Investment PhilosophyThink Differently

Some Thoughts on Cheap Stocks-Gold Miners Thoughts Part 2

In my last post I began writing down some thoughts on gold and why I think that generally speaking, there are some undervalued stocks in the group. Today I’ll talk some more about mining stocks, and how I categorize them.

First, Some Thoughts on Cheap Stocks

It’s important to remember that some stocks, even if the business has few/no competitive advantages, can still offer an investor a large margin of safety and potential outsized returns at the right price. Ben Graham and Howard Marks have both discussed this at length. Walter Schloss routinely owned high cost, capital intensive businesses that were extremely undervalued relative to assets or cash flow (and often relative to their own historical valuations and stock prices). Many investors disagree with me on the idea that owning average but stable businesses can sometimes be better than owning great businesses. I can understand why, but I try to think differently about the topic…

I want to protect the risk of permanent capital loss first and foremost. I divide risk into three categories: valuation, leverage, and business risk. The first thing I do to try and achieve this goal is to analyze the valuation risk. Once I know that I’ve identified cheap stocks, I then look at the balance sheet. I want the stocks to have low debt, and adequate liquidity. Then I look at the business itself and try to come up with an opinion on the business model. This last step is the most difficult, and many investors choose to do this first. But since it’s the most difficult and the easiest area to make an error, I want to make sure that I’ve eliminated valuation risk and leverage risk first.

Completing these risk management steps in the above order dramatically reduces the amount of potential mistakes. I never look at overvalued stocks even if they are great businesses. It’s too easy to make an error in evaluating the business and/or future prospects, and when an evaluation error occurs, you have nothing to fall back on because you paid too much.

Back to Gold Stocks

It is pretty obvious that gold miners have virtually no competitive advantages. There are certainly some businesses that are better than others (I’ll list a few), but they all mine for the same commodity. Newmont’s gold is exactly the same as Yamana’s. So they all sell the same product, and to make matters worse, they have no control over the cost of their product. They have no pricing power, as is the case with most commodity companies.

But at the price levels we’ve seen recently, I think that despite these underlying business fundamentals, miners might be significantly undervalued. I’m not overly confident of any one particular business, and that’s why I have around 7% of my capital in a diversified basket. But they are mostly all quite cheap.

Categories of Mining Stocks

As I said in yesterday’s post, I began studying the miners a few months ago and put together a basic spreadsheet to track about 25 different businesses. Precious metals mining stocks can be divided into three main categories:

  • Explorers
  • Producers
  • Streamers

Explorers– There are over 1000 listed stocks that are primarily explorers. These are speculative companies that are often quite small, and have no history of making money, or even sales. They are simply trying to find gold. I stay away from these stocks, as they are basically just speculations on striking gold.

Producers– The producers are the companies that already have gold in the ground, and are in business to pull it out of the ground. Some of these can also be speculative, but I try to locate the stable producers (some senior, some junior) that are well capitalized, have a long history, and mine in stable countries to reduce geopolitical risk.

Streamers– These stocks represent the best business models in the industry in my opinion. Unlike the miners, that have to spend a lot of money trying to pull metal out of the ground, these streaming companies simply pay an up front fee to miners in return for being able to buy a percentage of all gold produced at that mine at a specified price (typically well below the current market price).

Royal Gold (RGLD) and Silver Wheaton (SLW) are two examples of streaming companies. SLW typically contracts to buy silver for around $3-$5 per ounce, providing a significant profit margin at the current prices. Even if the price of precious metals drops further, these companies will still remain profitable. They are also low cost businesses. They need very few employees to operate, and they don’t have to invest in heavy machinery or other costs associated with mining. Plus they have a free call option on any future production and/or exploration that occurs at the mines they have contracted with. These are actually good businesses with low fixed costs that produce high amounts of steady free cash flow.

So I focus on the producers and the streamers, specifically the ones with longer histories, positive operating cash flows, stable jurisdictions, and good balance sheets.

I’ll probably write one more post just to summarize why I think these stocks are cheap and list a few that I like. Be careful if you invest in these businesses. They aren’t for the faint of heart, they carry risk, and therefore I take a basket approach to investing in the best companies (relatively speaking) in this undervalued group.

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