Scott Wright November 30, 2007 3240 Words
In the wild and whacky world of gold stocks, investors and speculators have a wide range of options for capital deployment. These options can be categorized in many different ways, but it all boils down to risk. The degree of risk varies from extremely risky with the junior gold explorers to just plain risky with the large senior producers.
This risk is inherent due to the nature of mining and commodities-market volatility. And in general the gold-stock sector is going to carry greater risk than most other stock sectors. But of course the old market adage applies here, greater risk can lead to greater rewards. So while gold-stock trading is not for the faint of heart, catching this sector in a secular bull market has so far led to legendary gains for those willing to take these risks.
Measured by the venerable HUI gold-stock index, which is comprised of a basket of unhedged gold stocks, gold stocks have soared greater than 1,100% from their late 2000 lows to their very recent highs. These massive gains by the gold stocks have shown superior positive leverage to gold’s paltry 225% gain over this same period of time.
And this leverage model has been very enticing to stock traders. Put in simple terms, rising gold should lead to stellar profits for the gold producers. As long as the price of gold rises faster than the operating costs required to mine an ounce of gold, profits should exhibit positive leverage making the gold miners wildly profitable. Through the course of this bull gold-stock gains are running at about a 5-to-1 positive leverage to gold itself.
In order to grasp the legitimacy of gold stocks’ amazing positive leverage to gold it is extremely important to gain a firm understanding of gold’s bullish fundamentals. Once you are comfortable with the big picture and realize gold stocks are not just speculative vehicles for gun-slinging adrenaline junkies then you are ready for the arduous task of actually picking stocks. And with hundreds of gold stocks available to choose from, this is a chore in itself.
At Zeal we have been recommending gold stocks to our newsletter subscribers since the beginning of this gold bull. And seven years ago there were nowhere close to as many gold mining companies as there are today. Those few that existed in 2000 were either battle-hardened producers or deep-pocketed/dormant explorers that were doing everything they could to survive the great commodities bear of the late 1980s and 1990s.
With gold rocketing higher after the turn of the century the bear is now long-forgotten. And the gold mining industry is once again a sexy venue for the entrepreneurial sort. Not only has there been a glut of fresh new companies hitting the markets looking for the next big gold find, but incumbent miners that had been in the doldrums for so many years are on the warpath with renewed vigor.
With so many stocks to choose from today investors must be a lot more discerning on where to invest or speculate. Today there are literally hundreds of gold stocks available to stock traders and it has become increasingly difficult to sift out the winners. Deep fundamental research is more important now than ever before. This is why even our own research team has had to dedicate a lot more time and effort into the gold-stock research that feeds our newsletter trades.
But not all stock traders have the bandwidth to spend time researching stocks. This is why there is a market for subscription-based research. And this is also why there is a need for guidance on where to start if in fact you do want to research gold stocks on your own. Folks come to me all the time asking where they should start when performing their own gold-stock research.
The first thing I try to encourage investors to do is to understand where in the gold-production lifecycle they want to invest. Now there are in fact many different stages in which a gold company can reside, but there is one big divider that can be used to partition the gold stocks. And this is simply to determine whether or not a given company is actually producing gold. There are the producers and the non-producers.
On the non-producing side are the high-flying junior gold explorers. These companies comprise the riskiest group of gold stocks and can be grouped into several different categories. First and most risky are the grassroots explorationists. These are companies that do not possess a defined gold deposit. They are looking for gold either via land plays adjacent to known gold deposits or are true pioneers looking for gold where it has never been found.
Included in this group are what I call the “dot-juniors” that investors need to watch out for. These juniors are simply momentum players that are looking to steal from the growing inflow of capital into the gold-stock sector. They have no intention of ever discovering gold and are egocentric promoters.
Ultimately this category of juniors is the riskiest because, whether dot-juniors or true explorationists, there is a very high probability these companies will fail. But with this great risk is the opportunity for incredible rewards. When a $25m-market-cap junior finds a $1b gold deposit, shareholders that were long at the time of the announcement would see legendary gains.
The next category of junior is that which has identified a gold deposit and is exploring it to expand and upgrade resources. Be careful though, the dot-juniors are known to reside in this category as well. Gold can be found in small quantities anywhere from the local playground sandbox to sea water. Dot-juniors may cling to “discoveries” of this sort.
The next category hosts the junior that has advanced the exploration of its deposit far enough to warrant a feasibility study that would reveal whether the economics are favorable to extract gold. And of course this leads to the category of juniors that have had successful studies and permitting, resulting in positive development/construction decisions. Juniors that actually make it to this category are few and far between.
With all the different categories in which juniors can reside, investors looking to speculate in this exciting realm really must exhibit an incredible degree of perspicacity. After publishing a research report that profiled Zeal’s favorite junior gold stocks, I penned a series of essays in the beginning of this year that outlined what was helpful for me in analyzing this class of gold stocks.
Moving to the other half of the spectrum we see the gold producers. Now the natural evolution for a vertically integrated gold company takes it from a primary explorer to a producer. But this transition is no small feat. It is in fact an incredibly challenging hurdle that only a small number of elite juniors are able to accomplish.
The odds of a high-school athlete making it to professional sports are probably not much lower than a junior graduating to a producer. And this is why investing and speculating in non-producer/junior gold stocks is so much more risky than doing the same in producer stocks.
But even the companies that do find their way to the producer class have challenges and distinctions of their own. There is indeed a hierarchical structure among the producers. And when looking at which producers to invest or speculate in there are indeed the good, the bad, and the ugly. Just because a company is producing gold it doesn’t mean its stock is lined in it.
This is why in our latest research report we wanted to focus on the gold-producing stocks. Though they number less than the junior explorers, there are still more than enough out there that investors should be exercising prudence in which ones to trust their hard-earned capital.
Now in looking at the producers we can indeed separate them into different categories based on their production profiles. There are the junior, mid-tier and senior gold producers. Typically the market capitalization of a producer scales consistently with its production volume and revenue. And naturally a junior with one mine will be a little more risky than a senior with many.
In our report we profile junior producers with less than 100k ounces of gold production volume all the way up to major producers that are producing multi-million ounces of gold per year. Regardless of size, in order to understand a producer you need to understand how it got there. And the circumstances that surround a producer’s current production profile tell the story of how it will likely be received and perform in the markets going forward.
Today’s top gold producers are either new graduates to the producer class or existing producers that are able to exhibit longevity through organic development and/or strategic acquisitions. Both of these types of gold producers should showcase long-life low-cost mining operations that are positioned to greatly profit in today’s gold market.
But these miners didn’t get to this point with personality and good looks. They got there through a combination of superior technical and managerial execution supported by massive capital injections. And though the most difficult step in building a gold mine is finding the gold, once the decision is made to develop and construct a mine the capital expenditures have really only begun. A decent-sized mine can cost up to $1b to construct. Keep in mind this is on top of the capital that went into initial exploration and development programs.
So in analyzing gold-producing stocks it is important to look at how these usually-cash-strapped miners obtained their capital along with the terms, conditions and effect of this capital. These massive capital injections can come in a variety of forms, either debt, equity or the combination of both.
Debt typically comes in the form a project loan facility from one or a combination of large financial institutions. Now due to the risky nature of commodities and the volatility attached to the markets in which they trade, the terms of debt financing in the mining industry are much more favorable for the financial institution than any other industry. Since the price a miner can sell its product for is subject to such extreme volatility, the miner’s ability to repay its debt is more at risk.
This is where hedging comes into play. Sometimes lenders will attach terms and conditions to a project loan that require the miner to sell forward a fixed volume or percentage of annual gold production each year. Locking in the sales price ensures that the lender will get paid. This practice was very common in the bear market years. But in a rising-gold-price environment, hedging tends to strip profits from the miner as the contracted sales price falls below the market value of gold.
In equity financings the gold miners place themselves in a dilutive environment that can also be harmful to shareholders. In order to raise capital a miner may sell, or place, new shares into market via private placement subscriptions or through general open-market offerings. This dilutes each existing shareholder’s equity interest in the company and can have short-term and long-term effects on the performance of a stock as it absorbs the new shares and tries to regain a balance.
Raising capital will always be a point of contention for gold miners. Even the larger miners that have sizeable cash flows from existing operations need to raise additional capital to either expand or extend existing operations, develop a new deposit, or fund M&A activity. And how the miners are obtaining and managing this capital is important to consider before investing.
In my research I have come across some gold miners that at quick glance look fantastic with very impressive operations. But when you dig deep into their financials you realize that some poor funding decisions in the past have really damaged their growth and profit potential. I have also seen some very creative financings that have greatly reduced the project-financing burdens of the gold miners.
I believe in today’s environment that debt is a much better option than equity. With gold where it is today and where it should be in the future, the payback period for project loans should be very short. At some of the hot new mines that are coming to market the payback periods are equivalent to less than 1/10th the life of the initial mining plan!
Massive equity dilution can take a lot longer to burn off and is a lot more burdensome in a stock sector that is rising so fast and furious. And besides, debt does not need to come with hedging today. In fact, over the last several years there has been a “revival” of sorts that has seen a huge dehedging trend in the gold mining industry.
So while it is impossible to find “perfect” financials among the gold miners, those companies that are least impacted by past financing decisions are likely to outperform the rest in this gold bull. Once you understand the strategic financial background of a miner you can then look at its future potential on the financials front. And this all boils down to operating costs at its existing operations.
In simple terms the most profitable gold miners are the low-cost producers selling their gold at spot. And costs are king as these miners work to maximize their margins. Many investors are imprudent in thinking that capex goes away after construction. In fact the cost of operations at active gold mines is very expensive. Just because a company is a producer doesn’t necessarily mean it is going to be a cash cow.
The dynamics of unearthed gold vary to a large degree, as all gold deposits are not created equal. There are countless factors that can affect the bottom line of how much it costs to extract an ounce of gold. First and foremost is the geology of a deposit. The geology will guide the mining method and each mining method carries different costs. Ore bodies house differing ore grades, hardness, mineralization and porosity. Also commanding cost consideration is labor, energy, weather, equipment maintenance and royalties among many.
Gold mining cash costs are indeed one of the headline indicators that investors consider when analyzing gold stocks. And managing costs is a key strategic initiative for all mining companies. This area of focus has gotten even more exposure as the industry has seen ballooning operating costs that have really pinched the positive leverage that investors had expected at today’s gold price.
As gold companies scramble to make up for shortfalls in exploration and discovery in the bear market years, they are faced with geopolitical, regulatory, inflationary and environmental hurdles that are higher than ever. In an essay I wrote a couple months ago I dove into a detailed examination of some of these challenges.
And these challenges have had a huge impact on not only tangible but intangible costs that are party to the trend of decreasing global gold production. So not only do the next-generation juniors have increasingly difficult barriers to entry, but the existing miners are constantly facing an uphill battle in meeting the world’s growing demand for gold.
And while on the topic of costs, when analyzing gold producers it is important to view their production profiles in strategic context. A lot of the good gold miners are just ramping up production and commissioning the mines that will carry them well into the future.
So while near-term financial results are indeed important to consider, it is also important to consider an entire mining plan. Since creating and implementing a mining plan from scattered sampling and drilling of a defined gold deposit is not an exact science, subsequent operations may not always run as planned without some tweaking and perhaps some growing pains.
In most mining operations many costs are fixed regardless of volume. So if there is an unexpected problem with ore grades or weather or even a labor strike, then processing capacity may not be maximized. With fewer ounces of produced gold to absorb the fixed operating costs, per-ounce costs are naturally going to be higher.
When you see this happening at one of the gold stocks you are analyzing, don’t immediately toss it aside. This is when you need to dig deeper to find out why this is happening and what the company is doing about it. If you discover that this is simply quarterly noise and that the long-term mining plan will not be significantly compromised, then this gold stock may be trading at a discount.
Ultimately looking at a gold producer’s financial standing through funding mechanisms and operating costs are just a couple of the many areas you should examine when researching a gold-producing stock. It is also important to consider longevity (mining life), project pipeline, exploration potential, growth potential, cost management, geopolitics, community relations, resources and many other areas.
So as an investor looking to deploy capital into the gold-producer class, use discretion when analyzing each stock. Though this group as a whole has performed quite well over the years, your ability to drill down on what is important will make you a better stock picker.
And even though the gold stocks have performed well, I believe we are still in the first half of a secular gold bull market that will take them even higher. The fundamentals of gold continue to be stellar, buttressed by an economic imbalance that continues to see supply come short of meeting growing demand. A top industry executive puts the value of gold producers into perspective.
Greg Wilkins, the CEO of Barrick Gold (the world’s largest gold producer), was recently quoted saying “Global mine supply is going to fall at a much faster rate than people generally believe … Many of the mines that people are anticipating bringing into production will either not come into production or will be on a much longer timeframe.”
This statement really encapsulates the extreme difficulty primary gold explorers are having in joining the ranks of actual miners. And this is what makes the gold producers such an elite group. Which is why we decided to focus our most recent research report on actual gold-producing stocks.
After cataloging hundreds of gold stocks and researching nearly 100 gold producers, we’ve identified and profiled our favorite 20 gold-producing stocks. In a brand-new report format, we delve into an in-depth fundamental examination of each producer on a project-by-project basis.
This report includes producers of all sizes ranging from those that are in the process of commissioning their young gold mines to those that are among the largest in the world. We believe we have identified a good mix of innovative, long-life, low-cost and well-managed gold companies that are in position to be the gold-stock leaders in the years to come. Purchase this report today so you can have this valuable research at your fingertips.
The bottom line is picking gold stocks involves more than finding a stock symbol and liking the name of the company. With all the gold stocks that exist today it is important for investors to perform diligent research on whichever class of gold stocks they choose to trade.
And when considering the stocks of the elite gold producers of the world, there are some core fundamental features that distinguish the top performers of the future from their peers. Gold mining is a tricky business, and only a select group of producers will truly excel at it.
Scott Wright November 30, 2007 Subscribe at www.zealllc.com/subscribe.htm