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Chapter 8 - Gold and Gold Mining Stocks
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Ten years ago, gold analysts had a minimum annual 100,000 ounce production
parameter before they placed gold mines on their radar screens. Today, the bar has
been raised to the current minimum of 200,000 to 250,000 ounces of annual production,
as many juniors have made major discoveries over the past five years.
Stocks with less than a $50 million market capitalization are classified as juniors.
The average mid-cap or independent mining company holds a market cap between
$100 million and $500 million.
Large producers tend to trade at two to three times asset value compared to midtier
companies that trade in the area of one to one and a half times asset value.
Substantial price appreciation often occurs:
• When stocks graduate from one category to a higher one.
• Whenever a mid-tier or independent producer inter-lists on either U.S. exchanges
or the London AIM market, it tends to increase international exposure which in turn widens the shareholder base.
There has always been a tendency for Canadian mining stocks to peak when U.S.
and foreign shareholdings are at their highest and then to bottom out when
Canadian shareholdings are at their maximum.
By tracing the changes in the relative volumes of interlisted stocks on Canadian
and American exchanges the astute investor can gauge when such stocks benefit
from increased and widened shareholder based momentum. This was particularly true
of the former Glamis Gold and Goldcorp over the past three to five years.
GOLD STOCK MERGERS AND ACQUISITIONS
It has often been said that the best cure for low prices is even lower prices, which
forces the industry to consolidate, reduce costs and prices, and in the process stimulates long term demand.
Mergers and acquisitions tend to occur at both extremes of the gold cycle:
• At the bottom of the cycle, when healthy companies buy out weak and poorly managed companies.
• At the cycle peak, when companies are flush with cash.
Deals in the latter group tend to be less successful than in the former group.
The 35 major gold mining companies that existed in 1995 have been reduced to
five. North American, Australian and South African senior gold mines have been
consolidating domestic as well as international operations. This reduces the number
of potential and senior blue chip investments available to gold investors and drives
them to reach for the independents and juniors.
Besides the merging and consolidation of the senior gold producers, many
majors have taken over mid-tier independents with large reserves and divested
themselves of limited reserve and marginal low-grade properties to independents.
One rule of thumb is, that for a major gold company to justify taking over an
independent or junior mining company, it should be capable of an accretive $0.05 to $0.10 a share to earnings to be of any significance to the larger company.
A second rule of thumb states that a mining project should have a rate-of-return-
on-investment (ROI) of at least 15% in order to interest a major.
Major mining companies are under extreme pressure to maintain or increase
physical gold production and have had a tendency to overpay for acquisitions. One
study, done several years ago by Universal Precious Metals Fund, found that 80% of
the benefits of a takeover went to the company making the discovery and only 20%
to the acquisitor.
When stocks in any sector trade at hefty premiums to their intrinsic value of
their assets, management is prone to use their stocks as currency to make acquisitions.
The gold sector is no exception to this tendency and one should not be surprised
that acquisitions of many majors and aggressive independents often lead to
write downs of acquired assets.
MINING COMPANY DIVIDENDS
Only a handful of gold mining shares outside of South Africa pay significant dividends.
In the 19th and the first half of the 20th century, this was not the case. In an era
of virgin high-grade discoveries, low corporate and individual taxation and limited
capital requirements, many investors bought these securities for their cash yield. It
was common practice in 19th century Britain to raise capital for a specific or domestic
mining project, pay out all the cash flow to the shareholders and close the company
upon the expiry of the deposit’s economic reserves. The most spectacular of
these were the1,024 shares of the Devon Council that paid out 263 times its purchase
price in dividends.
Similarly, in North America, Homestake Mining was funded at $0.25 in January
1877 and exactly12 months later it began paying a dividend of $0.50 a month. The initial
startup cost of $200,000 was paid back within several weeks and each single dollar
of investment created several thousand dollars of dividend wealth. This resulted in the
stock appreciating from $0.25 to $118.00. In 1934, when Roosevelt raised the price of
gold from $20.65 to $35.00, the shares went from $35.00 to $600.00 in two years.
Today, the current beneficiaries of mining activities are the employees and governments.
In the U.S.A. in 2002, the average wage in the mining industry was
$45,000 per annum, the highest of any sector and in Canada it was over $1,000 per
week, also the highest in any sector. By 2007 the average wage in British Columbia for miners was over $100,000 per annum. This leaves very little for investor dividends.
MINING STOCK LIQUIDITY
Liquidity is primarily a function of company structure, age, shares outstanding, their
distribution and institutional/retail shareholdings.
Many of the mining stock winners begin their large moves while they are
extremely illiquid. Approximately 60% of the biggest percentage gainers listed on
Canadian markets, on an annual basis, start to appreciate while they are still illiquid.
As the stock price advance continues, they become more and more liquid.
An extreme example of this was Diamet, the first major diamond discovery in
North America.
Between June 1991 and May 1992, the shares appreciated from a low of $0.35 to
a high of $17.50, a gain of 2,233%, whilst never trading over 850,000 shares in any
month. The average monthly trading volume for the stock for this period was a mere
332,000.
GOLD ROYALTY COMPANIES
The term ‘royalty’ is drawn from the fact that in medieval Europe, all mines were the
property of the Crown and all revenues from those mines were taxed with a ‘royalty’
going to the Crown. Until recently, there were three North American gold royalty
companies, but Repadre merged with IAMGold and Franco-Nevada was merged
with Newmont. The only major gold royalty company left is Royal Gold.
Probably the first major royalty in modern times was on the Bewick Moering
Company managed large mine in Kalgoorlie, Australia at the turn of the century, to
which Herbert Hoover was the advisory engineer. The CEO of Royal Gold, Stanley
Dempsey, used the same royalty sliding scale as a model for his company.
few examples from which to make an assessment, all three royalty companies have
traded at 25 to 40 times cash flow. Royal Gold, in 2003, had only 14 employees but
had 16,000 shareholders. Like silver stocks, royalty companies benefit from their
scarcity, which causes them to trade at a heavy premium to their intrinsic value.
By far, the most successful royalty company in history was Franco-Nevada.
$1,000 invested in Franco-Nevada in 1983 would have been worth $1,250,000 in
Newmont stock by March 2004. Founded by Pierre Lassonde and Seymour Schulich,
the company had a basic strategy of taking up to two years to acquire a mining royalty
and to attain a return of capital within a further two years, as well as getting the
“blue sky” potential for nothing. Many of the royalties they acquired were in the
Carlin Trend and they shared in the profits from the rapid expansion of reserves of
those deposits.
GOLD STOCKS AND LEVERAGE
“Gear today, gone tomorrow”
– British Stock Market Adage
“Leverage and Liquor are the two largest causes of failure.”
– Warren Buffett
Gold mining operations and shares are subject to three basic forms of leverage:
- Operational Leverage — This comes from a large amount of production per share.
- Financial Leverage — This comes from the debt the company carries and can be mitigated or increased if the company has hedged productions.
- Multi Mineral Leverage — This occurs with the existence of multiple minerals within an ore body. In the case of gold it comes from the existence of silver and or copper. Many low grade multi-mineral properties can vary from extreme profitability in a bull market to negative cash flow in a commodity bear market.
Many mining companies, such as Echo Bay, Pegasus, Royal Oak, Coere d’Alene
and TVX Gold, had both operating and high operating and financial leverage in a gold bear market; this can be a dangerous combination and that led to the extinction for all except Coure D’Alene.
A debt-free mine can survive a bear market merely by closing or reducing production.
A heavily-debted or hedged company does not have the luxury of such an
option. A marginal mine, in a protracted bear market, may run out of ore before
prices recover. For many of the capital intensive, low-grade and heavily hedged companies, it is often as one British mining analyst put it, a case of, “Gear today, gone tomorrow”.
Leverage has proven to be a double-edged sword for gold mining companies.
The combination of hedging at low prices and high debt levels, has given the sector
a survivorship problem.
The gold stock investor should be wary of companies with large debt, hedged
production and low grades. As gold prices fall, breakeven grades increase and
reserves fall.
In the current late stage bull market for gold shares costs have risen in line with the appreciation of gold bullion causing many remote, large scale open pit, low grade deposit development costs to soar at an exponential rate. This in turn led to large shareholder losses in stocks such as Nova Gold and Teck Cominco and the abandonment of several large scale “shelf projects”.
As the very reason for many investors buying gold stocks is as a hedge against
excessive debt by governments, consumers and corporations, it does not make sense
for the investor to purchase a heavily leveraged indebted gold stock.
One of the main attractions of gold shares, along with the high price/earnings
ratio they enjoy even in bear markets, is their tremendous leverage to gold prices.
While iron ore and coal stocks merely stayed in lockstep with their respective commodity
prices between mid-2003 and early 2004, with each gaining 100% from lowto-
high, gold stocks moved up or down three times the rate of change
in the gold bullion price.
U.S. AND CANADIAN GOLD MUTUAL FUNDS
Gold and precious metals mutual funds, like most mutual funds, are victim to very
subjective ratings criteria, evaluation and methodologies.
In practice, most are invested in mining equity securities. In the United
Kingdom, legislation prevents them investing in bullion directly. Many U.S. based
mutual funds limit their exposure to bullion to a maximum investment of 10% and,
in practice, rarely hold more than 5% of their assets in bullion.
As gold funds made their journey over the past 15 years from worst to first and
then back to worst, it caused a survivorship problem for the sector. According to the
Eaglewing Guide to Gold Funds, over that period 19 gold funds ceased to exist,which
is almost half of the total universe of gold funds.
To the end of 2003, for a 15 year period, gold and the surviving precious metal
funds accounted for six of the 20 worst surviving mutual funds in the U.S.A., with
rates-of-return over that period ranging from minus 80.63% to plus 16.75%.
One shudders to think what the return in our universe would be if one included
the 19 gold funds that failed to survive.
In all sectors, there are exceptions. One example cited by Eaglewing shows the
difference clearly – from1985 to1995, the Lexington Strategy Fund showed a rate-of return of minus 22%, while the Oppenheimer Gold and Special Minerals Fund achieved a rate-of-return of plus 228%.
The performance of funds depends on the structure and style of the portfolio,
country and continental focus, as well as the flexibility of allowable investment
options of the fund charter.
While the vast majority of funds rise and fall with the basic bull and bear phases
of the precious metals markets, there are always a few astute and knowledgeable
investment managers willing to invest in new discoveries, new developing gold
regions or to ride trends in silver, platinum-group minerals or diamond exploration
and development.
Gold mutual funds, like the securities they own, always exaggerate trends in the
underlying commodity price. The general rule of thumb is, that gold stocks rise and
fall three times as much as the price change in bullion. There is, however, a lot of
variance in the short-term correlation of bullion with gold equity prices.
According to Eaglewing, in1993, the average U.S. gold fund showed a capital gain
of close to 100%, while the gold price increased 17%; a ratio of close to 6 to 1. In
2000, when gold bullion prices came off close to 6%, the average U.S. gold mutual
fund declined approximately 30%; a ratio of 5 to 1.
In 2002, gold bullion was plus 25% in price, while the average U.S. gold fund was
up over 65%. For 2003, while gold bullion price increased close to 20%, the average
U.S. gold fund was plus 50%.
Like most mutual funds, the majority of the large and dramatic percentage gains
occur long before the public come to the party. U.S. Global had four of the top ten
performing funds of 2002, all in resources and precious metals.When the inflow did
eventually cause a surge in new investors, the sector was about to undergo a correction.
Through to January 2004, the RBC Precious Metals Fund in Canada, despite a
stellar short and long term record under John Embry, was suffering from net
redemptions. This characteristic is not unique to gold fund investors, as two out of
three mutual funds are sold and not bought; they are sold on their track record by
investment advisors. It is not in the nature of the public to participate in the highrisk,
high-reward early stages of a sector bull market.
This leads us to mention one
rule for investing in gold mutual funds or any sector fund: “When money flows in at
a faster rate than the net asset value of the fund appreciates, it is time to exit”. The
reverse is also true when the net asset value appreciates faster than money flows in;
it is bullish and time to buy.
Many professional traders and investors will “clear the decks” every so often,
especially when trading goes poorly.Most of the gold mutual funds that went out of
business, either by folding or being acquired, were stuck with gold stocks for which
managers had either overpaid or overstayed and never cleared the decks. Mutual
funds often have a good year in their first year of existence. The Sprott Gold Fund
was created in November 2001 and gained over 300% to its subsequent peak.
You can always tell a gold and precious metals mutual fund manager by the
“companies he keeps”.Most funds post their top 10 holdings on the Web or with the
Ratings Services. In a limited universe of gold stocks worldwide, there are only a few
major differences between most of the funds. In general, the gold index funds have
not performed as well as the managed funds on the upside, but have generally done
slightly better in the downtrend.
There are some noticeable differences between U.S. based mutual funds and
their Canadian counterparts:
• U.S. funds are more international in scope, especially in regard to the domicile
and nationality of the mining company management – e.g. most U.S. mutual
funds in December 2003, had large positions in the Peruvian company
Bonaventure, while very few Canadian Funds held the stock.
• U.S. funds also favored gold companies where the head office was in the U.S.A.
and companies with only U.S. properties.
• Canadian mutual funds had more juniors and independents in their portfolios.
With these three exceptions, there were remarkable similarities between all
North American mutual fund portfolios.
Gold stocks are more suitable for trading by hedge funds than mutual funds.
Because mutual funds have to stay invested in gold stocks they are not able to benefit from seasonal trading strategies or to exit at correction points in the sector.
Reginald W. Ogden
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This article is solely the work of the author for the private information of readers. Although the author is a registered investment advisor at Canaccord Capital Corporation ("Canaccord Capital"), this is not an official publication of Canaccord Capital and the author is not a Canaccord Capital analyst. The views (including any recommendations) expressed in this article are those of the author alone, and are not necessarily those of Canaccord Capital.
The information contained in this article is drawn from sources believed to be reliable, but the accuracy and completeness of the information is not guaranteed, nor in providing it does the author or Canaccord Capital assume any liability. This information is given as of the date appearing on the article, and neither the author nor Canaccord Capital assume any obligation to update the information or advise on further developments relating to the information provided herein. This article is intended for distribution in those jurisdictions where both the author and Canaccord Capital are registered to do business in securities. Any distribution or dissemination of this article in any other jurisdiction is strictly prohibited. The holdings of the author, Canaccord Capital, its affiliated companies and holdings of their respective directors, officers and employees and companies with which they are associated may, from time to time, include the securities mentioned in this article.
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