Buying gold miners? Here’s what you should be aware of

The gold trade has picked up some steam this year as investors look to protect themselves from any financial shocks that might rock global markets. Concerns about the state of China’s economy, Europe’s economy and the US economy coupled with capital markets trading at all-time highs have inspired many investors to seek insurance in the form of precious metals.

gold miners photo
Some gold miners — Photo by State Library of Queensland, Australia

Owning gold as an insurance policy has both drawbacks and benefits. Buying gold hoping that the price will rise in the event of a financial crisis is tantamount to speculation, gambling on higher prices. And if you speculate with the physical metal, storage costs will eat away at returns over time.

So, buying an ETF that tracks the price of gold or investing in the physical metal can be a speculative business. Investing in gold miners is a more attractive alternative. Owning gold mining shares gives you exposure to the gold price and qualifies as an investment as these companies generally produce an income stream for investors.

Buying gold miners? Here’s what you should be aware of

Finding the right gold shares to buy can be a tricky business. To help investors separate the weakest gold miners from those with a bright investment outlook, Bank of America has put together a list of red flags investors should consider when evaluating potential investments in the sector. Four of the most important red flags are highlighted below:

Watch the grade

“Prefeasibility studies can range in accuracy from plus or minus 20-25%, while the range for feasibility studies can vary from minus 15% to plus 15%. RPA reviewed 75 failed or troubled projects. Of these, 35 were related to grade… If you are mining a 1 gram per tonne gold deposit and your calculations are off by 0.2 gram gold, that is the equivalent of losing 20% of your deposit.”

Better than who?

“Benchmarking is particularly useful in determining fixed costs and things like corporate general and administrative expenses. Even simple benchmarking will highlight that something may not be quite right in a cost estimate.”

Not enough staff

“Teams are often understaffed (especially for mega projects), and it is not uncommon to see “TBD” or “Vacant” on organizational charts, which should be a warning sign.”

High demand for skills pushes up costs

“Studies show that cost overruns are higher when markets and metal demand are overheated. This results in a shortage of skilled workers in all aspects of the…In Canada, this is particularly evident because so many workers have migrated to the oil patch…if those with the right skills and experience are not available, companies have to resort to less qualified employees and contractors, many of whom are less experienced and less productive.”

These are just some of the items to look out for when analysing gold miners. If you’re looking for more tips, why not check out my interview with Old West Investment Management in which we discussed some of the best gold miners to buy in the current environment. Here’s an extract:

How did we choose the mining companies in our portfolios? First, following our investment process, we own companies run by owner/managers. Management teams that are heavily invested in their company, combined with modest compensation packages that are respectful to us shareholders. Second, when a company’s revenue is dictated by the price of a commodity, a strong balance sheet is imperative. The price of gold can be at or below breakeven for long stretches, and too much debt can be crippling. Third, reserves must be in business friendly and stable countries.”