GOLD COMPANIES ARE COMPANIES, TOO!
In making decisions such as these, and as I regularly remind my subscribers, the question should be asked, "Would I buy this stock today?" Where past purchases are concerned, they should be constantly re-evaluated to make sure that-at present market prices-the company whose shares you own is still a buy. The main point here is that, when you buy shares of stock, you are becoming part owner of a COMPANY; and that company's health, prospects, finances and much more must be thoroughly understood and continually reevaluated. Underlying all of this, of course, is to have both the proper macroeconomic view of things so as to know the health of the overall economy and its likely direction, as well as to understand the industry in which subject companies are operating.
When it comes to investing in gold shares, too many investors seem to forget that gold companies are companies, too! Instead, they become enamored with a sales pitch from a paid spokesman for a fledgling exploration company, or an unrealistically bullish picture for the entire gold sector. Far down the list, sadly, is doing some homework on the individual companies involved: "kicking the tires," if you will.
Following gold's recent bottom, I advocated that subscribers once again increase their overall allocation to the sector from the "core" positions we've maintained most of the time since the June, 2002 initial peak in gold stocks. I did so for the most fundamental of reasons: I believe that the gold sector continues to enjoy an overall bullish scenario. Near the top of the list is an important element lacking in many other industries these days: pricing power. Simply put, gold is one commodity which can still be sold to those who desire it at current or even modestly higher prices. Coupled with other longer term bullish fundamentals including a declining U.S. dollar and the lack of new hedging by producers, and you have a sector which-though I still believe this bull market will be grinding and rather unspectacular most of the time-has more inherent health than a lot of others these days. But even all this does not mean that one can indiscriminately buy gold stocks and make money, any more than you can blindly throw money at companies in any sector.
In a previous commentary I've addressed this subject by talking primarily about what investors should not do. Today, let's do the opposite and talk about how investors who, as I, are convinced that the gold sector is a suitable place for part of their portfolio should go about looking for suitable companies.
Where all resource companies are concerned, I categorize them as falling into one of three general groups. First we have established companies; these are the best known, larger, profitable and generally better capitalized ones. Next we have what I like to call the "tier jumpers." These are smaller and usually less known companies, but ones whose fundamentals and growth are improving at a faster pace than their peers, and are about to take the next step within their industry in the maturity process. This could come from an impending transition from operating losses to profitability, or maybe just reaching a point where they're cash flow positive provided other aspects of the company are sufficiently strong. Last-and least more often than most people realize-are those companies which can be most accurately described as speculative.
Unless you're even more savvy (and lucky) than those who are the professional investors/analysts in the area, you need to confine the majority of your gold investments to the first two of these categories. When doing so, you need to consider all the various factors which affect companies you're investigating. Even in the case of some established/larger companies, not all are created equal. Factors such as production bottlenecks, higher costs than its peers, accounting issues, energy and labor costs, recovery efficiencies, currency translations and more can impact even what is otherwise a sound company. Just ask the management and unfortunate owners of Barrick Gold, whose shares have performed horribly during most of this gold move while virtually all others among the "majors" have done well.
Particularly when the average "major" gold company no longer has the kind of explosive upside they once did as they moved up the food chain, it's that much more important to separate the strong from the relatively weaker when examining investment candidates. Are their production costs under better control than their peers'? How does management intend to deal with issues of currency hedging (where appropriate) now that the U.S. dollar is declining? What opportunities are there to grow the company and increase future production? Are there any developments on the horizon slated to noticeably improve profit margins and net income; for example, did one of the company's geologists or chemists finally figure out how to meaningfully improve recovery from troublesome concentrates?
When looking at mid-tier companies, management talent and honesty becomes even more important. In addition, you want to look for those producers who for one or more reasons are about to see a quantum jump in fundamentals, particularly in reserves or production. This could be, for example, a company currently producing 50,000 ounces of gold a year that has one (or preferably more) opportunities due to their exploration success of increasing annualized production dramatically. A "major" is unlikely to see 100%, 200% or greater increases in production; however, there are several gold companies out there which appear close to being the latest to pull off such a feat who, longer-term, will be rewarded by the market place for their success.
Other questions: Is this company about to become cash flow positive, preferably with some momentum that will take it to being positive where the bottom line is concerned? What kind of company does it keep, in the case of joint venture projects? How successfully has it operated its properties in the past? How has the company dealt with and come through past misfortune? Does it have a "reputation" with the investment community that it must overcome or, in the alternative, even benefit from?
Where speculative companies are concerned (generally, to include those which are producing only modestly and losing money, and those who are pure exploration plays) it's important to know that a rising gold price does not change the laws of mathematics, economics or common sense. As with fledgling or start-up companies in any industry, the odds are against them. Most won't be around a few years down the road-and not because they were successful and were gobbled up by a bigger player. It will be because they didn't make it.
To determine what speculative companies could nonetheless represent a good, calculated risk for your portfolio, look at the reasons why others have failed in the past. Incompetent management. Inability to control costs. A lack of a sound strategy or business plan. Inability to remain sufficiently capitalized to carry out and achieve even a sound business plan. No credibility with investors because of too much stock promotion relative to other productive activities.
Especially with speculative gold companies, it's easy to begin a process of elimination by weeding out those exhibiting that last characteristic. I like to check out how much of the company's budget and outstanding shares are devoted to stock promoters. Sure, I realize that this is an important area; and that for companies needing to raise money in the future (and virtually all in this category will need to eventually) the ability to build up a share price now by spending money on promotion may well mean less dilution later. However, some clearly go overboard. One company I was asked about by a subscriber just a few days ago, in fact, seemed to have marginal speculative attractiveness concerning its South American exploration projects. Then, however, I had to consider the fact that promoters(largely operating via the Internet) had just been granted a block of stock that was THREE TIMES that already outstanding!
Management is the other big thing. What are key mangers' previous successes/failures, both in the gold industry and out of it? What do THEY have at stake? Are they taking a disproportionate amount out of the till to pay themselves, or are they pretty much waiting to get paid until the company's exploration leads to some cash flow? Best of all (if, like me, you try to visit companies and their management personally, perhaps in settings like precious metals industry conferences) can you look insiders in the eye and get the feeling you're dealing with a straight shooter?
Finally, when looking at companies in any of these categories, it's a plus if you can find one which passes your due diligence test and which also happens to be currently unappreciated by the market. Great investors such as Warren Buffett and Sir John Templeton have always followed this simple formula: find good companies, and buy them when they're out of favor.
Closing with a specific example, I recently re-recommended Bema Gold (AMEX-BGO) after it made another successful test of the $1.00 per share area. Bema was one of the more spectacular performers among gold companies in the initial days of the new bull market, rocketing from under 40 cents per share in late 2001 to very near $2.00 per share in a matter of a few months. Subsequently, however, BGO lost half its value. Now, this kind of drop was matched by many gold stocks during the same time; but what was most curious Bema's fall-off was the main reason why.
In Bema's case, investors reacted negatively to a major acquisition that prompted the company to increase their outstanding shares to finance it. The fact was, though, that both reserves and income approximately DOUBLED. Now, I may not be a Nobel economist, but I am fairly decent at math; and any company that can double its assets and income while increasing shares outstanding by only a third is great in my book. Most didn't see it that way, however; and until its recent nearly 50% advance, investors in my view were continuing to under appreciate this company.
It's our good fortune to find opportunities such as this from time to time; opportunities that appear to exist even now in the gold sector for those who use good old fashioned common sense, and realize that GOLD COMPANIES ARE COMPANIES, TOO!
-Chris Temple
www.nationalinvestor.com
July 4, 2003
PLEASE REPLY TO: chris@nationalinvestor.com