Gold Miners: How to Sift the Winners From the Duds

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With the price of gold declining last week and with gold mining stocks approaching their December lows, I think investors should consider buying gold mining stocks on weakness. While gold has been relatively weak over the past couple of years, the catalysts that have been driving it higher over the past 15 years are still in play. These include:

  • A weak dollar, an overvalued U. S. stock market, and a tepid economy.
  • Rising demand from Asian investors who are becoming more affluent.
  • Geopolitical tensions between the Americans and the Russians, and also in the Middle East.

More recently, other drivers, such as central bank demand and quantitative easing, may not have moved gold prices higher, but eventually they will.

With that being the case, gold is becoming increasingly more appealing. The same can be said about gold miners. But how should you go about choosing gold miners?

One approach that I dislike is to buy an ETF such as the Market Vectors Gold Miners ETF (NYSEARCA:GDX). This is the case because gold mining is a difficult industry. Many of these companies have issues. Some of those issues include:

  • Gold miners mine in risky geopolitical jurisdictions.
  • Gold miners cannot keep productions costs from rising as fast as the gold price.
  • Gold miners making lousy acquisitions.
  • Gold miners mine other metals, such as copper.

With this being the case, I think you need to be selective. If you research individual gold miners and pick the right ones you can make a lot of money, especially since the prices of these stocks are so depressed right now.

Here are some tips for picking the winning gold miners.

First, pick companies that are making money. For many gold miners, especially the larger and better-known companies, the cost of production is near the price of gold. Even if a company reports a certain cost projection, simply look at its cash flow and income statements for the real story. Consider a company such as New Gold (NYSEMKT:NGD). This firm claims to be one of the lowest-cost gold miners in the industry, but look at its first-quarter income statement — the company lost money!

If you look under the hood, New Gold actually isn’t such a low-cost producer. It has a large interest expense that it doesn’t include in its cost estimates. It also uses its copper production to offset the cost of gold mining. So when you are picking a gold miner, pay less attention to the numbers it advertises and more attention to the numbers it generates.

Second, pick a company with a plan. Many companies just say that they are going to produce such-and-such amount of gold in the next year or two, but they don’t have expansion plans. If management says that it is going to increase production, make sure you know where that production increase is going to come from and make sure you know how much it will cost and where the funding will come from. Also, if the company is working on some sort of agenda — such as bringing a new project into production — make sure you know what the company plans on doing afterwards.

Third, pick companies that know when to give up. Many gold mining executives get caught up in fighting losing battles. This is a difficult industry, and even the best managements fail sometimes. If they are capable of recognizing this failure, then they can move on, cut their losses, and hopefully generate shareholder value. Consider Consider Kinross Gold (NYSE:KGC).

The company gave up on a major project in Ecuador last year because management saw that it was a lost cause. It took a write-down, but now it can focus on its winning projects that will make money for shareholders. The company can now focus more of its energy on expanding its Tasiast project in Mauritania, which is going to make shareholders a lot of money over the next five to eight years.

Finally, avoid companies that have an enormous number of projects, such as Barrick Gold (NYSE:ABX). These companies are simply spread too thin, and management has to do too much in order to monitor all of its projects. While a company with fewer projects is also smaller, if you buy these companies, you will be investing in management teams that can focus their efforts on three or four projects. They will have a better working knowledge of these projects, and there is a better likelihood that they will make money.

Disclosure: Ben Kramer-Miller is long Kinross Gold.

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