behaviour of the gold mining industry and markets.

Gold Mining Rules of Thumb

The average cash cost of world gold mines in 2002 was $180.00 per ounce. Add in overhead and development costs of $50.00 to $70.00, gives an overall average cost of $260.00 an ounce.

For a new mine going to production, to earn a satisfactory rate of return revenue should be two times the cash cost.
Minimum open pit grade should be one gram. Minimum underground grade should be 8 grams.
In an underground mine a zone or intersection should be economic if the grade times width, in feet, exceeds 3.
Large low-grade open pit operations are as much a factor of engineering and management as they are of geology. Specific gravity, work ratios and metallurgy are just a few of the many factors to be considered.
The very nature of the mining exploration business dictates that only a few companies will find a mineral deposit and even fewer will bring it into profitable production.
Unlike the oil industry, most major discoveries are initially made by Juniors.
While great ore bodies can make great companies - e.g. Barrick, Agnico-Eagle and Goldcorp - management still has to explore for more properties to keep the market interested.
One strategy that has been very rewarding has been to buy the shares of each Junior or independent exploration company that pulls a surprising drill hole. Specifically, we mean a "surprise not only to the market but to the operator as well". Then to sell half-on-the-double or half three to six months later. This would have given the astute gold mining investor a position in Barrick Gold, Goldcorp and Corona in the early stages. Historically, the successes would have more than compensated for the failures.
Although management of exploration companies is important, it is still true that "a good jockey needs a good horse". Management may have an excellent track record but they still need a good property.
Drill for structure, drift for ore. The investing public has a tendency to exaggerate the significance and conclusiveness of drill holes into vein structures. For this reason, Abington Ventures is currently planning a bulk sample to correlate with results of their recent drill program.
High-grade drill holes should be cut to either:
1. Two to four times the average grade or
2. Cut to one ounce

In order to provide a conservative estimate of ore grade, both the frequency and distribution of high-grade assays should be carefully identified. One needs to be wary of narrow high-grade intersections that are averaged over large core lengths to create "stretch assays", which can be misleading.

Trading Rules and Criteria

Use fundamentals for the main direction, quantitative and technical analysis for timing.
Like all commodity producers, for a gold stock to provide the investor with stable long-term capital appreciation there must be substantial increases in reserves or physical production over time.
A review of the Financial Post 10-Year Range and Dividend book provides ample evidence that the vast majority should be traded. Only a small number rank as "buy and hold" investments and only a few pay dividends. Over the past twenty years, gold stocks have been great speculations and, with few exceptions, poor investments.
The investor needs to identify in which category he wishes to place a specific security:< >Those securities he should rentThose he should lease orThose he wants to own outrightDemand is always more important than supply in determining the price of any commodity. Analysts tend to emphasize supply because it is easier to measure and quantify.
Speculators and hedge funds can be influential when demand for gold is high, especially when the U.S. dollar is weak - they have little or no influence when demand and supply prices are in stable balance.
The long term investor should be agnostic on bullion prices. The "gold bug" buys and never sells, the "gold cynic" misses out on the potential for large capital gains, as he never joins the party.
In dull markets, it pays for the investor to stay on the sidelines. While gold itself outperforms the stock market in only two out of ten years, there are often mini bull markets in the other precious metals such as platinum and diamonds. It is a time to pull in your nets and to go for casting.
In a sideways market, the traders often practice "range bound" or bracket trading especially on stocks like Placer Dome and Barrick, which are now mature, established investment grade securities with limited long-term growth potential.
In a bull market for gold securities momentum trading can be very rewarding for the trader.
One does not always need a bull market for gold bullion to trigger appreciation in mining stock price - e.g. 1970 to 71, 1974 to 75 and 1982 to 83.
North American gold stocks tend as a rule to rise before the bullion price but the time lag and extent of the gain vary enormously. South African gold mines tend to parallel the gold price as they trade on a low price earnings and yield basis. As the gold price rises, so do the prospects for dividend increases.
The market is very efficient at valuing gold mining securities at a point in time. For this reason we should be surprised by a study done by Merrill Lynch in the late 1960's that showed that fundamental value ratios had little or no predictive value for the future price performance of mining securities.
Large producers tend to trade at two to three times asset value and mid-tier companies at one to one and half times. Substantial price appreciation can occur as stocks move from lower to a higher category with production or reserve increases.
Inflation is not necessarily good for gold or gold mining stocks. In 1981, the CPI was up 8.9% while the gold price lost 31.3% and in 1986, the CPI was up 1.1% while the gold price increased 21.3%.
At times, gold shares trade as gold instruments and other times as equities. In December 1981, the gold index bottomed out and doubled before gold bullion stabilized in July/August 1982. In August 1984, the index was up 20% before gold turned up. Thus, gold stocks operate at times as a thermometer reflecting the price of gold and at times as a barometer predicting the future price of gold.
In the early phases of a gold bull market it pays to be an investor, in the later stages a trader.
Historically, when the speculative phase of the general equities bull market is over we often get a three-year bull market in gold and gold securities.
The biggest moves often come from dull markets when a commodity such as gold goes from "bad to not so bad", as in the October 2001 - May 2002 gold stock bull market.
Whenever a mid-tier or independent producer interlists in the U.S.A. it invariably increases the shareholder base and audience for the stock. These stocks often show rapid appreciation as U.S. and foreign interest increases. They also often peak when U.S. shareholdings are at their peak - e.g. Glamis Gold, Agnico-Eagle and Goldcorp in 2002. By tracing the relative volumes on the Canadian and American markets the astute trader can gauge when they are about to run out of momentum.
In a bear market, one should visit with the rest but buy only the best.
Once the bull market is underway then fundamentals do not matter as much. Every large low-grade deposit and marginal producer is carried along with the bullish trend.
It is not sufficient to get the sector timing right. One needs to sit in the right pew as well as attend the right church. In 2001 and 2002, investors in Barrick Gold and Placer Dome missed out on the gold bull market due to investor antipathy to hedged companies.
Buy scarcity, sell surplus. In the early stages of a gold bull market only a few "elite" stocks move; these stocks tend to have excellent fundamentals and growth prospects. When all gold stocks are appreciating, it is an early warning that it is time to consider profit taking. As the commodity silver is in surplus, at these low prices very few pure silver mines exist, as mining operations are, for the most part, uneconomic. As a consequence, there are only a few silver mining securities and so they tend to trade at high premiums. The same carries true for gold royalty companies such as Royal Gold, the former Franco-Nevada and for North American platinum group producers, such as North American Palladium, their main value lies in their scarcity.
Major mining companies under pressure to maintain or increase physical production tend to overpay for acquisitions. One recent study done by the Universal Precious Metals Fund found that 80% of the benefits went to the company making the discovery and only 20% to the acquisitor.
Leverage is a double-edged sword for gold mining companies. Excessive hedging at low prices and high debt level has given the industry a survivorship problem. The investor should be wary of companies that have large debt, hedged production and low grades. As gold prices fall, breakeven grades increase and reserves fall.
As many investors see gold as a hedge against excessive debt in the economy, they tend to shy away from companies that have "hedged away their hedge". For many of the capital intensive, low-grade and heavily hedged companies it is often a case of "gear today, gone tomorrow".
The investor needs to keep a keen eye on technological, economic and regional trends in the gold mining industry. In the early days of gold leaching, such companies as Glamis Gold and Pegasus were big winners. The switch from shallow drilling to deep drilling in the Carlin Belt in the 1980's led to rapid increases in reserves and production for both Barrick and Newmont, and made Barrick the first one million ounce producer in North America. In recent years, deep drilling of vein structures in existing mines, resulting in large increases in high-grade ore, made Goldcorp and Agnico-Eagle into winners. Over the past five to ten years, the expansion of exploration into the non-English speaking world has provided many successes in Africa and South America. Companies in this category such as IAMGold, Meridian, Nevsun and PMI Ventures have shown substantial price appreciation.
The percentage of gold produced as a byproduct of base metals has steadily increased over the past ten years; it now stands at close to 20% of world production. The market treats such companies as closer to base stocks than as gold producers.
In recent years, the industry has been consolidated on a worldwide basis. In South Africa, in 1995, there were thirty-five major gold mines, now there are five. North American Seniors have also been consolidating at home and abroad. This reduces the number of potential investments for the gold investor and increases interest in mid-tier independents and Juniors.
As 85% of all gold sold ends up in the jewelry trade, the latter has an important influence on the seasonality of gold bullion. Demand slows in the summer months as dealers and retailers work off inventory. Fabrication tends to be strongest at the year end as jewelry manufacturers stock up in anticipation of the Chinese New Year and the Indian wedding season. In gold bull markets, the October to January period can be very strong. The seasonal low months occur in August and September. In the final quarter of the calendar year forward selling of bullion by producers and hedge funds tends to decline as rising bank bullion lease rates deter forward sales, which reduces supply to the market and leads to higher gold prices. Once a rapidly growing gold mining company's physical production plateaus, they become candidates for seasonal trading. For exploration companies, nature is not always kind in locating mineral deposits, and exploration work is often confined to a seasonal basis.
One rule of thumb for gold mutual funds is that when money flows in at a faster rate than net asset value appreciates it is bearish, when money exits faster than net assets depreciates it is bullish.
When you buy is as important as what you buy. Based on the nature of the stock selected to trade the investor needs to determine an optimum time frame to hold the stock. It can be better to buy the wrong stock at the right time than to buy the right stock at the wrong time.
In any secular bull market, the first stocks to break out are often the best investment buys. They tend to go further and faster than stocks that break out later. Such companies plough their own furrow. These are the companies that have made discoveries, scaled up production or reduced costs during the bear market. In the 2001 - 2002 gold bull market Agnico-Eagle, Southernera, Goldcorp, Glamis Gold and IAMGold were the sector group leaders. In the second phase, beginning in December 2002, the whole index broke out. Companies with marginal properties and/or semi-developed ore bodies gained momentum. Then in late May and early June 2002, when almost all gold stocks were trading at new highs, a sharp correction occurred. After June 2002, a new phase occurred when attention switched to exploration companies such as PMI Ventures, Canadian Royalties, Midway Gold, Abington Ventures and SouthWest Gold.
In selecting Junior and mid-tier independent exploration companies to trade, one should bear in mind the old maxim that for a geological deposit to have a chance of being a successful producer it should be exceptional in at least two dimensions such as high-grade, low strip ratios or existing infrastructure. For instance, Abington Ventures has access to a smelter within trucking distance of their high-grade ore, obviating the need to build a mill to process potential ore. PMI Ventures in Ghana has assembled a regional exploration area equivalent in size to the Carlin Belt in Nevada and is surrounded by deposits belonging to Majors, two of which are being prepared for production.
One of the most surprising elements in reviewing the three phases of the 2001 - 2003 gold bull market was the relatively clear demarcation between the three phases.

Anatomy of a Gold and Precious Metals Bull Market

In our sample of 106 gold and precious metal companies between September 2001 and May 2003, three clear and distinct phases clearly emerge.
Phase One: September 2000 to August 2001. The so-called "early birds", eighteen stocks with an average gain to subsequent high of 395%.
Phase Two: October 2001 to June 2002. Group sector move of one- hundred-six stocks with an optimum hold period of twelve to fourteen weeks.
Phase Three: Exploration phase with over forty Junior exploration companies showing up on our radar screen, with the best performers including: Midway Gold, SouthWest Gold, Abington Ventures, Canadian Royalties and PMI Ventures. Another surprise was the relatively short time frames over which most of the price gains were made, and in some cases lost in Phase Two and Phase Three, proving the point that, as in comedy, in the stock market timing is everything.
Selling is the flip side of the coin, as the poet Robert Frost expressed it, "Take care to sell your horse before it dies. The art of life is passing losses on." Before entering a trade, the trader needs to have an exit strategy planned. When it comes to volatile gold stocks it pays to be an anticipatory seller, not a reactionary one. In June 2002 when the first sell off occurred in gold stocks many dropped as much as 40% in a week.
Some traders try to trade every little wave. Volatile gold prices can make this a dangerous practice. There is an old trading maxim: Do not eat like a bird and excrete like an elephant, taking small profits but setting yourself up to suffer a big loss.
In timing sells, one rule of thumb is that large gold stocks make small moves over long periods of time while small mining stocks make short, sharp moves over short periods.
The most attractive gold warrants are invariably issued in a gold bear market as a sweetener to an equity issue. One need not concern one self about the liquidity of the warrant as long as the common shares are liquid - e.g. Goldcorp warrants in 2002.

Gold and Precious Metals Group Sector and Individual
Stock Breakouts and Duration of Bullish Trend
October 2001 to June 2002

Mean Optimum Holding Period = 4 months
Median Optimum Holding Period = 4 months
Note: Month in which initial breakout occurred and peak subsequent high was reached are counted as complete months, which tends to exaggerate the length of the Optimum Holding Period.

Reginald W. Ogden
Canaccord Capital Corporation
E-Mail: [email protected]
FAX: (604) 643 - 7009