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I Like Cheap Stocks-Gold Miners Thoughts Part 3

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.

20 thoughts on “I Like Cheap Stocks-Gold Miners Thoughts Part 3

  1. Thank you for the article, similar thoughts and similar approach. I have some stocks that i own and thought since you are looking to build a portfolio of low cost healthy juniors, I would give you some names.

    Silvercrest mines (svlc) check it out. i own it and i am pretty sure you will like it. one speculative stocks is mcween mining (mux). I think the El gallo project will be a big project even though at present it seems small. plus the management is good and knows their stuff. This is very volatile stock ans speculative so be careful. btw if you like new gold and ego, you might like IAG.

    look forward to hearing from you . thank you.

    ws

    1. Thanks for the comment WS. I’ll take a look… I’ve tried to build a basket of good low cost producers along with a few streamers (SLW and SAND look cheapest to me, and well managed). IAG looks very cheap, and I’ve looked at it, but they operate in what I would consider higher risk geopolitical areas. But it probably has large asymmetric upside assuming those risks don’t come to the forefront. Thanks for reading…

  2. Hi John,

    Thanks for sharing your thoughts on gold miners. I’ve looked at them in the past, but can don’t fully understand the industry.

    You mention that some minors are cheap relative to cash flow. When analyzing miners, are you using free cash flow (operating cash flow minus capex) or just operating cash flow in general? Since the industry is capital intensive free cash flow for some companies (like Newmont and Goldcorp) is usually negative from what I’ve seen. And that’s the part that confuses me. If you could share your insights for how to analyze the cash flow on miners I would much appreciate it. Thanks and keep up the great job!

    1. Thanks Henry… I use operating cash flow simply as a way to compare companies in each category. I’ll try to compare senior producers to other seniors, juniors to juniors, etc… It’s just a way to determine relative value, but not necessarily a good metric to determine absolute value. Owner earnings are the best way to do that of course.

      But since these aren’t compounders, and these don’t have moats, I try to value them based on the assets. You are right…many of the seniors have negative FCF. But some juniors have positive FCF, and the streamers are excellent low cost businesses that produce good FCF.

      My thesis is that they are significantly cheap relative to the NAVs and also relative to their own historical valuations. These typically trade at 2-3 times book and sometimes more, and many of the juniors are priced at 70% of tangible book or less. Some of that will get impaired through writedowns, but there is a huge asset backed safety margin from what I can see. I think that the well financed safe companies will survive any further deterioration in the commodity prices, which certainly could happen, and then they will be the ones that will gain market share when the cycle turns.

      I treat this like a good old fashioned Walter Schloss way of investing in high cost cyclical businesses when they are very cheap. If you look at his past holdings, one of his strategies was to invest in cyclicals when the market caps (stock prices) are very depressed and they trade at low multiples of their assets. They might have high P/E’s or even negative earnings, but they are cheap relative to historical valuations and net assets.

      Some of these stock prices are at decade or more lows. ABX first hit $16 in 1993. There are many problems with the businesses, but the market will force them to use capital more wisely and I suspect that we’ll see better returns on capital, some consolidation, some bankruptcy, and then the best businesses will recover. Not unlike other cyclical businesses. The cheap and safe ones will likely do well over time, but it will take patience.

      Since I don’t know in depth (nor have confidence) in any one particular business over others, I diversify using a basket approach. I invest a portion of my overall assets in a group of the best capitalized, safest, and of course cheapest miners and streamers.

      Hope this helps.

      1. Thanks for the great insight, I much appreciate it! I tend to avoid the basic materials sector in general, except for a tiny few, due to its capital intensive nature. I never felt comfortable with my ability to analyze companies in that sector. Anyways, I did a quick screen and came across this company called Revett Minerals (RVM). I think they’re a silver producer, not really sure. They’re selling for at almost at cash value with very little debt and slightly above net asset value. That’s the farthest I got with my analysis. In trying to apply your approach, do you think the stock is cheap?

        Thanks again.

  3. John, thanks for sharing your trilogy on the gold miners. We’re cautiously optimistic on the industry right now. Our leading candidate is NEM, but we’re waiting on some more things to come to light before jumping in. Mainly, we’re interested in seeing how QE shakes out, we really want some more color on the plans, as we think there might be a better entry point. Also, we’re holding out for the miner that stands strong on the no hedge philosophy. It appears some miners might be walking their no hedge strategy back, suggesting they might look to hedge in the future. As a side note we focus on NAV calculations and rely heavily on that as it pertains to determining what we consider fair/intrinsic value.

    1. Thanks Marshall… yeah NEM took the big write down along with ABX and a few others. I think the senior producers have enough firepower to transform their businesses to more of a return on capital model vs the growth model that ends up diluting shareholders more than anything else… NEM has a pretty good balance sheet, and good assets. I like the streamers the best, but they aren’t nearly as cheap. I like a few of the juniors with no debt, sizable cash, good mines in good locations… they will most likely survive. Many of the leveraged businesses will go bankrupt if gold and silver go lower. Nolan Watson is also a great manager. He runs the Sandstorm companies, which are very small, but have some unique advantages. This industry is full of low return high cost businesses, but the assets are cheap right now. I took a basket approach to try and increase the chances that the investment works out over time.

      Thanks for reading and I’ve checked out your work on Seeking Alpha also. Keep in touch…

  4. this comment is in regards to Henry’s comment.

    RVM is cheap and I am a shareholder. I also hold SVLC, MUX, and IAG. Regarding RVM, their troy mine is shut since last December because of earthquake and rock falls. They are working on route to access their ore and if they can safely get the route fixed, then they will mine the ore. The management are good, and have been buying share in open market. share outstanding is very low. and once operational they will be profitable at current metal prices. More than this, we need to look at the potential of their other project Rock Creek. its a big deposit and the permit process has taken a long time but its slowly getting there. At these prices, RVM is a good value and their current cash on hand is around 15million or about 50% of the current share price so I think it does have some margin of safety.

    Good luck and hope it helps.

  5. “Low cost producers-I want the businesses that can survive the biggest drop in the metal prices”

    John, when you identify a gold stock, how do you know that it is a low cost producers?

    – newfound

  6. I’m an avid reader of your articles. Would the mining thesis be relevant to other metals say copper, silver etc. I see no real difference from other metals? Am I right?

    1. Thanks for reading… my general thesis was primarily bottom-up based… what I mean by this is that I saw many precious metal stocks selling for less than their tangible net asset value, so I started doing some digging. I basically lumped gold and silver miners together in one group. I didn’t look at the base metals like copper and I didn’t really check out the more industrial companies like AA and others. Many of the miners are cheap, and some of the streamers are historically very cheap with clean balance sheets. So I haven’t spent as much time on the other metals. Some of the base metal stocks may be cheap, but I think one main difference is that the valuation is cheap with the precious metals, but the pessimism is extremely high: much higher than the other metals I think.

      But the idea is to look at tangible asset values, and then look at balance sheets. That’s how I put together a basket. And it’s a small basket. It’s diversified, but relatively small (I have 6 holdings in the precious metals basket). I might add a few more if they get even cheaper. Some are up 50%+ though, so I’m not as interested at the moment, but many are still cheap. But be careful, because many will go bankrupt if metal prices go lower. The key is to look for the well capitalized firms.

      Hope that helps…

  7. Hey John,

    I know I probably said this a few times on your site but it bears repeating again. I really appreciate you sharing your ideas on companies but more so because you explain the reasons behind your ideas. Thanks again for doing so on your free time to educate your avid readers.

  8. Thanks for the good series! Whats your thoughts on Dundee Corp? It might be a good way to get an extra discount as they own stakes in alot of these undervalued miners. /Jesper

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