An inordinate number of articles that are lacking in perspective have been circulating of late about the failure of mining stocks as a precious metals investment vehicle. On Wednesday came yet another example with Paul Price’s article, “Gold Mining Shares: Less Than Glittering.” Price makes a skewed argument about the poor performance of gold stocks by selecting points of reference that begin in the confine of late stage bull markets such as 2003 and 2008, and end in the depths of bear markets.
Although mining is clearly a challenging business, bear markets are not the sole domain of this industry. For those who may have forgotten, there have been some doozy boom-bust cycles witnessed in many asset classes during the last 15 years. In the case of mining, there have been three terrific booms — and now three nasty busts — over the last 20 years.
But rather than write post-mortem analysis articles about the most recent bust, a far better exercise is to analyse whether valuations are now conducive to creating the conditions for another bull market. The time has come to do some real digging into what the mining industry has to offer.
Chart Source: Morris Hubbartt
Mining market bears frequently tie their litany to three extreme examples: John Paulson, one of the big losers of this bust; Barrick’s ill-conceived Pascua-Lama project on top of a mountain in Chile; and the all-in-cost (AIC) method of valuating mines.
In Paulson’s case, he simply bought high during the boom and lost. Pascua-Lama is an extreme outlier that doesn’t represent all projects. And while AIC is a useful tool for looking at the economics of the exploration and development of a new mine from start to finish, it doesn’t accurately gauge valuation of existing mines.
AIC uses cash cost plus capex (development cost), discovery cost, depreciation and general administrative to determine the total cost of producing one ounce of gold. This formula is far less relevant when applied to advanced-stage discoveries or when a gold miner’s stock is trading well-below its initial capex, which is commonplace right now.*
Once an economic ore body has been discovered or a mine has been constructed, initial capex becomes a sunken cost incurred by previous investors. In these instances, the primary considerations should be the stock’s current enterprise value (EV), gross profit relative to a reasonable gold price (say $1,275) and the leveraged optionality value from higher gold prices.
Canadian miner Detour Gold (DGC) is a prime example a miner selling well below capex or development cost. It currently trades at $8.50, representing $900 million EV (market cap minus cash plus debt). The capex that brought it into commercial production was $1.5 billion. The “market” doesn’t assign any value to Detour’s in-the-ground reserves, its 21-year, expandable mine life or its reasonable cash cost.
When Detour kicks into full gear in 2014, it will produce 570,000 ounces for a cash cost of $550 per ounce, generating a gross profit of $400 million. If gold prices move higher, it will offer investors even more profit leverage. Therefore, the real opportunity for substantial gain is not in the ETF or physical market.
The overly used AIC approach has incorrectly valued the world’s best undeveloped, feasibility-stage deposits, which are trading at 10 to 30 percent of net present value, using a 5 percent discount. It has created opportunities to invest in some quality names that are barely trading above cash.
Once assigned a correct enterprise value, mid-tiers sell at two to three times gross profits [see Brigus] — even using $1,275 as the price received per ounce of gold. If the prospect is located in a so-called questionable jurisdiction — defined broadly as Africa, and about everywhere else for that matter — anticipate about one-and-a-half-times gross profit [see Teranga].
Finally, there’s the refrain that mining costs are spiraling upward. Costs did increase exponentially up until about a year ago. I have had this discussion with several mining company CEOs. They have told me that, with the exception of fuel, costs for materials, mining services, drilling and consumables have turned lower [see “Mining Costs Fall For Gold Producers“]. In sum, this is a rare opportunity for intelligent investing if you apply some perspective in identifying excellent candidates.
*The costs of mining are customarily divided into cash and total costs. The cash costs are the regular working costs of the mine. The definition varies between companies and may include smelting, refining and any by-product benefit but generally excludes taxes, exploration, depreciation, depletion expenses and financing.