6 Tips for Picking Winning Gold Miners

There is no substitute for gold.  But gold miners, if you choose them correctly, can not only leverage your exposure as they grow their businesses, but they can generate cash-flow and dividends that are correlated to the gold price.

This sounds great!  Unfortunately it isn’t so easy to pick gold miners that provide these advantages.

If you take a look at some of the largest gold mining companies in the world, you’ll find that they have done a lousy job of generating leverage to the gold price.  In fact some have even lost value!  Just consider the performances of the following gold miners over the past 10 years and keep in mind that the gold price has more than tripled during this time frame.

• Barrick Gold (ABX): Down 9%
• Newmont Mining (NEM): Down 40%
• Harmony Gold (HMY): Down 68%

Even if you look at some of the winners, and some of the stocks that gold mining investors tend to like, you’ll find that their performances over this time frame is lackluster.

• Goldcorp (GG): Up 132%
• Yamana Gold (AUY): Up 233%
• Agnico Eagle (AEM): Up 192%

Of these six companies, only Yamana Gold has kept pace with the gold price. So, picking winning gold stocks is more difficult than it would appear on the surface. Indeed, it requires hours of research, due diligence and a little bit of luck for good measure.

So what has caused the lousy performance?  There are a number of reasons and the case studies are evident in the companies listed above.

First, production costs have been rising, and this counteracts the leverage that gold miners are supposed to provide investors.  If the gold price is $1,300 and the company produces gold at $1,000, then its profit doubles if the gold price rises to $1,600/oz, even though the gold price rose just 23%.  But what has been happening lately is that the cost of production has been rising at a faster pace than the price of gold. This has been putting pressure on profit margins and most mining companies and leading to their underperformance versus the metals.  If the gold price rises by $300 but the cost of production rises by $400, then the gold miner in question is inherently less valuable.

Second, many gold mining companies are dealing with increasing government regulation and taxation, thus making it very difficult to grow their bottom line.  These challenges add to a company’s total production costs.  Some countries are riskier than others. For example, the first three companies that I listed above all operate in high-risk jurisdictions.

Third, gold mining is difficult, and every gold mine is different.  There are a myriad of operational pitfalls and unexpected problems that can arise and delay or derail progress. Competent and experienced management teams are few and far between in the mining industry, so shareholders will often feel the pain of a management learning curve that is all too steep. Misallocation of capital can be very costly for mining companies and a few mistakes can completely jeopardize the future success of any miner.

How, then, do you pick the winners?

There is no definitive checklist, and there are no perfect companies.  No matter which gold miner you buy, you are going to expose yourself to some risk. Further complicating the issue, the least risky companies are nearly always overvalued on a purely quantitative basis.  However, there are several ways that an investor can mitigate the risk associated with investment in mining stocks. In order to increase my chances for success, I look to do the following things when investment in a gold miner…

1–Invest alongside management

This should be pretty obvious, but you want to bet on management teams that have a substantial stake in the company.  A good rule of thumb is a 10% minimum, but the threshold should be higher for smaller companies.

When management owns shares in the company it means that its members want the company to succeed, and it also means that they believe it will succeed.   When managers don’t own a significant stake in the company, it can signal that management’s interests aren’t as closely aligned with shareholders as they should be.

2–Invest alongside winners

Find companies that have management teams that have succeeded in the past and that are using their past success to leverage their potential future success.  Management teams that have succeeded in the past are more likely to do it again. Furthermore, they are better able to overcome the challenges that will arise as they bring mines into production.

A great example is Rob McEwen, who built Goldcorp into the behemoth it is today.  Now he is the chairman of two other companies–McEwen Mining (MUX) and Lexam VG (LEXVF).  He also owns about a fourth of each company.  McEwen’s involvement in these companies doesn’t guarantee their success, but it raises the likelihood and probably means that you should keep them on your radar.

3–Pick good places to mine

Many investors simply focus on large, high grade deposits, regardless of where they are located.  Sure, they may avoid places such as Venezuela or South Africa, but they don’t pay sufficient attention to the mine’s particular geography.

This oversight is unfortunate, as it is easy research to perform and can make a huge difference to an investor’s return.  I like mines that are near, but not too close to minor cities.  I also like mines located in mining camps such as the Timmins Camp in Ontario.  These areas have easy access to key infrastructure which can determine whether or not a mine is economic. Access to roads and other transportation, water, electricity, and labor are all critical elements.  Mining camps have an added advantage because they have communities of people who are a part of a mining culture.

These companies are more likely to attract talent, get financing and permitted, and find more gold (gold deposits are often found adjacent to other gold deposits).

4–Pick low-cost miners

Most often the higher the grade, the lower the cost, the greater the profit margin. However, while grade is a key component in keeping costs down, management is another key driver that often gets overlooked. Management teams that keep costs down aren’t simply mining high grade deposits.  They know how to operate mines efficiently and have a greater chance of creating long-term value for shareholders.

Consider Mandalay Resources (MNDJF).  It is one of the lowest cost miners in the industry and it recently bought a high cost miner–Elgin Mining.  This appears to be counter-intuitive until you realize that the CEO Bradford Mills believes that Elgin’s Bjorkdal mine can be operated more efficiently.

Operators of low cost mines have a way of thinking about mining that allows them to bring out efficiency, and I think they have a better chance of generating shareholder value and leverage.

5–Emphasize small gold miners

Small companies are often riskier, but with greater risk comes greater returns. If you are able to perform your due diligence and narrow your choices to the small cap stocks with the best prospects, the returns can be astronomical. And while most investors assume that larger cap companies are of higher quality, there are other reasons to consider smaller miners…

First, small companies are easier to manage because they have fewer projects.  Executives at larger companies have to oversee a dozen or more mines, and they wind up spreading themselves thin. What smaller companies lack in project diversification, they often make up for with a laser-like focus on optimizing the economics at their core project.

Second, small companies are often overlooked by the investing public, who focuses on the 5-20 largest companies and only companies that trade on the NYSE or NASDAQ.  If you think small, you’ll find companies that large mutual funds and hedge funds simply can’t buy. Their stock price is below $5, they make lack liquidity and the funds would have to purchase a significant share of the company to move the needle.  With small cap stocks, you will often encounter companies where management owns 15% – 25% of the outstanding shares. This means your interests and managements’ are aligned.  Finally, you’ll find companies that can make small acquisitions that can move the needle.

Third, large companies have to deal with Wall Street scrutiny more often than smaller companies, who only have to deal with scrutiny from industry insiders.  This means that management at large companies have to focus on quarterly numbers, and this could lead to short-term decisions that aren’t always in the best interest of shareholders.  

Large-cap miners have a limited number of projects significant enough for acquisition potential and they can only sell unwanted projects to other large companies. Lastly, large companies simply lack the same percentage growth potential of smaller miners. Their growth curve has flattened and the chances of hitting a home-run with the major miners is pretty close to zero. The limited returns they offer do not adequately compensate for the operational risk. Investors might as well own the metal or pick up diversified ETF such as GDX.

6–Find companies with portfolios that make sense

When you construct your portfolio, you don’t just group together a bunch of stocks, bonds and commodities.  You diversify and balance risks, and you try to find assets that compliment one another.  Mining companies that have assets that “work together” or compliment one another can succeed in many different scenarios.

Take a new company–Chaparral Gold (CRRGF)–as an example.  It has two projects.  The first is the Goldfields Project, which contains a mine that is ready to be constructed and that is highly economical in the current gold price environment. It also has another project–the Converse Project–which contains a huge deposit, but because the prospective mine is so large it is not very economical at the current gold price.  But if we start to factor in even modestly higher gold prices, the value of the Converse Project rises exponentially.  The company is prepared to succeed in the current gold price environment and it offers enormous leverage in a rising gold price environment.

Conclusion

These are by no means hard and fast rules. Individual conditions can warrant a different approach, if you believe the reward outweighs the risk. I own or have owned a few large cap mining stocks, a few companies operating in unstable political environments and a few high-cost operators because I believed they were undervalued at the particular time.

But these are largely exceptions to the rules outlined above.  These are easy rules to follow, even if you don’t have a degree in mining, business, or geology.  I have found them to be very effective and hope that by using them as guideposts, you can pick the winners in the next upswing in the gold bull market. If you prefer to let us do the research and heavy lifting for you,click here to subscribe to the GSB Contrarian Gold Report.

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Courtesy of   Ben Kramer-Miller for Gold Stock Bull