Investing in Undervalued Themes-Gold Miners Thesis Part 1

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A few weeks back I wrote a post discussing some general areas where you might be able to find some undervalued ideas. I always approach investing from a bottom up perspective, meaning I’m looking for businesses that have undervalued assets or high free cash flow relative to the stock price. I’m trying to find ideas where if I were buying the whole company, I would be satisfied that the assets and/or free cash flow (i.e. owner earnings) would provide me an large margin of safety and eventually produce solid investment returns.

However, there are often times when I begin to get interested in broader themes. These are rarely top-down macro themes (I never have an opinion on macro-economics, or at least one that would influence my investment decisions much). But these themes can sometimes be industry specific themes. In other words, I sometimes find that many different stocks in a specific industry all appear to be undervalued to varying degrees.

I never invest to get exposure to a specific industry. I don’t search for ideas using industry analysis. It starts with finding individual stocks that are cheap. I maintain a diversified portfolio of undervalued stocks. I only invest in these themes because many stocks in the industry appear to be undervalued. This past year, I’ve been able to find value in a few different areas including insurance stocks, community bank stocks, for profit education, and metals/mining. These are themes where many stocks are cheap within the industry.

The Mining Theme-Currently a Hated Group 

“A gold mine is a hole in the ground with a liar on top” – Mark Twain

Today I’ll make a few comments on the gold mining sector, which is an area that has some very passionate participants (to make an understatement). The mining industry is one that I hadn’t ever really paid much attention to because these aren’t businesses with great advantages and until now, they never were really that cheap. But I was amused reading about the industry because it’s almost like a religion. There are certain gold bugs that would own gold and gold stocks at any valuation, and there are other investors that despise gold and think it’s worthless.

In fact, many value investors eschew gold and gold stocks, for reasons I can certainly understand (no competitive advantages, poor capital structures in some cases, revenues tied to a commodity that is difficult to value, etc…). Many recite Buffett’s thoughts on gold, which are also relevant (but I would also point out a somewhat related note that Buffett once invested billions into silver when it was selling below production costs in the late 90’s).

But the point is, for whatever reason, gold is a very polarizing investment topic. Gold stocks are loved by some, hated by others… but currently, they are hated by the majority. Here is a chart of Hulbert’s survey of gold newsletter writer’s recommendation (a group that typically would be bullish most of the time):

Hulbert Gold Sentiment

The short recommendations are higher than they were during the 2008 bottom. Other sentiment readings show similar bearish extremes. Commercial hedgers are net long (meaning small speculators are net short) for the first time in over a decade.

But I don’t typically make investments just because they are contrarian. Ben Graham said that you’re right not because the crowd agrees or disagrees with you, you’re right because the facts and your reasoning are accurate. Having said that, looking at places where sentiment is terrible is often a good place to start, and often is a place to find some value.

Gold Stocks and the New Low List

I’ve been analyzing and reading about gold mining stocks for months, basically beginning in mid April the day gold dropped 10%. That day it appeared that panic was in the air and many mining stocks were down 10-20% or more (and this was after they had already dropped in half in some cases).

I check the 52 week low list regularly, and if you do that you would have noticed gold stocks had been on the list for months. But in April, it seemed like we might be getting to the point of maximum pessimism. I hadn’t ever owned a gold stock, but I began tracking lists of the major producers, and some smaller producers as well. I began reading annual reports and learning some about the business models. I put together a rudimentary spreadsheet to track a few different variables and try to make some valuation comparisons between the different businesses.

Gold Stocks are Cheap

“Good things happen to cheap stocks.” 

After spending a few weeks reading numerous annual reports and learning some about the businesses, I came to the conclusion that although I’m not enamored with the business models, I think the stocks are simply too cheap at these prices. Howard Marks talks about any asset could potentially be cheap enough to buy, and expensive enough to sell at various times. Ben Graham said the same thing essentially.

I have a few different reasons for why I own some of the miners at these prices, but it really comes down to the fact that they are very cheap relative to tangible assets. I have a secondary reasoning that they also VERY cheap relative to where they have historically traded (50-70% cheaper than historical valuations in many cases).

A couple months back I began investing in a number of different gold stocks, taking very small positions in each. I think of the miners collectively as one basket investment, but it’s still only about 7% of my overall assets. My plan was to invest somewhere between 5-10% of my capital into a diversified basket of well financed miners at low multiples to cash flow, book value, and reserves. This takes away most of the company specific risk, but still allows me to have the asymmetric upside that I think will eventually occur in this industry.

Tomorrow I’ll post a follow up on this theme and get more specific into the metrics I used to value these stocks, and make a few more comments about why I think that the miners are a good investment at these levels.

5 thoughts on “Investing in Undervalued Themes-Gold Miners Thesis Part 1

  1. “I always approach investing from a bottom up perspective, meaning I’m looking for businesses that have undervalued assets or high free cash flow relative to the stock price. I’m trying to find ideas where if I were buying the whole company, I would be satisfied that the assets and/or free cash flow (i.e. owner earnings) would provide me an large margin of safety and eventually produce solid investment returns.”

    Well said John!

  2. excellent,john. there are some opportunities existing in gold mine. but i think the best time to buy them is when the gold price is depressed.

  3. Hi John,

    I’ve been following the blog for quite a while, ever since I saw your first article on Seeking Alpha (which led me to GTAT, and their shift to sapphire, which has led to a nice return this year, so far). I’ve been recently following gold stocks, too. IAG and EGO, specifically. I was watching ANV, too, but I haven’t read their transcript, yet (apparently, it wasn’t good). I’m looking forward the second part of this article.

    I’m also interested in your stance on Ebix? I know you were long Ebix at one time–and maybe still? But, the headlines today were a bit more nefarious than what I’d imagined from my previous readings about the company.

    At any rate, I’m fairly new to investing and I’ve enjoyed your writing style and your stance on value investing. I’ve learned a lot from reading your articles and your suggested readings. Also, the recent Pabrai video was quite entertaining. I loved that if he didn’t feel a stock was going to go 3x, 4x or higher over the next three years, it’s not worth his time. I wonder if he’d feel the same if the market turned south. He seemed to diversify more during the downturn, if I understood him correctly.

    Best,
    RW

    1. Hi Ryan,

      Thanks for the nice words and thanks for reading. Regarding EBIX, I still own it. I typically am quite patient with the stocks I own after I buy them. I saw the headlines and honestly haven’t been that impressed with the reporting from Bloomberg both now and back in June. They don’t get very detailed and seem to repeat the same message but without much evidence. Often times I include these types of stocks in a basket approach to investing. Some will provide fantastic gains, others might go to 0, but I’ve found the former to greatly outnumber the latter. Much of the time the market misprices this uncertainty to the downside. I manage the risk through the basket approach and small position sizes. Similar to investing in net nets. EBIX is very likely not worth 10, a level that is close to a 20% FCF yield if the numbers aren’t fraudulent. If they are a fraud, then of course the whole thing will be close to worthless. If the fraud doesn’t come to fruition, it’s likely back to 20 or higher. Raina (the CEO) has a major position, the company has few liabilities, and it produces a lot of free cash… these typically aren’t the signs of frauds. But we’ll see. I follow it with interest, but I’m more focused on other (bigger) opportunities that have more clear cut values.

      As for Pabrai, yes he took a basket approach in 2009 when everything was cheap (he wanted to make sure he achieved his expected result). When things get more expensive, he chooses to concentrate. It’s a strategy that has provided him with 25% per year, but it also can cause 60% down years if you concentrate too much. That type of performance is probably once in a lifetime (maybe twice), and he has since recovered, and still has a great long term record (25% gross). I am more comfortable with more securities in a few different strategies (compounders, cheap and good, cheap assets, some arbitrage). I will still concentrate when I get a great idea, but I am not as confident in my ability to judge business prospects and other qualitative aspects, so I choose to invest in cheap stocks primarily using simple income and balance sheet analysis, and let the odds work in my favor over time.

      The portfolio is dynamic though and I’m always looking to improve and always looking for opportunities. Sometimes I come across a business or idea that I really like and understand, it’s cheap, maybe has a catalyst, etc… those scenarios can be weighted accordingly.

      Pabrai is very good, and very simple, and it works. To each their own… 🙂

      Thanks for reading.

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