I didn’t think I’d be writing three posts about mining stocks (I never thought I’d write one post about them actually), but I’ve spent some time looking at them, and have invested small positions in a bunch of them, so here we are… They are cheap stocks, and I love cheap stocks. In part 1 I talked about how hated the mining stocks are (always a good thing), and in part 2 I described some general thoughts on investing in cheap stocks of capital intensive businesses and also described how I categorize precious metals mining stocks.
I’ll wrap up these posts on the precious metals and mining industry by summarizing my thoughts on a few metrics I use to value these stocks.
Note: By the way, even though I’ve made a lot of comments on gold stocks, these posts really aren’t designed to discuss specific securities in the industry. I really am just writing down general ideas for why I have spent some time in these areas. These last few posts may or may not be helpful to you in choosing stocks to focus on, but hopefully they give you some general food for thought regarding mining stocks and other high cost commodity businesses like them.
My basic thesis for owning a few of these stocks revolves around the following logic:
- Cheap-They are cheap relative to tangible book, cash flow, production, and reserves
- Cheap relative to historical valuations
- Poor Sentiment-They are a hated group of companies (“buy at the point of maximum pessimism)
- Good Balance Sheets-The ones I own have good balance sheets with net cash, operating cash flow, stable jurisdictions, and are the lowest cost producers (I also own some streamers)
Which Gold Stocks To Choose?
I mentioned in the previous post that I divide the precious metals industry into three groups: explorers, producers, and streamers. I am not interested in explorers, so that leaves just the producers and the streamers (maybe 50-60 stocks). I then look for some of the following characteristics among these stocks:
- Well financed businesses
- Low debt to equity
- Adequate liquidity (current ratios of 2-3 or more-this is especially important with the junior producers)
- Low cost producers-I want the businesses that can survive the biggest drop in the metal prices
- History of operating cash flow
- Stable jurisdictions
Some of the smaller producers that match most or all of these descriptions are EGO, AUY, HL, NGD, GORO, PAAS. I don’t own all of these, but track them all. The larger producers like NEM, ABX, and KGC have more debt, but also are quite cheap relative to cash flow and book value, and reserves. But I don’t like these as much as the smaller producers with much cleaner balance sheets, net cash, and significant reserves relative to stock price. My favorites in the groups are the streamers like FNV, SLW, and RGLD. SAND is another small company run by an outstanding manager named Nolan Watson who was CFO at SLW.
Gold Stocks-It Boils Down to This: They Are Cheap
I’m not a gold bug. I described in previous posts that I don’t invest using top down macro ideas. I have no idea what interest rates, inflation, or the economy will do. I simply look to buy assets or cash flow for less than what they are worth. Ben Graham’s 50 cent dollars are what we are looking for.
I use just a few metrics to determine and compare value among the miners:
- Price to Tangible Book Value
- Price to Operating Cash Flow
- Price to Oz Proven and Probable Reserves
- Price to Oz Produced
Cheap-Absolute and vs Historical Valuations
I looked at various miners in Value Line and noticed that most of the stocks are selling at price to book ratios that they haven’t seen in the last 15 years, if ever. For example, Barrick Gold (ABX) first hit $16 per share (the current stock price is around $16) in 1993, about 20 years ago. But at that point it had a book value of $1. Today it has a book value of $15. So it’s selling around book value (tangible book is about $12), when it the past it typically sold at 3-5 times book or more. I don’t think ABX is the best investment in the group, and it just took a big loss last quarter, but it has a long history so I’m just using it as an example. Many other stocks have similar discounts to their own historical valuations and stock prices, which is something I always prefer to look at (even more so than comparing them within the industry).
The same relative discounts can be applied to the other metrics like operating cash flow, production ounces, and reserves.
I’ve looked to build a small basket of the lowest cost producers and streamers with good balance sheets in stable locations that have the lowest multiples from the categories above. My basket collectively represents a discount to book value, mid-single digit multiples to operating cash flow, and cheap multiples to production and reserves relative to historical valuations.
To Sum Up the Mining Thesis
- Cheap valuations vs tangible assets, normalized cash flow, and historical valuations
- Terrible sentiment
- Depressed prices
- Upside in the event of price stabilization
There are opportunities to buy lowly leveraged companies in this industry for less than their net tangible assets, and far less than their own average historical valuations. The sentiment is terrible, which is always a good thing when making an investment. It increases the odds of mispricing. Also, depressed prices (some are near 5-10 year lows) reduces some risk. As Schloss says, it’s always better to invest near multiyear lows knowing a stock has traded much higher in recent years.
My basic thesis started with the fact that some of these stocks have successfully grown their book values over time, and they are selling for discounts to the tangible assets they have in the ground. When stocks get cheap like this, it often represents an opportunity. I am not confident regarding future business prospects or competitive advantages, but I think there is a large margin of safety at these prices relative to net tangible assets.
As I mentioned, I’ve taken a basket approach to investing in a few different precious metals stocks. I didn’t really comment on any individual names because they all have similar characteristics I described above. I think of the basket as one diversified investment. I own some senior gold producers, some smaller gold and silver producers, and some streaming companies, which are my favorite businesses in the group. All of the stocks I own are cheap.
I tried to eliminate valuation and leverage risk from the equation. Business risk exists, and that’s why you want to diversify into the best run low cost operators in stable jurisdictions with significant reserves and good balance sheets.