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October 27th, 2009
It is a long-established pattern of the precious metals sector that in any long-term bull market the precious metals miners outperform bullion, itself - with this especially being true at any medium-term tops and (of course) at any long-term top. The fact that relatively few investors know anything about these companies is one indication that this market is many years away from peaking. However, with gold recently reaching a new nominal high it is only natural that investor curiosity about these companies should start to grow.
Unfortunately for investors, there is not a lot of guidance openly available on these companies. Those advisors who specialize in this sector and focus on the mining companies typically offer their advice by subscription only. For novices to this sector, even those who are willing to pay for a subscription , knowing who is worth the time and money for such a commitment can be a very difficult question to answer.
While we are building a database of these companies at Bullion Bulls Canada, we do not market ourselves as "stock-pickers". We're happy to provide information to investors on these companies, however our own choice has been to try to show investors how to approach investing in these companies on their own, so what advice we do offer in this area is offered free of charge.
In selecting potential investments in this sector, there are many criteria to evaluate. As a starting point, in Part 1 I will lay out a basic check-list of what to look for in these companies. In Part 2, I will add some necessary caveats in evaluating these companies - to hopefully prevent novices and near-novices from being careless or over-confident in choosing among these miners.
The first, and perhaps biggest choice for investors is deciding what size of mining company in which they want to invest. There are clear trade-offs here. For simplicity, I will focus my discussion on the gold miners. 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. The companies are more liquid, have less volatility, and are "covered" by a lot more analysts.
On the down-side, these companies typically have much more modest growth profiles than smaller producers. This is even more true with gold miners than in many other sectors of the economy 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 near quadrupling in price, many (including myself) are now talking about the concept of "peak gold".
What this means is 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. I presume that the situation here is the same as with other specialty-sectors which receive partial "coverage" from mainstream analysts. 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.
These people have little to no understanding of the gold market, itself, so their forecasts generally either assign extremely conservative and arbitrary future prices for gold - or simply ignore that factor altogether. 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 alternative to investing in large gold-producers is to buy into 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. While others may have a different method of dividing-up these companies, I prefer to place them into three groups:
While the companies in these categories are not entirely homogenous, this break-down separates these miners into groups with similar valuations and similar levels of risk.
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 who 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 as alternatives to investors. First, you can have such investments represent the "speculative" component of your portfolio. Find one or two companies which you like, and invest perhaps 5% of your portfolio (depending on portfolio size and risk-appetite).
For investors who have more enthusiasm for this sector, and who want to make precious metals miners a significant component of their portfolios, you must divide your investment dollars into a "basket" of these companies. Even 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. However the risk for individual juniors is much greater than for the larger companies. By buying a "basket" of these companies, you can capitalize on this superior performance - and accept the fact that some of these companies will end up as "losers", which will have to be dumped and replaced at some point in the future.
As the name implies, these are mining companies which have officially commenced commercial production. However, once a junior miner begins production, this doesn't end its growth as a company, but typically represents a beginning of the returns these companies will generate for investors.
For one thing, few mining companies ("juniors" or otherwise) 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.
I'll spend significant time in Part 2 discussing some of these factors. For now, I'll simply point out that 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. They can profit on the rising price of the commodity, with the natural leverage inherent in the business model of all commodity-producers (see "A Novice's Guide to Precious Metals, Part 2: the miners"). They can realize gains from the increasing production of these mines, and 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.
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 "feasability 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. Once again, I'll have more to say on this subject in Part 2. For now, I will simply point out the obvious: 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.
I have chosen to lump these companies with the "near-term producers" (as opposed to the "early-stage explorers") for two very important reasons. 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.
Once this resource estimate is completed (which hopefully demonstrates a potentially viable mineral resource) the next stage is to undertake feasability studies - to demonstrate that it is also possible to mine that ore at a profit, and thus obtain financing to build a mine. The obvious point to make here is that all feasability studies must make assumptions about commodity prices in order to ascertain whether production is commercially viable. Thus, a company could conduct such a study and be told that their resource is not "commercially viable", but 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.
However, the reverse is also true. 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.
At worst, buying into these companies is like buying a lottery ticket. At best, buying into these companies is like 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(s). They range from companies which have done little-to-no drilling on their properties, to companies which have done preliminary drilling, established some level of mineralization - but are still a long way from establishing 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". The most important variable (as is the case with most property) is 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.
The second-most important factor is 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.
Ultimately, this sector is 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, requiring 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.
ABOUT THE AUTHOR
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and I encourage you to complete your own due diligence when making an investment decision.
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