Precious metals miners are the most volatile stocks on earth. They're so volatile that investors often forget that underneath those whipsawing stock prices lie real businesses. But even many of those who consider themselves old pros in natural resource investing tend to get one thing wrong. Eric Angeli, an investment executive with Sprott Global Resources and protégé of legendary resource broker Rick Rule, explains how not to fall into the "top down" trap…
If the past two years have taught us anything, it's that trying to predict short term moves in the gold price can be a road to ruin. Parsing the umpteen countervailing forces that combine to set the price of gold is tough. And it's even tougher when you consider that oftentimes, market moving news, such as a central bank trade, isn't reported until after the fact.
In my years spent evaluating natural resource companies as a broker and analyst, I’ve found that there are two ways to successfully invest in precious metals equities. Doing it right can bolster the strength of your portfolio, not to mention your own confidence in your holdings.
Method #1—Top-Down Approach
You may have heard this method referred to as “Directional Investing.”
A directional investor decides that gold prices will increase in the long run. That's the starting point of his thesis. He then proceeds to find the companies that will be successful if his prediction comes true. He looks for companies with leverage to the gold price.
If an investor can get the timing right, this can be a lucrative strategy. There is an obvious caveat, though: for this strategy to work, precious metals prices must rise.
In my role as a broker, I deal with both companies and investors all day long. I can tell you that most speculators involved with gold equities use this top down approach.
That's why the number one question I’ve heard over the last three months has been, “Why isn’t gold moving up?” To directional investors, the answer to this question is paramount.
This mindset leads to the herd mentality and, frankly, gives us our best bull markets.
I prefer method #2.
Method #2—Fundamental Approach
Fundamental investors ignore prognostications about where gold prices might move next. We eliminate gold price movements as the crux of our investment decisions, which removes a lot of the guesswork from our portfolios. For a fundamental investor, gold prices are still a piece of the puzzle, but they are not the only driver.
Fundamental investors want to know: which company has a promising deposit in a relatively safe jurisdiction? Which has a tight share structure? This “bottom up” method, however, does require a lot more homework.
Fundamental investing is all about identifying the difference between a stock’s intrinsic value and the price at which it is trading at in the open market.
While I do believe in higher gold prices eventually, and inevitably, I know that short-term movements in the price of gold are beyond my control. I instead prefer to position my clients for success in the current environment. Instead of focusing on when the gold price will move, which we can never know, we focus on picking quality companies.
Why Hasn’t the Top-Down Approach Been Working?
You might say: because the price of gold hasn’t gone up! That's true, but there’s more to the story.
Until quite recently, gold has continued to rise, though not at the same clip we enjoyed after 2008. The problem is that miners' operating costs rose faster than the price of gold. Investors didn't expect that.
Nor did they factor in other cost increases. Sure, the value of a deposit rises every day the gold price rises. But did oil prices jump at the same time, making trucking the goods out more expensive? Did your laborers start demanding high wages? Did energy costs increase? Did the federal government demand a bigger slice of the pie?
Top down investors can stop trying to figure out why they haven’t been correct over the last several years. They were correct on the gold price, but they ignored underlying cost factors.
The Top 7 Things to Look For
This is where the Fundamental Approach shines. All of your investments should fulfill a few key checkpoints:
- Look for companies where management owns a large percentage of the stock. A vested interest at a higher share price is even better.
- Look for a tight capital structure. A bloated outstanding share count is a red flag. As is a history of management carelessly diluting away shareholder interest by issuing new stock.
- Look for a thrifty management team. A good company should spend their capital on projects, not swanky new offices.
- The company's mine should remain profitable even if gold drops to $1,000 per ounce. It could happen.
- Look for companies with enough cash to finance their current drill program, expansion plans, feasibility study, or construction phase. This year in particular, companies are having a very difficult time finding financing. Those who have adequate cash are diamonds in the rough.
- Know which countries support mining. A tier-one asset under the control of a wildly corrupt government isn't really a tier-one asset. You don't want to get caught in the middle of a government dangling final permits above managements’ heads.
- Know the geological potential of the exploration area. A four-million-ounce gold deposit is swell, but what if your company discovers not just one gold mine, but an entire new gold district? How will you factor in that upside?
Don't Let Fear Make You Miss Out
Mining companies have a fiduciary responsibility to make their shareholders money, so they can’t help but paint a rosy picture for potential investors. That's why you need to have a disciplined and impartial eye. Most companies are not worthy of your hard earned capital.
Having an advisor you trust, or access to technical expertise, is crucial. Ideally you should have both. The most educated investor always has the edge.
I'll conclude with this: the markets have not been kind to the miners recently. But selling a stock just because it dropped in value is an emotional decision. Seeing red on your computer screen is painful, but it is not relevant. What is relevant is what you do with that capital going forward. Don't let emotion cloud your judgment.
On the other hand, if you’re waiting for the gold price to move higher before you sell, then you’re a speculator masquerading as an investor, and you may as well buy a ticket to Vegas.
My boss and mentor, Rick Rule, recently said, “Bear markets are the authors of bull markets.” When these markets do start moving, if you’re not positioned with the highest quality tier one companies, you could miss out on one of the biggest bull market moves of your investing life.
Eric Angeli is an investment executive at Sprott Global Resources.
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