Which Gold Stocks To Buy For The Least Risk?

By Adrian Day

Editor's Note: Last Thursday, in my Perspective article, I talked about the most commonly asked question Michael and I hear as we travel. The second most commonly asked question is, "What is going on in the gold mining industry?"

And, that is exactly what I asked our good friend and long-time contributor, Adrian Day, when I ran into him at the Metals and Minerals Conference in New York last month. If anyone knows, it is Adrian. He has successfully managed resource stocks for individual investors since he founded the firm bearing his name back in 1991.

Adrian is one of our 'go to' guys when it comes to the straight scoop on miners. And, if you are interested in this sector, I would highly recommend you read a copy of his latest book on the subject, Investing in Resources – How to Profit from the Outsized Potential and Avoid the Risks (Wiley, 2010).

Adrian was most kind in allowing us to share his answer with you today. And, he suggests how you can participate in the sector while lowering your risks. Please read and enjoy his insights, and, let us know via email if you would like to consider using his asset management services. We'd be happy to make an introduction.

--Rich Checkan

In truth, gold stocks have been a pretty poor investment for some years—at the extreme, Barrick's stock price today is lower than it was back in 1993. And the same goes for Newmont. Yet, investors hold on and buy, because of the expectation of the leverage stocks bring when the price of gold moves up, and also because of the huge gains that stocks in this sector can bring, gains few other sectors can match. But what to buy, to minimize those horrendous losses that come in bad markets?

Let's start with the proposition that mining is inherently a tough business, one which government, environmentalists and others make only more difficult. Add to this the sometimes gross incompetence of managements, and it's no wonder that stock prices have not always brought riches to the investors.

It's A Tough Business

The difficulties of mining are well known. A major issue is the costs of mining have risen in lockstep—and sometimes more so—than the increase in the price of gold. Though mining costs have, on average tripled, environmental costs have jumped as much as tenfold. The result is the margin on mining today is hardly higher than it was back in the early 2000's, at the beginning of the bull market. Half of the mines in the world today are barely break-even on a cash basis, and the cash costs are only the beginning of the story.

Since mines are depleting assets—unlike, say, a widget factory—if a company is to be an ongoing enterprise, it must find a new ounce of gold for every ounce it mines. Whether the ounces come from existing mines or new deposits, these costs must be included if one is to look at the profitability of a company rather than of individual mines.

Getting Bigger

Which brings us to the second major problem for mining companies, the difficulty in replacing ounces. For companies like Barrick or Newmont that produce seven million or five million ounces (respectively) per year, that is no easy task. In fact, it's an almost impossible task. Think: in the 14 years since gold bottomed, the price has gone up nearly five-fold (more than seven-fold at the peak), and yet the number of ounces produced globally has budged only marginally. It is difficult in most cases to boost production at existing mines much beyond the depletion.

As for new deposits, despite the increase in the price of gold and despite the global exploration spend on looking for new deposits multiplying fivefold, the number of new gold discoveries has declined steadily and precipitously. (See Table #1 below.)

The result is the mining companies look to replace those ounces "in the market," by buying other companies, and this has all too often meant expensive, non-synergetic acquisitions undertaken for no reason but to get bigger. When Barrick, in a major mea culpa at the end of last year, stated its new policy would be to mine profitable ounces rather than just get bigger, it summarized much that had been wrong with the industry for many years. (It remains to be seen whether Barrick or other companies have truly learned the lesson.) All too often, they have bought at the top of the market, and looked to preserve cash at the bottom, when they should be buying.

Environmentalists and Taxes

This is only the beginning of the challenges facing miners. In addition to inherent difficulties—such as unstable rock or veins that disappear—there are man-made ones. Because of environmentalists and other NGOs, the time line for bringing deposits online has been greatly stretched at best, while at worst, many deposits are not mined. And once a mine is built—after hundreds of millions of dollars of capital expenditure—the mine becomes a sitting duck for rapacious governments. And unlike that widget factory, it cannot be moved elsewhere if government policies become unfriendly.

So mining is a difficult business, often made worse by management decisions. No wonder the shares have significantly lagged even the price of gold over the past several years.

Explorers Face Other Challenges

At the other end of the spectrum, the exploration companies have their own difficulties. Prime among these is the long odds against discovery. It is often quoted that only one in 5,000 anomalies even become a deposit. In the meantime, exploration companies, which by their nature do not generate revenue, need to continually raise new funds, usually through issuing dilutive equity, in order to keep going.

Success Brings Huge Rewards

If all this sounds depressing, let us remember that in strong gold markets, the gold mining stocks can produce outsized gains. Junior miners that set out on a growth program can see share prices rise dramatically. Goldcorp, for example, went from under $3 a share to the mid $50s in just 10 years, as it grew to become the fourth-largest gold mining company in the world.

Then, an exploration company that makes a discovery can see its stock price rise 10 or 20 fold. Reservoir Minerals has gone from just 50 cents a share to over $6 today, just two years later, after making a discovery in Serbia. And often these companies with discoveries become acquisition targets for the larger miners that are hungry for new ounces.

But these are few and far between and the timing needs to be right. It should be said that some of the top managers have records that are far superior to the dismal returns for the sector because of selection and timing.

For many investors, a better approach is to buy companies exposed to the mining sector that have low-risk business plans. This would include the royalty companies, which, with low cost structures, obviate many of the risks and difficulties inherent in the business outlined above. (See Table #2 below.) Though not exactly inexpensive on traditional valuation metrics, they do offer exposure to the sector without the risk of the sort of catastrophic failures we have seen in both major mining companies and junior explorers.

Adrian Day's eponymous firm, Adrian Day Asset Management, manages accounts in both global stocks and gold and resources for individuals and small institutions. He can be reached at assetmanagement@adrianday.com or at 410-224-2037.