3 Gold Miners Cutting Costs and Seeing Gains

Source: Thinkstock

Source: Thinkstock

With gold prices rebounding this year, investors have naturally bid up the prices of several gold mining stocks. The Market Vectors Gold Miners ETF (NYSEARCA:GDX) is up over 12 percent for the year, and this is much better than the S&P 500’s 2 percent gain year-to-date. I think this outperformance is set to continue given that stock prices are elevated, and given that gold prices are depressed while remaining in a long term bull market.

But simply buying the GDX because gold prices are rising doesn’t make sense. After all, there are two numbers that are important to gold miners — the cost of gold and the cost of mining it. Gold miners underperformed so markedly over the past couple of years because both numbers were going against it – the gold price was falling and the cost of mining it was rising. In fact, for many larger companies costs exceeded the gold price.

Thus, rather than buying GDX shares, investors would be better off finding those gold miners that are effectively seeing gains on the cost side of the equation. Companies that are taking aggressive measures to cut costs may be forced to write-down some of its high-cost producing mines, and it may also wind up cutting production. But this fiscal responsibility is going to put these companies at an advantage longer term.

Virtually every major gold mining company has taken some measures to cut costs, but the three companies I mention here in particular have done an excellent job. It is large companies that are geographically diversified, and I suspect that it will be longer-term outperformers.

1. Kinross Gold

Kinross Gold (NYSE:KGC) has had a rough couple of years. In fact, the stock price is down to $4/share from $25/share prior to the financial crisis. However, the company has taken aggressive measures in order to reduce production costs. It wrote down its Ecuadorian assets and it refigured its mine plans in order to maximize near-term cash-flow so that it can make money at $1,300/ounce gold and still have gold to mine when the price rises. The company was able to bring its production costs down to about $1,000/ounce, which means it is making a little more than $200/ounce before taxes. With over 2.5 million ounces in annual production, the company is generating over $500 million in cash-flow. Not bad for a company worth $4.6 billion.

Investors have been bidding the shares lower because a lot of the company’s cash-flow comes from Russia. But while there is a lot of saber rattling, nothing pertaining to the conflict between the U.S. and Russia over the Ukraine indicates to me that Kinross’ production will be impacted. Thus, I think investors should take advantage of the fact that the stock is trading at a multi-year low and pick up some shares now.

2. Gold Fields Limited

Gold Fields (NYSE:GFI) has a bad reputation because it used to get most of its production from South Africa. South Africa is considered to be a risky place to mine. Furthermore, a lot of the gold mines in South Africa are expensive deep underground mines. Fortunately, the company spun off all but one of its South African assets into a new company — Sibanye Gold (SBGL). Now the company has operations throughout the world, but its largest presence is actually in Australia. With this being the case, the company has reduced costs. Even though its one South African project is losing money at $1,300/ounce gold, the rest of the company’s assets make up for this. With the stock price depressed — shares trade at just $4 each — now is a good time to pick up the stock for the long run.

3. AngloGold Ashanti

AngloGold Ashanti (NYSE:AU) is one of the best performing gold mining stocks year to date, with shares up 50 percent. The company has done an excellent job of cutting costs so far, and it has recently brought on a new low cost producing asset in Australia. The company has the potential to produce over 4 million ounces of gold, which is a lot for a company trading with a market cap of just over $7 billion.

Investors bid the stock down because it had incredibly high costs exceeding $1,500/ounce. It also has operations in Africa, although several of these are in West Africa, which is one of the better places in the world to mine. With costs coming down and with production diversifying out of Africa, I think this stock is becoming very compelling. While shares are up 50 percent for the year, this is after a terrible performance, and the stock is still depressed. With costs coming down 25 percent on a per-ounce basis this company has a lot of potential to generate cash-flow for shareholders going forward, especially if the gold price rises.

Want to read more about investing in gold? One of the most common objections to an investment in gold is the fact that it doesn’t pay a dividend. In an earlier article we discussed how to earn an income with gold. Here’s a recap:

One option is to buy the Credit Suisse Gold Shares Covered Call ETF (OTC:GLDI). This fund buys gold futures contracts and then sells call options against its gold holdings. The fund distributes the proceeds from the sale of covered calls to shareholders in the form of a hefty dividend, which exceeds 13 percent.

A call option gives the owner the right to buy gold at an agreed-upon price regardless of the actual market price of gold. So, for instance, if the fund sells a covered call with a strike price of $1,400 per ounce, the call’s owner has the right to purchase gold at $1,400 per ounce even if the gold price is $1,500 per ounce. The call’s seller hopes that the call expires worthless (i.e., that by the time the call expires, the gold price is below $1,400 per ounce, so that the call’s owner has no incentive to act upon the agreement).

The good news is that this enables investors to generate income from an asset that normally doesn’t generate income. The bad news is that if the gold price soars, then investors in GLDI shares don’t get to participate in much of the upside because they have sold this right to the owner of the call. Given that the income on this fund is so high, a good strategy might be to buy a small part of your gold holdings through this fund. You can still retain a lot of exposure to the gold price and collect a small dividend on your entire gold holdings.

The second is the buy a gold royalty company. There are two large ones: Franco Nevada Corp. (NYSE:FNV) and Royal Gold (NASDAQ:RGLD). Both of these stocks have outperformed the gold price and the S&P 500 in the long run, and they have created a lot of value for shareholders.

These companies buy royalty agreements from gold miners. This means that they make a payment to a gold miner, and the gold miner then agrees to give these companies an agreed-upon amount of gold. The mining companies agree to this because they need capital with which to develop their mines – a lot of the mining companies involved are smaller companies that have just one or two mines that require capital to build. Thus, the relationship is symbiotic.

Royalty companies are very profitable because they have such low fixed costs. They have also paid steady dividends to shareholders, and, in fact, while most gold mining companies cut their dividends last year, these two companies recently announced dividend increases.

While these companies pay small dividends, they have a strong track record of raising these dividends. Furthermore, they have excellent balance sheets, strong pipelines of future royalty income from various gold miners, and very little risk. Investors looking to generate income from their gold holdings should therefore seriously consider taking a position in one or both of these companies.

Finally, investors do have other options in the mining space if they dig deep enough. If you don’t mind owning small mining companies or thinly traded ones, you can collect healthy dividends. A couple of examples include:

  • Caledonia Mining (OTCBB:CALVF), which is a $40 million market cap company operating in Zimbabwe, but which pays a 7.3 percent dividend that it can afford to sustain.
  • Mandalay Resources (OTCMKTS:MNDJF), which has agreed to pay 6 percent of its trailing revenues to shareholders in the form of dividends. It operates two mines, one in Australia and another in Chile, and it pays a nearly 4 percent dividend.
  • Alacer Gold (OTCMKTS:ALIAF), which is a small mining company with a mine in Turkey. While its peers were cutting dividends, Alacer Gold initiated a 3 percent annual payout.

These aren’t low-risk investments, but considering their strong dividend policies, one could make the case that they are more appealing than their larger counterparts, which took huge write-downs and cut their dividends.

Disclosure: Ben Kramer-Miller is long Kinross Gold, Royal Gold, and Caledonia Mining.

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