Managing Expectations Part III: Picking Mining Stocks in a Bear Market by Frank Holmes

In the first part of this three-part series, I discussed the importance of cycles such as four-year presidential elections and the life of a gold mine, and how they play into our investment strategy here at U.S. Global Investors. Part II dealt with statistical diagnostic tools, in which I strived to simplify the definitions of standard deviation and mean reversion and explain how they’re applied.

The third part of this series on managing expectations is devoted to fundamental resource stock evaluation. I’ll discuss some of the statistical tools we use to pick quality stocks during a treacherous bear market, such as what we’ve seen in gold stocks the last three years.

Let it be known, however, that, though our approach might vary slightly depending on the condition of the market, we fervently seek to pick the best stocks at the best price and execution.

How I Learned to Respect the Bear

The traditional definition of a bear market is when broad stock market indices fall more than 20 percent from a previous high—which sounds like a catastrophe, but is in fact “normal” market behavior. According to self-professed “investing nut” Ryan Barnes, a contributor for Investopedia, “bear markets… are a natural way to regulate the occasional imbalances that sprout up between corporate earnings, consumer demand and combined legislative and regulatory changes in the marketplace.”

Think of bear markets, then, as the gradual transition from warm summers into frozen winters. Trees lose their leaves, snow and ice blanket the ground, many animals—the bear the most notable—hibernate for the season. All life seems to take a breather. But just as you can always count on spring to emerge and, with it, new life, you as an investor can count on the market to rebound with fresh vigor.

As you might have known, the tail end of “winter” is when you want to take part in the inevitable recovery. If the market never had a winter season, if it were perpetually trapped in an endless summer, investors would be hard-pressed to find an ideal entry point.

It’s easy to determine when winter becomes spring. But what about the end of a bear market? How do you know when it’s bottomed and the optimal buying time has been reached?

CLSA consultant Russell Napier, in his now-classic 2009 book Anatomy of the Bear, describes the determinants of the end of a bear market:

The bottom is preceded by a period in which the market declines on low volumes and rises on high volumes. The end of a bear market is characterized by a final slump of prices on low trading volumes. Confirmation that the bear trend is over will be rising volumes at the new higher levels after the first rebound in equity prices.

Look at the chart below. You’ll see that, in three decades, the PHLX Gold/Silver Sector (INDEXNASDAQ:XAU) has never had a losing streak for more than three years.

Mining Stocks
click to enlarge

Historical precedent suggests that gold stocks were due for a jump in 2014, and just as expected, the XAU has returned close to 20 percent year-to-date (YTD) after an abysmal 2013, the “final slump of prices on low trading volumes.”

The following line graph illustrates just how dramatically gold and silver stock performance has rebounded. As you might remember from our discussion last week, what we see here is an example of mean reversion, which occurs when the price of a security reverts back to its historic average.

Mining Stocks
click to enlarge

These data exemplify the notion that you should remain patient during downturns, avoid getting discouraged and allow the security—in this case, precious metal stocks—to revert back to its long-term mean. When it does, you’ll find that the wind is suddenly at your back instead of in your face.

Spencer Johnson, author of the 2009 book Peaks and Valleys: Making Good And Bad Times Work For You—At Work And In Life, writes, “You cannot always control external events, but you can control your personal peaks and valleys by what you believe and what you do.” Likewise, we might not have any control over how the market behaves, but we can control how we respond to it: with grace, intelligence and levelheadedness.

Value Drivers for Superior Performance

One of the tools we use to navigate around volatility, regulate emotion and focus on facts and fundamentals is an invaluable model we call the portfolio manager’s cube. It helps us separate the weak from the strong, evaluate a company’s attractiveness and pick the best GARP-y stocks. “GARP” stands for “growth at a reasonable price,” which is an investment strategy that aims to identify companies with superior growth and value metrics.

Mining Stocks

The cube allows us to sift, sort and prioritize. It draws attention to the intersections among a resource company’s production, cash flow and reserves (rows) and relative value, momentum and event drivers (columns). Using this model, we compare stocks on a relative basis in production per share to find attractive opportunities and overpriced risks. We also identify events that could increase reserves and/or production per share over the next 12 months.

More than anything else, the cube affords us the framework for conducting relative valuation of a stock. Relative valuation is a method that compares a security’s value to that of others to determine its financial worth.

For example, we evaluate mining stocks in the same way you or I might compare cars on multiple metrics before making a purchase. On this topic, I urge you to check out one of my favorite websites, Dennis Boyko’s GoldMinerPulse, for a look at the type of fundamental analysis and relative evaluation that goes into comparing and contrasting mining stocks.

The following is an example of how we might use the cube. Suppose a young mining company has just discovered a gold deposit. This event might excite potential investors and compel them to enter when the stock is undervalued, expecting it to skyrocket. But it’s important to conduct a cross-sectional analysis of this discovery in terms of production, cash flow and reserves. How much gold does the company expect to produce in relation to others? The average concentration of gold in the earth’s crust is 0.005 parts per million, making a substantial yield very rare. About one in 2,000 companies is lucky enough to stumble across at least a one-million-ounce deposit.

Other questions might include: Does the company have ample cash flow to finance the costly yet necessary infrastructure, equipment, geological analyses and manpower to extract the metal, not to mention pay dividends? Has it kept up with its cash reserves to remain solvent during development of the mine and subsequent excavation? Many years, after all, typically go by before ounce one is plucked from the ground.

Besides using models such as the portfolio manager’s cube to determine a mining company’s or asset’s relative value, we also rely on “boots on the ground” experience. Members of our investment team and I

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