An Alternative Approach To Picking Gold Stocks
Greg Silberman CA(SA), CFA (Retired)
Is there anything more frustrating than losing money in a BULL market?
Lets be honest, how many of us have bought at the TOP and sold out at the BOTTOM?
At least one of us!
Me !
To make matters worse, I KNEW that the market was topping, but I still plunged in….Ahh, emotions. They make you do funny things.
Thankfully, that was a few years ago. I've tried very hard to refine my trading style to stop me from making those irrational mistakes - no doubt I'll continue working on this for my entire trading career.
In my last article (HUI Targets) I explained why it was crucial to know where the overall Mining and Energy (ME) Universe was going before looking to buy individual stocks.
Based on my analysis at the time we were NOT at an optimal buying level.
I notice that prices have started to correct. Will the correction continue? I have no clue. But sure enough, as night follows day ME stocks will eventually move into an oversold position.
WHAT DO YOU DO THEN?
Everyone's stock picking techniques are different.
A lot of traders only buy stocks when they break out to new HIGHS,
I can't trade like that. I guess I'm just not built that way!
My technique is to look for stocks that are DEAD and FORGOTTEN.
Better yet, I like stocks that are so UNLOVED, shareholders pay me to take them off their hands.
Let me explain:
My trading style always favoured a Contrarian approach - going against the crowd. My style was finally solidified after I read a book called Contrarian Investing by Anthony Gallea and William Patalon in the late 90's. Gallea and Patalon detail, in enormous detail, 5 or 6 simple, quantifiable and unequivocal rules that can be used to find Contrarian plays. I'm not going to list all their rules because I think it is important for every contrarian to read the book. Also, I've adapted their rules a little to suit my own style.
The PRIMARY rule to being a Contrarian is to buy out of favour stocks.
To start, I compile a shortlist of ME stocks that are trading at least 30% below their 52-week high. Secondly, I exclude companies with high debt levels. A company that has been sold down and has lots of debt is at risk of going bankrupt. I like debt to equity ratios below 50%.
The 'Contrarian Investing' approach is aimed at constructing a balanced diversified portfolio across all industries. My adaptation is to only focus on industries which I believe are in SECULAR BULL trends ie. Mining and Energy.
A brief scan of your shortlist will show a mix of Exploration, Small, Mid-tier and Large Producers. THE COMPOSITION WILL VARY DEPENDING ON WHERE WE ARE IN THE OVERALL RESOURCE CYCLE.
Large corrections will uncover value in all areas. Intermediate corrections may only uncover value in exploration and small producers.
I think you need a mix of all ME stocks to balance your portfolio!
EXPLORATION COMPANIES
What do you call a Company that has a HOT idea, no Sales, no Earnings and negative Cash Flow?
A dot com?
Sorry…Try a Resource exploration company.
No offence intended to Resource exploration companies. But look here, essentially you are dealing with the same concept. You are buying into a company on the HOPE that they discover the next Witwatersrand (massive Gold region in South Africa). Granted, some have different risks than others. Some have more experienced management, more cash or better mining licences. But until there are recoverable resources its still an exploration company.
So how does an investor choose which exploration story to buy?
Sure you should know the geology of the area they are exploring.
It's always a good sign if there are other existing mines in the area.
But that's no guarantee!
I'll tell you what I look for:
INSIDER BUYING
The one and only indicator I base my FINAL buy decision on for exploration companies is insider buying.
ARE THE DIRECTORS PUTTING THEIR OWN MONEY INTO THE COMPANY?
I'm looking for significant on the market purchases over the last 6 months. Anything North of $100k I like.
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Here are some methods to find Insider Buying:
If anyone knows of reliable links to insider trades on the Johannesburg or London exchanges, please let me know.
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PRODUCERS
There is more scope when selecting Producing ME companies because they already generate revenues, profits and cash flows.
Using the companies in my shortlist I look to match at least 2 or 3 of the financial indicators below (a match on all 4 means the company is too weak and should be avoided).
The indicators I look at are an adaptation of Gallea and Patalons approach:
- Price : Sales per Share < 1.5
- Price : Earnings per Share < 15
- Price : Book Value per Share < 1.5
- Price : Free Cash Flow per Share < 11 (Free Cash Flow = Cash Generated by Operations less Regular Capital Expenditure)
The objective here is to use financial indicators to identify stocks that give you the most BANG for your BUCK.
For example a stock selling at a Price : Sales ratio of 1, effectively allows you to buy $1 worth of revenue for a buck. Now that's a good Deal!
Consider this, Google sells at a Price : Sales ratio of 18.5 as of today.
So it takes $18.50 to buy $1 worth of Google Sales - that's expensive!
Note: Significant insider buying still qualifies a Producer as a BUY regardless of the above ratios.
Most companies will not meet these rigorous measures, which is why it is considered a contrarian approach. However, I have purchased some well known Gold stocks based on the above method eg. Royal Gold and Goldfields.
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Make no mistake it is time consuming and work intensive to find these Diamonds in the rough. And even after you've found them there are no guarantees. I try to put together a portfolio of 10 to 12 companies identified in this way. Always trying to diversify by market cap, geography, politics and type of resource.
In addition, I also use technical analysis and money management techniques to time my purchases, but I'll leave that for another day.
Personally, I enjoy the hard work and challenge it takes in finding stocks, building a portfolio and managing my money profitably.
I hope you too have such good fortune!
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Greg Silberman CA(SA), CFA (Retired)
goldandoil@yahoo.com
February 3, 2006
I am a private investor in the resource sector.
Please visit my blog for more free articles and analysis
Click here: http://goldandoil.blogspot.com
This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision.
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