How to identify the best prospects in the risky gold and silver mining sector

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For precious metals investors looking to increase their exposure to this asset class beyond owning bullion or gold and silver ETFs, mining companies are a natural consideration. Their prices usually move much more dramatically in response to smaller price moves in the underlying metals they mine. In a bull market, it’s very possible for the share prices of these companies to increase by hundreds of percents within a year or two.

But there are a lot of gold and silver mining companies out there, many of which are small operators. Risk abounds in this sector. And for the past half-decade, most of these companies have been absolute widow-makers for investors. How do we identify which companies are worth considering and which should be avoided? How (if at all) should the small investor go about gaining exposure to precious metals mining companies?

To address this, Dr. Leanne Baker, former mining analyst at Solomon Smith Barney and current director of Agnico Eagle Mines Ltd, joins the podcast this week:

 

Start by focusing on the longstanding fund managers. A number of these investors have very good track records and do a great job of providing investor commentary on a week-to-week or month-or-month basis. Look at mutual funds like the Tocqueville Fund run by John Hathaway, or at Frank Holmes’ fund down in San Antonio. That’s where I think investors who don’t want to do the nitty-gritty of looking at individual companies should start.

If you’re interested in investing in individual companies, you have to start with the publicly available information. You can get pretty much everything you need from the reports that the companies put out. They have to report their reserves. They have to report their cost structure. They report the grades of their reserve bases. You can get into as much detail as you want looking at whether they are mining lower grades, higher grades, and on and on and on.

You want to focus on the free cash flow potential and on the balance sheet.

What I have found with many individual investors is that it turns out to be more work than they are willing to do. The first thing is to realize what kind of an investor you are. If you’re not someone who wants to stay on top of all that information, then perhaps you’re better off with a good mutual fund because they hire people who do all that work for you.

When I was an analyst, I really felt like I needed to see all of the operations of the mining companies that I followed. At the time, I only followed the large producing companies. It was relatively easy to make judgments about the quality of the ore deposits. Did management seem to have a good handle on the cost structure, etc?

The focus should be on cash flow, just as you would for an oil company. You can get bogged down in all the details, but in the end what you really want to see is whether these companies can generate operating cash flow that is meaningful. Even beyond that, can they get to the point where they generate free cash flow, which is what they generate after they have paid for all the capital that it takes to bring these mines into existence? As a rule, there are not a lot of gold companies that get to the point where they can generate free cash flow, because you’re always in a situation where you have to replace the reserves that you have mined.

Gold companies tend to have very short reserve lives compared to copper, nickel and other base metal companies where deposits can sometimes go on for 100 years, or certainly several decades. There aren’t that many gold deposits that have that kind of extensive, long lives outside of South Africa. Most gold mines tend to have reserve lives of 10 years or less. Those are the companies that are always going to be scrambling to continue to replace and grow the reserve bases that they have.

Another important factor to consider is that the growth of many gold mining companies often comes by issuing debt in addition to going and getting equity from investors. That can be a death knell right out of the gate. In my mind, only the largest gold companies that have a reserve base that can support a debt structure should have debt. If you’re looking at a small company, and if for any reason they have acquired debt, and in that I often include hedging strategies, that’s a red flag. I’m not interested in gold companies that want to hedge their gold production, because the reason why you buy is because you are expecting that the price will go up over the life of the asset.

Click the play button below to listen to Chris’ interview with Leanne Baker (46m:16s).

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