Sunday , 19 November 2017


Jeff Nielson: More of What to Look for When Investing in the Gold Miner Sector

gold-miningThe fact that relatively few investors know much about the various types of companies in the precious metals mining sector is an indication that this market is many years away from peaking. This article provides a basic check-list of what to look for in these companies.

Large Caps

The biggest choice for investors is deciding what size of mining company they want to invest in. There are clear trade-offs here. For simplicity, I will focus my discussion on the gold miners because in the case of silver miners, the sector is so small relative to gold mining that there aren’t the same, sharp divisions between different classes of miners.

The “pluses” and “minuses” in buying shares of a large gold miner (generally companies which are already producing at least half a million ounces of gold per year) are very similar to buying large-cap companies in other sectors. [On one hand,] the companies are more liquid, have less volatility, and are “covered” by a lot more analysts [while on the other hand, these companies typically have much more modest growth profiles than smaller producers because the size and quality of new gold discoveries are generally vastly inferior to new deposits discovered in previous generations. Indeed, with gold production only rising by about 2% per year throughout this bull market, despite a…[major increase] in price, many (including myself) are now talking about the concept of “peak gold”. This means that investors buying into these companies will generally have to rely upon a rising price of gold to earn a return on their investments as “organic growth” for most of these companies will not be a major component of their value.

Before going further in this discussion, let me take a minute to talk about analyst “coverage” of gold miners. Specifically, the coverage of precious metals miners by mainstream analysts is superficial and mediocre, at best. About all you get from such ‘analysts’ are simple, bottom-line financial summaries, with (in most cases) virtually no insights at all into the operational performance of these companies. Thus, any “guidance” they provide as to “price targets” are virtually meaningless.

Typically, the “price targets” of these “analysts” are simply 5% to 10% above whatever the current price is because they have little to no understanding of the gold market. In short, any investor who devotes a weekend of serious study to precious metals miners would likely have a superior understanding of these companies compared to most mainstream analysts.

The Juniors

The alternative to investing in large gold-producers is to buy the “junior” miners. Since this is where both the greatest selection and the greatest profit-potential exists, I will focus the remainder of this discussion on the “juniors” – with the understanding that some of this analysis will also be applicable to larger miners (but naturally on a larger scale).

The “junior miners” are not separated by market-cap, but rather by category. I place them into three groups with similar valuations and similar levels of risk:

  1. producers
  2. a) near-term producers, b) advanced-stage exploration companies
  3. early-stage explorers

Before discussing these companies in detail, let me provide investors with an important warning. There are significant risks associated with investing in these companies – even those that have producing mines. While these are certainly not the sort of “fly-by-night” entities investors were pumping their money into during the tech-bubble, such investing must be done carefully. There are two approaches which I would recommend:

  1. for conservative who see such investments as representing the “speculative” component of your portfolio that they find one or two companies that they like, and invest perhaps 5% of their portfolio accordingly
  2. for investors who have more enthusiasm for this sector, and who want to make precious metals miners a significant component of their portfolios, that they divide their investment dollars into a “basket” of preferred companies. Most experts in this sector follow this approach – based on the following reasoning:

It is an established fact that the junior miners (as a whole) will always outperform the large-cap producers but the risk for individual juniors is much greater than for the larger companies. By buying a “basket” of these companies one can capitalize on this superior performance and accept the fact that some of these companies will end up as losers.

1. Producers
As the name implies, these are mining companies which have officially commenced commercial production. Once a junior miner begins production it typically represents a beginning of the returns these companies will generate for investors as few, if any, are able to commence commercial production at their maximum potential output. Getting a mine into a smooth chain of production, from extracting the ore to producing the “concentrate” which is shipped to refiners/smelters is a process at least as challenging as other “manufacturing” processes – and generally more so. Most new mines will at least double their initial production over time. In the cases of mines which have large reserves/resources, it is not uncommon for production to even triple or quadruple – as production hurdles are overcome, and cash-flow allows production to be expanded.

Investors buying into junior miners will have three ways to capitalize on their investments in these companies:

  1. they can profit on the rising price of the commodity, with the natural leverage inherent in the business model of all commodity-producers.
  2. they can realize gains from the increasing production of these mines, and
  3. they can benefit from improving valuations on these companies as the combination of rising production and a track-record of consistent production reduces the risk-profile of these miners.

2. a) Near-term Producers
As the name implies, these are mining companies which are past the highly-speculative stage of merely finding an ore-body. They have already established that they have a mineral resource capable of supporting a commercial mining operation. Through a “feasibility study” they have identified and selected a specific process for mineral extraction which is also commercially viable. They have obtained all the necessary permitting and royalty agreements with the local government. Most importantly, they have all the financing necessary to take them into production.

Again, just because most of the speculative issues have been resolved with these companies does not mean they are free of risk. There are nearly as many things which can go wrong in building a mine as in operating one. However, because these miners are in an earlier stage of development than the producers, there is more up-side potential in these companies – and commensurate with that, there is also more risk.

2. b) Advanced-stage Exploration
I have chosen to lump these companies with the “near-term producers” (as opposed to the “early-stage explorers”) for two very important reasons:

  1. Unlike the “pure” explorers, these companies have already done extensive drilling on their property, and have established commercially significant grades of ore in those drilling-results. Depending on exactly how far they have progressed in their chain of development, these companies generally already have “resource estimates”. A resource estimate is a scientific evaluation of the quantity of ore in a given area, extrapolated based upon the quantity of drilling data. Where such data is at a minimal level, the analysis produces an estimated “resource” where there is still a fairly considerable margin of error. When drilling is done more extensively (thus producing much more data), the analysis produces an estimate of “reserves” – a quantity/concentration of mineralization with a high degree of reliability.
  2. Once this resource estimate is completed (which hopefully demonstrates a potentially viable mineral resource) the next stage is to undertake feasibility studies – to demonstrate that it is also possible to mine that ore at a profit, and thus obtain financing to build a mine.

All feasibility studies must make assumptions about commodity prices in order to ascertain whether production is commercially viable and, as such, a company could conduct such a study and be told that their resource is not “commercially viable”. However, should the price of the commodity rise significantly (or if a second study was done which simply assumed a higher price) that same body of ore could suddenly become economical. The reverse is also true in that, should the price of a commodity fall, or should input costs dramatically rise, an ore-body previously judged to be commercially viable could suddenly be considered uneconomical.

With significant volatility in both commodity prices and input costs, in theory the analysis of any particular ore-body could flip-flop several times. Indeed, when commodity prices plummet or input costs skyrocket, even mines in operation for decades are sometimes forced to close (at least temporarily). Despite all these variables, these companies are still much less speculative than the early-stage explorers, and thus their valuations will tend to be more closely aligned with near-term producers than with the pure exploration companies.

3. Early-stage Explorers
At worst, buying into these companies is like buying a lottery ticket [and,] at best, buying a winning lottery ticket. Putting aside that flippant remark, these companies are generally all highly-speculative in that they are “mining” companies which are just beginning to explore their property. They range from companies which have done little-to-no drilling on their properties, to companies which have done preliminary drilling and established some level of mineralization but are still a long way from establishing that they have discovered a commercially viable body of ore.

The important point here is that there are factors which dramatically affect the chances of these “lottery tickets” becoming “winning lottery tickets”:

  1. Location. Obviously a company drilling in an area with a history of profitable commercial mining has a better chance of discovering a future mine than a company drilling in some “virgin” wilderland. Conversely, a company which is exploring “in the middle of nowhere” which does discover a significant body of ore will generally provide more profit to investors – much like successfully betting on a horse with high odds.
  2. Management. A company run by people with a previous track record of discovering significant deposits is more likely to succeed again than explorers which lack that experience. Sadly, it is very difficult for novices to know/identify such expertise making these mining companies generally more suitable investments for those with experience investing in this sector, or (perhaps) through paying a subscription for the advice of an experienced analyst.

Conclusion

  • The stocks of junior mining companies are not the place for investors with a “get rich quick” attitude.
  • Investors need to “do their homework” and remain disciplined.
  • There is an enormous amount of volatility in this sector which requires people to buy and sell rationally rather than emotionally.
  • Those who tend to “chase” these companies on the way up and dump them on the way down will have a hard time making consistent profits. Instead, investors must be patient and buy on “weakness”, and along with that regularly take profits when significant gains materialize. Those who do not feel comfortable with such trading are probably better off sticking with the larger, more-established miners.
The comments above are edited ([ ]) and abridged (…) excerpts from the original article by Jeff Nielson

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