A Few More General Thoughts on the Miners

Posted on Posted in General Thoughts, Portfolio Management

I’ve received a lot of emails about the posts I did regarding my thoughts on the precious metal miners. As I mentioned in one of the posts, that industry is one that contains many passionate opinions, on both the bull and the bear side. I have received many questions regarding my opinions on the commodities themselves (gold and silver)… of which I really don’t have one, and also questions about Fed policy among other things…

I really didn’t get too deep into any macro thinking when it came to the investments. These stocks are just a small part of my “cheap basket” of undervalued securities.

I have no idea where gold and silver prices are going to go, especially in the short term. The basic thesis was simply that the miners (the ones I selected at least) were selling for historically low valuations relative to book value and cash flow. Also, and more importantly, they were actually selling at a discount to their tangible net asset values. The stocks are just plain cheap. That was really the driving reason behind my idea.

Stocks that sell for 50-70% of NAV are typically good places to look for ideas. My idea was to build a basket to diversify business specific risk (which is prevalent in this group). But it’s a small basket. I currently own a small basket of six precious metals stocks, and I cherry picked what I considered to be the best ones.

The way I did this was very simple:

  • I made a list of the producers and streamers that I could research (no explorers)
  • I found the cheapest ones based on price to tangible NAV
  • From this cheap group, I analyzed each balance sheet and picked the stocks that I decided carried the lowest amount of leverage risk.
  • I bought a small basket of well capitalized businesses in safe, stable political jurisdictions with good assets, good balance sheets, and a history of profitable production. 

I categorized this list by metrics such as cash flow multiples, price to production, price to P&P. The most important to me was the price relative to tangible net asset values (I’m not saying this is the best way to value these stocks, but it is what I decided was most important to me. I wanted a tangible margin of safety to protect me against further write downs and commodity price deterioration).

Depressed Prices and Low Leverage Provide Margin of Safety

I basically figured that buying these assets at the levels where they were two months ago provided me with a large margin of safety, even if metal prices go significantly lower. Certainly, the businesses won’t benefit from lower prices, but I think at the valuations that some of the stocks were at were already discounting in significantly lower metal prices.

Also, I like the businesses over the commodities themselves because businesses have management teams that can evolve, adapt, and get more efficient at returning capital to shareholders, improving ROC, and cutting costs. The best businesses will survive, and then have a larger share because many companies with inferior capitalization structures will go bankrupt if prices go lower.

The upside is if metal prices stabilize, or (heaven forbid) increase… which no one seems to expect at this point. If that happens, there is huge upside. I think downside is priced in, so there is a margin of safety because of the depressed prices and discount to tangible NAVs.

Luck Favors the Prepared, but… My timing was pure luck

So far, I’ve been very lucky. I say this because I just happened to make the investment at a time when the pessimism was extremely high and valuations seemed to be at a (temporary?) bottom. I say I’m lucky because although I expected this investment to be very successful over time, I didn’t expect a 30-50% increase in most of the positions so quickly. In fact, I expect most of the positions I bought to make moves much larger than that eventually, but it will be volatile. It’s a small basket and a small part of the portfolio, but I expect it to do well over time.

However, I would not be surprised in the least if the stocks revisit their lows, and possibly go significantly lower. In that case, my position is small enough to buy a few other stocks that I would like at lower levels (one stock I liked actually doubled in the last month before I had the chance to buy it. It was selling for less than the net current assets on its balance sheet).

So I was lucky in the timing… for now. The stocks are still cheap, and they might get cheaper again (i.e. go lower-maybe much lower). This is the way it usually goes with many value investments…

How Do Miners Fit Into the Portfolio Management Strategy?

To understand better how this basket metal investment fits into my portfolio, I’ll quickly review my portfolio management strategy. My portfolio is typically divided into a few main parts-I think of these as business lines:

  • Cheap and Good Stocks
    • Good businesses at great valuations-these are usually my larger positions. These are only available at certain times, and I am very picky about the valuations.
  • Quantitatively Cheap Stocks
    • These are individually very small positions that collectively might represent 20-30% of the portfolio. They are all very cheap relative to assets and might have significant upside or catalysts. These might carry too much risk individually to take larger positions, but have much more upside than most other positions. As a group, they are all cheap and have a large collective margin of safety. The miners represent a portion of this cheap group.
  • Special Situations
    • Spinoffs, Mergers, etc… These tend to be workouts that depend on the corporate event, and typically provide interesting risk/reward scenarios, sometimes with significant upside. They are also usually much less correlated to the overall market.

Together, the investment portfolio has a collection of some great businesses, some very undervalued stocks, and sometimes some very interesting workouts. The metal stocks fit the middle category. They are cheap, and they aren’t great businesses, so I diversify and take smaller positions.

But 50 cent dollars usually work out as a group, even though the dollar looks old, worn out, and crinkly. I think these cigar butts have a few puffs left.

And one thing to remember, sometimes today’s cigar butts magically turn into tomorrow’s Cubans….

11 thoughts on “A Few More General Thoughts on the Miners

  1. A brilliant blog post. Clear thinking, simple value techniques and concise reasoning. Tell me, what do you do with cash when it’s abundant? Treasuries?

    1. Thanks David. Most of the time my cash just sits in the account or in some short term money market. I’m always looking for new investments so I don’t want to take on any duration risk with the cash, and it mostly earns nothing while I wait. But occasionally I’ll use it for special situations that are liquid and can easily be sold to invest in other ideas.

  2. Would you invest in capital intensive businesses like autos, airlines etc if they were cheap enough? (Good balance sheets, poor sentiment, really cheap)

    The only problem I have with them though is that they destroy value..

    1. I would invest in most stocks at the right price. There are a few exceptions. I wouldn’t own a stock if I wouldn’t own the whole business (for moral reasons). But as for stocks that are in commodity industries or other capital intensive industries, I would consider owning them if I could own the assets at a discount. Sometimes cyclical companies can make very good investments if you buy them when they are very cheap relative to assets or normalized earnings. Of course, I prefer good businesses, but I like stocks that are cheap.

    1. I think of my portfolio as being a dynamic business. I do categorize investments… mostly into three categories. Cheap and good businesses (typically good businesses that I might own a larger position in), quantitative cheap stocks (these are often asset investments, where I’m buying the assets for 50-70 cents on the dollar), and special situations. The last category could be single positions, or sometimes a group of positions.

      Concentration just depends on conviction. The portfolio is a living breathing dynamic business so it all changes. But if I understand a situation and it makes sense, and the downside is limited, I might increase my position size. I tend to run adequately, but not overly diversified portfolios with various weightings within the portfolio…

      I don’t like the structural dynamics or shorting or options. In client accounts, I don’t short at all. It’s a difficult game with inherently poor risk reward dynamics.

      Options could be used, but only on rare occasions and only significant long dated options. I would look at long dated warrants where the expiration is 5-10 years out. But these would always be based on my understanding and conviction of the underlying business behind the security.

  3. If you got the assets at a discount, what would be your reaction if the business is at danger of shedding assets because it’s so capital intensive? As in with the case of Ford, not being able to sustain it’s auto manufacturing so it had to take on a lot of leverage which in turn forced them to shed assets to pay off the debts.

    So the answer would be well capitalized businesses? What’s your opinion on this?

    And for moral reasons I’m assuming cigarettes, weapons manufacturing etc?

    1. I don’t have a problem with tobacco or weapons per se, and I’m not necessarily closed off to one industry by itself. It’s just a case by case situation. If I felt the business sold a product or provided a service that I had a problem with, I wouldn’t own the stock.

      As for the assets at a discount, certainly the business factors into the analysis to a degree… but my analysis is usually focused on the management and their track record in those situations. How much cash is there? How have they allocated capital in years past? Are they burning through cash currently? etc…

      Businesses like this often run into the problems that you referenced, but that’s part of the analysis. You need to make sure you have a margin of safety, so if the assets deteriorate more than you anticipate, your investment may still work out okay. But there will always be mistakes made, and thus the necessity for multiple investment transactions over time (diversification or multiplicity of transactions… like a life insurance actuary, some lives that he underwrites will unfortunately not work out and a claim will be made, but on balance, good underwriting that adheres to a certain set of metrics will over time work out).

  4. Part of your premise is that valuations (price/book value) are at historical lows, Goldcorp makes this point, but they use a 5 year window which only takes you back to Nov 2008. Gold prices are still historically high, if they drop back to pre financial crisis levels these companies will be additionally impacted. How much price reduction in gold are you baking into your calculations (margin of safety)?

    1. Hi Tom, yes many of the firms have already taken write downs. That will continue as (if) gold goes lower. I don’t have a specific model or projection of the price of gold/silver though. I like the historic low valuations, but what I’ve tried to do is locate the lowest cost producers that are also well capitalized. Like Buffett has said, in a commodity business, the lowest cost wins. My basic idea here is that the firms with the cleanest balance sheets and the lowest cost structures will survive and will be flexible enough to support significantly lower gold prices. Some of the streamers (although they aren’t as cheap on a P/B basis as the producers) are in the best position. For example, SLW has numerous contracts between $3 and $5 per oz, so they can support a much lower price in silver.

      Some of the smaller producers have really clean balance sheets and even after write downs (assuming further deterioration in the commodity) will be able to survive.

      In the long term, lower prices will be good overall for these firms because they’ll survive with larger market share, and the ones with the lowest balance sheet risk and lowest costs will thrive when/if the commodity rises again.

      But these certainly aren’t compounders. In the end, I felt they were just too cheap relative to the possible upside, and I thought the downside gave me a large margin of safety.

      1. I agree with your overall premise, just worried things could get much worse before they get better. I’ve dipped my toe in also using the basket approach. Plan to do in increments. Regards

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