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….