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):
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.