This month’s digest will cover the gold mining stocks and how they are reacting to gold’s recent move. We’ll provide detail on how the mining stocks track the price of gold over various points in time. We will explain how the miners provide a leveraged, speculative play on the physical metal. And we will explain how to go about valuing the miners and finding winning companies to invest in.
We are going to use the ETF database to pick the top 4 gold funds by assets. There are more index funds, but these are the main ones that get the bulk of investment and are the most liquid.
Source: ETF Database
The largest fund by assets is the GDX gold miners ETF. Since gold broke out in June, the GDX has followed suit. As the price of gold rises, the mining companies get more interest from the market largely because their margins are now rising, providing more profits for investors.
Source: Yahoo Finance
Comparing the largest fund to the others on the list, we get this picture since the June gold price move. Notice how different the lines are for each of the funds. Even though they all moved the same direction, each reacted differently to the gold price move. NUGT and JNUG move higher than the other two because they are leveraged funds designed to move 3x the direction of the gold price.
Source: Yahoo Finance
Both GDXJ and JNUG are junior minor indexes. Junior miners are exactly what they sound like – the smaller gold companies that produce moderate amounts of gold each year compared to the larger companies. But there are many more of them, which provides diversification into different regions, geologies, and management teams within those ETF funds.
The junior miners moved up less than the gold majors. Why is this? Primarily, the major gold minors have more investment capital and stocks issued. Their stocks are much more liquid in the market, meaning they trader higher volumes of shares on a daily basis. Therefore, they are more sensitive to daily gold price movements.
The junior miners, on the other hand, are relatively illiquid in daily trading and often have much lower market caps. A market cap is a multiple of the share price and number of shares issued by the company. Even though you may see a lot of shares issued by junior miners, their prices are often much lower. We will discuss why this is the case in the next section.
There are other gold miner indexes, namely the HUI, XAU, and XGD. You are encouraged to do research on each one to determine if they are a fit for you.
Valuing gold miners is not overly complex, but it can be confusing. Many an investor has spent years learning the tricks of the trade, and doing research to facilitate various trading strategies. In general, valuing miners is as simple as:
a) determining the quality and quantity of assets they have in the ground
b) determining the recovery ratio of assets into recoverable metal
c) applying a market price range to the assets consistent with both the near term and longer term expectations for market prices
d) evaluating the costs of mining, relative to both the market price and other projects of similar geology
e) evaluating management’s past successes, particularly with similar rock and metal formations
f) assessing the project value using technical studies and ones own knowledge to determine what the overall market cap should be
g) discounting the market cap number by the time value of money, minimum 5% per year (but sometimes much higher), for every year of expected mine production
g) dividing the discounted market cap by the number of shares issued, to get a target share price TODAY
h) monitoring share issuance by the company, typically to pay for mine development costs, for dilution of individual share value from the initial assessment value over time
That is the basic formula that can be applied to any resource mining company, regardless of sector. Speaking specifically of precious metals, I would order the previous steps into the following buckets of risk based upon my personal experiences in investing in them.
1) Management matters more than anything else to me, because good projects can turn into bad ones when they are run badly. Conversely, good managers can make challenging projects profitable for investors without destroying share value by over-issuing stocks to pay for company mistakes.
From experience, I look at management from the top down through the mine managers running the actual operations. A recent example of a gold stock I have followed for years showed that the first operations manager did poorly in setting up the gold leach pad, which is used to extract the metal from the dirt using an acid draining process. The company was not profitable, though they met most of the goals of their technical feasibility study except for the metal recovery rate. When they changed out mine managers, results improved both quickly and dramatically. So it is not just senior management that matters, but any person on the team with daily decision-making ability over the mine operation.
2) Deposit quality is the second most important factor. Great deposits can often cover up mining mistakes, whether by sloppy management or through unforeseen stumbling blocks that almost all mines will invariably present to the operations teams.
Be careful with this one and don’t make the mistake most novice investors do. Not all deposits are created the same, so it is important to look beyond the overall gold ounces contained in the ground. The investor should assess how hard it is to get the gold out, how much it will cost, and whether management has done this type of project before.
3) Jurisdiction matters a lot, and directly affects the discount value discussed on point G above. Safer jurisdictions mean less chance the mine gets shuttered, whether temporarily or permanently, due to outside factors. These factors entail political and cultural risk.
For example, if new administrations are elected that are less favorable to mining, it may slow down permitting or result in higher taxes. Both can have adverse affects on project value, which will be reflected in the share price for the company.
Also, non-governmental organizations (NGOs), particularly those with an environmental focus, can bring tremendous local pressure to bear. Many times companies can navigate this pressure by starting communications with local community leaders early, but often times NGOs often get on the ground early in the process. Many of them are organized internationally and have presence in many countries for the purpose of keeping mining companies in line with their objectives. Some local cultures are influenced more than others, so knowing the culture of the jurisdiction your company mines in is very important to assessing risk to the project and expected share value.
Where jurisdictional risks rise, investors should calculate higher discounts to apply to the monetary value of the mine production. For example investors may want to apply higher discount rates for some higher risk jurisdictions like South American countries to reach more conservative company valuations. Some jurisdictions may exceed the risk appetite of investors, such as in South Africa where high political conflict currently exists with regards to land and mine assets.
There are many other risk factors to assess for a given project and company, such as access to infrastructure near the mine versus costs of building it out on site. Access to water and electricity, which are two major mining process inputs, is of key importance. But the three risk factors above are the most important when valuing a mining company, generally speaking.
We live in a global world where information travels fast. Add in social media and the ability to influence wide swaths of the public with very little information, and we have a potential powder keg ready to go off within the investment markets. Especially markets that operate on smaller scales, such as the precious metals markets.
Typically I am not a huge fan of investing in stocks or other paper assets. Those who have followed me for some time know my view on the Ponzi nature of the stock market. Without going into too much detail, stocks are often influenced by the crowd sentiment, often unfairly when taking into consideration the logical business risk factors each company presents. Wide valuations can occur even if the risks turn out to be much less risky than originally perceived.
Here is an excellent presentation where Tan Liu and I discuss the four factors in which stocks act as Ponzi schemes. In sum, most of the actual value of your stock investments are on paper, and can only be realized when selling to some other third party such as yourself.
There is very little redeemable value from companies in stock once they are issued. Many large companies have par values less than a penny! When there are no buyers in the market, stock prices often fall precipitously. Only about 1% of stocks trade hands in a day, and many times this percentage will fall sharply. This occurs during every major recession, but can occur in individual stocks and sectors for a large variety of other reasons that we cannot control as investors.
And all too often, valuations can rise much higher or lower than the math would indicate due to passive investing and the crowd herding effects of less knowledgeable investors. Look for management to have a quality public relations team to deal with the public and provide guidance on current events with their mining projects. However, many times public sentiment can be overwhelming for short periods of time until cooler heads prevail.
For example, a few years ago Apple computer was basically slandered by many pundits for their handling of a battery life-cycle slowdown. The issue was blown up so big that the share price began to fall, and fall some more. Eventually it was pointed out that the lithium ion batteries in Apple phones were of the same quality and design as in all other phone models, and further that all phone manufacturers (as well as portable computer and device markets) experienced the same issues. Battery technology was the same across the industry.
I was one of the few calm market analysts that pointed out Apple did not ship faulty or substandard batteries with their phones. Most independent major battery tests actually indicated Apple batteries were designed to last longer per charge that the majority of their counterparts. I discussed the variety of factors that caused early battery failure, backed up with reputable information resources.
Eventually the share price returned to the normal trading range, as I predicted that it would. Those still angry at Apple huffed and claimed (as shown in the first Apple article linked above) that Apple somehow had the responsibility of educating users on lithium ion technology in its phones.
It was at fault of not anticipating the lack of technical knowledge of its customers, which is truly an absurd standard. The market had not called for the same requirement for Android phone makers. Or for that matter, computer notebook, mobile device, or even wireless camera manufacturers. Why should Apple suddenly be singled out as the sole participant in technology education?
The responsibility for using technology, or any product, falls upon those purchasing it. In response, Apple offered discounted battery replacements ($50 installed) on all its phones, which amounted to a nearly free extension of the mobile phone’s lifespan. Further, Apple updated their software to allow users to choose their battery discharge modes. As a result, all major phones now have very similar battery management enhancements built in, precisely because they all suffer from the same phenomenon.
The same thing can happen in mining company stocks, and often does. One piece of bad operations news can cause a major price run to the down side. When the actual problem identified is less risky than originally perceived, patient and wise investors now have opportunities to pick up shares of quality companies at cheaper prices.
During market downturns, sectors of stocks often get slammed downward. Usually it is a function of which sectors had more bad news and were affected by the economic problems experienced. Often, the stocks with the highest valuations relative to a variety of accounting metrics will get more severely discounted when the economy begins to slow. This is natural behavior for markets, but often the slide swings too far before correcting to some middle ground.
Beware that the precious metals markets are relatively small compared to other, more liquid sectors. Additionally, they are very cyclical. If we have an extended downturn in the economy, then precious metals stocks tend to do better overall than the general market. This is because investors buy gold and silver in response, which bids up the price, and causes the mining stocks to rise. But before the miners rise, they often suffer the same downward slide at the beginning of recessions that all stocks do. Understanding this behavior is important if you want to invest in these markets.
During bull stock markets, gold and silver are often less popular as investments. Gold especially is a ‘safe haven’ asset when times are tough, but relatively forgotten when people feel good about the markets. Silver tends to follow gold around, though it lags gold’s movements by quite a bit most of the time. Strong gold moves result in strong silver moves, but not typically vice versa.
To a value or market cycle investor, both the cyclical nature and leverage to physical metal that gold stocks provide are very attractive. Patient gold investors will do their research when gold is not in fashion, and then invest in their favorite companies when the stocks are cheap. Many times, gold stock investors will gobble up large producers that are trading well below their project value. For example, buying a gold stock when its total stock market capitalization is only 60% of the net profits from the held gold reserves to be mined means the investor could easily make up the 40% difference during the next gold bull run.
Gold stocks are leveraged to the gold price, and often the stocks will see much higher returns than the gold price move itself. This is because each new ounce of gold adds to total profits, but does not typically raise the cost per ounce. The additional profits hitting the bottom line bid up the market cap of the stocks already issued, resulting in multiples of the original price.
Gold stock funds take a lot of the risk of finding the right company away. Many times investors will buy shares of companies that they believe will do well when the gold price rises, only to figure out some hidden problem they did not know about. When this goes public, it tanks the share price perhaps beyond what is typically reasonable. The investors has the choice of selling at a loss or riding out the investment to see if it rises back to their purchase price.
Gold stock funds do their own extensive research into the markets and pick the miners that best represent the funds targets and risk profile. This saves investors a lot of time and effort. Even though some of the stocks in the fund index may not do well, usually rises in the price of gold will bid up most of the stocks and the overall fund. Investors may not be maximizing returns, but they are minimizing losses by leveraging the power of the broad gold sector.
There are other funds that invest in the actual precious metals, such as GLD. Shares are issued by the fund, gold is purchased into inventory, and the shares are then sold on the open market. Investors essentially place bets on where the price of gold will go, and hence whether their shares will rise and fall. GLD is a type of derivative, meaning it is a paper bet on an underlying investment. Share holders DO NOT have legal claim to the gold representing their shares. Only authorized participants, those that provide the gold for the fund holdings, are allowed to withdraw it. So GLD and gold itself are separate animals, where investors in GLD are getting exposure to gold price movements without having to store it.
Should an aforementioned economic crash occur, GLD price and the gold price will likely separate. That is because authorized participants will liquidate the gold, and most share holders will be left holding shares valued at much less as they are sold off. GLD is not, therefore, recession protection in the manner which many people think it is.
Better to hold the real metal when that happens, or if you are so included, speculate directly in the gold mining stocks or ETF funds. The stocks at least provide upside leverage to the gold price movement, even though they don’t get physical gold in your possession.
You should pick the gold investment vehicle that fits you. We buy primarily physical gold, and silver for that matter, and do not participate heavily in the funds or individual stocks. This flattens the risk curve considerably while still providing exposure to the long term bull market in gold.
That does not mean that investing in the paper side of the gold trade is always a bad idea. For many years, we held positions in many gold and silver stocks. Some were the recommendations of major investment news services; others were the result of our own extensive research. The leverage to individual stocks is enticing, but it does not come without risk. Funds blend some of the features of gold price exposure and stock investment. However, they lack the safety of holding physical metal and could result in large losses due to bad market timing and unexpected events with the miners.
Ultimately each investor has to make their own decision. At the most essential level, traders will typically buy stock funds or the GLD, while long term holders buy the physical metals. The objectives are similar – to maintain exposure to the price of gold. However, physical gold ownership provides benefits well beyond the paper market. Physical gold is and has been actual money for thousands of years, and could easily become again in an emergency. Physical gold can be used for many purposes, and is always desirable by society. It is much more likely that an individual miner goes bankrupt that it would be for the price of gold to fall to zero, which has never happened. Further, there is theoretical floor in the price of physical gold consisting of the major miner costs plus a boost for the amount of interest in the GLD, typically from fear or market uncertainty. And unlike physical gold, ownership of the GLD fund does not provide rights to the underlying metal.