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(Kitco News) - Dan Denbow looks for mining stocks that he believes would have redeeming factors in either a bull, bear or sideways gold market.

“In a down market in any commodity space, the low-cost provider will win out the day,” said the portfolio co-manager of the USAA Precious Metals and Minerals Fund (USAGX). “In a bull market, companies with growth in production, growth in cash flow and growth in resources will tend to outperform. An in a flattish market, valuation matters.

“Those three tenants lead us to building a portfolio that will survive in most markets.”

As of May 18, the approach enabled the fund to earn Morningstar’s No. 1 ranking in its category for 10-year return, listed at annualized 26.19%. Morningstar gave the fund a four-star rating in the category of equity precious metals and listed assets at $2.2 billion.

Denbow has been involved with a number of industry sectors over the year, including energy, precious metals, heath care, real estate and construction. He joined USAA 13 years ago and became involved with the precious-metals fund full-time in 2007. He is portfolio co-manager with Mark Johnson.

The fund managers try to be “agnostic” about the future price of gold itself, Denbow said. “We’re just trying to find the best companies in the space,” he said.

If a gold mutual fund were placing its bets based on where gold itself might be headed, it might focus on a limited number of factors.

“Therefore you have to be right twice,” Denbow said. “You have to be right on the companies. And you have to be right on your short-term call in the price of the metal itself. That becomes very complicated.”

The fund managers try to be consistent in the way they run the portfolio, which simplifies the decision-making process, Denbow said. “Then you don’t start chasing whatever the hottest story might be,” he said.

The fund managers study income reports and cash-flow statements for various companies to establish views on earnings multiples.

However, the managers also make adjustments for risk in different mining operations. They look at factors such as a company’s management, mining jurisdictions due to political risk when trying to run mines in different parts of the world, and even the difficulty of individual mining operations.

“No two mines are alike. Some are similar, but they all have different levels of difficulty,” Denbow said.

He also looks at the number of mines a company operates. “A one-mine company is more risky than a multi-mine company,” Denbow said. A company with a single mine, even if highly profitable, would hurt severely if a natural disaster, political event or labor disruption hated operations.

“A lot of these are subjective based on how we feel, and some are quantitative, such debt on a balance sheet, cash and things like that,” Denbow said.

The portfolio co-managers for the USAGX fund, based in San Antonio, travel extensively to mines around the world.

“It gives you a good feeling about the challenges that the companies face operating in those regions,” he said. “We meet with management—not the senior-level management, but the guys under them having to make it work. That is very informative.”

For one thing, they get a sense of whether any potential challenges can be easily overcome. “Then you can tell if the Street is over-reacting or under-reacting to that type of news event,” he said.

Further, the fund managers aim to meet individually with at least 90% to 100% of the chief executives of mining companies, whether at their offices or hooking up at conferences.

The fund tends to take a longer-term view rather than hopping in and out of markets. The turnover of stocks in the fund was around 23% in 2010 and has tended to average in the twenties for some time.

“It takes a lot of work putting all of this together,” Denbow said. “If you go to the trouble, you want to have a position and you want to be rewarded for that position.

“A lot of times, you’ll have companies you’ll take from the exploration or mine-development stage and you can follow them into becoming a producer. And as they grow from a one-mine exploration story to a two-mine production story, you might eventually get bought out.”

The fund relies on fundamental factors in its decision-making, rather than technical charts used by many shorter-term traders. “I think knowing the stories (of individual companies) and focusing on what’s there is the way it pays off for us,” he said.

The fund invests mainly in mining stocks, as these normally these move greater than the price of gold itself. Further, the fund tends to remain in mining stocks even if the sector as a whole turns lower, although it might increase its cash position some in order to take advantage of shares that might become cheap. As an example, when the market turned lower in 2008, the fund had cash to take advantage of buying opportunities while others were still liquidating, Denbow said.

“The reason investors give us their money is because they’re making the decision to be allocated to it (gold stocks),” he said. “So we feel it’s not our job to take their asset-allocation decision out of their hands for this fund. Our fund is a tool they’re using.”

By Allen Sykora of Kitco News; asykora@kitco.com

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Dan Denbow
USAGX's Dan Denbow: "We're just trying to find the best companies in the space."