Basic Use Of FA & TA Investing In Precious Metal Stocks

February 25, 2007

I have made a few assumptions to limit this article to a reasonable scope. I am focusing on the individual who is placing his/her own money in a vehicle in which there is a return commensurate with the risk taken. I am assuming an investor who buys and holds with certain adjustments. Last I assume that people who read this article wish to invest in precious metals and specifically in gold related stocks.

Fundamental analysis is the consideration of all data that leads to assessing the value of a sector and/or investment vehicle. The investor considers all data that affects the value of the item under analysis and determines the intrinsic value. There is one very basic assumption in FA that in the long run a security will achieve its intrinsic value.

TA (Technical Analysis) is an analysis of historic price action in order to characterize and determine the probabilistic price movement. There are many flavors of TA and I make no claim as to which is the preferred. I personally favor the John Murphy brand of charting. There are others and they each have their champions.

This article attempts to place TA and FA in their proper perspective (in the author's opinion). The reader is encouraged to acquire one of the many tutorials on TA and FA in order to gain an appreciation for the intricacies of each. Luckily for us there are on line resources available for free that go a long way toward getting one a good foundation.

Overview

Intelligent investing utilizes a number of tools to keep one placed in the best position in the risk reward spectrum. My approach is a modified buy and hold in well analyzed securities of a sector that is demonstrably in a bull market. I use the approach below to pick a sector, stocks within the sector, and the timing of the purchase. I periodically reanalyze the sector and the stocks to determine if conditions are still favorable for appreciation. If the fundamentals of a stock turn bad I dump it and find an alternate.

In your investment plan you must consider your goals, your tolerance for risk, your time frame for staying invested. I assume that the individual investor has performed this assessment.

The greatest modern practitioner of FA is Warren Buffett. He is known for value investing and FA is the primary method of determining value.

Fundamental Analysis: Sector

Fundamental Analysis (FA) is the first step in making the decision to consider investing in a given sector. Regarding FA of a sector, you will be looking at macro factors of a market. This approach below is focused on the precious metal sector. A brief list of the issues that must be addressed include at the macro level, supply, demand, regulation, external factors and trends.

  • Supply. In the precious metals supply is primarily from mining, recycling and dis-hoarding.
  • Demand. jewelry, manufacturing/fabrication, and investment.
  • Regulation. This would include laws and regulations established by government that affect the mining, distribution, and sale of precious metals..
  • External Factors. We have to consider what influences there are on PMs other than supply, demand. One may look to political issues, currency issues, affects of changes in pm prices have on other markets, societal issues, hedging, etc.
  • Trends. I recommend focusing on the changes in mine production and dis-hoarding year to year. Then look at changes in investment and jewelry demand year to year. Manufacturing/fabrication and recycling are relatively inelastic.

A sector where demand is greater than supply should appreciate until the two balance out given that no external factors affect the market. The precious metal sector should look strong if you have done the analysis above. I do not recommend looking at TA for the sector as you will analyze each individual stock using both TA and FA. The next step is to consider specific companies within the sector. (Of course you could stop here and decide to invest in the metals.)

Fundamental Analysis: specific company

The investor should use a company's financial statements to assess the fundamentals. The best sources certified quarterly and annual reports and the feasibility studies. The web has made it possible to get these easily from most companies.

One must look at assessing exploration companies differently than producers. It is hard to independently assess the fundamentals of a producer and near impossible to assess the value of an exploration company. For exploration companies one is often reduced to accepting what management offers in terms of estimated cost of production and other factors and modulating the estimated value by the non-quantifiables. In evaluating an exploration company it is Management, experience of the geologist, track record of both, and the properties owned or partially owned that are first priority.

One must consider the quantifiable aspects of a producer, and those iaspects which are not quantifiable.

Quantifiable

  • Resources and reserves: Reserves are proven assets with a good estimate of production cost. Resources are not proven and do not yet have a good estimate of cost to mine or are not proven to be mined at a profit. Look at the feasibility study for this and other info.
  • Cost of production: per mine.
  • Mine life: per mine
  • Earnings
  • Earnings per Share
  • Price/earnings
  • Price to book - Market Cap / book value
  • NonPM assets: cash, offices, mill, joint ventures, royalties, energy etc.)
  • Liabilities: debt hedges, leases, etc.)
  • Other costs (marketing, salaries, permits)
  • Profit history - Look at last 5 years. Growth is good, shrinkage is bad
  • Dividend history- Ratio, yield, how long. Look for a consistent history of dividends. Increasing dividend yield is very good.
  • Projected Earning Growth
  • Book Value

Non-quantifiable

  • Management. Look at dilution of shares, at what they do with proceeds, at hedging, at how much they are paid and how much of their compensation is in stock. I Google them to get a feeling for their past performance.
  • Business model. How do they plan to make you money?
  • Stock exchange. Best are one of the three US exchanges. After that liquidity and lack of regulation enforcement may become a problem.
  • Mining environment. Political stability, availability of access, availability of electricity, availability of water and environmental restrictions or permitting.
  • Possession of exploration properties and state of exploration. The future of the company.
  • Political and regulatory factors
  • Availability of labor
  • Availability of energy
  • Availability of water

So reviewing the list above the question is something like "what the heck to I do with all that info? Obviously the quantifiable factors should be reduced to the numerical value and then assessed for their ability to make a profit and generate stock value. Often this is difficult to very difficult and the analyst is reduced to accepting the summary numbers in the reports and comparing the numbers against other stocks in the sector for pricing inference. The non-quantifiable aspects should be considered because they can determine your perception of the ability of the company to be profitable.

Some suggestions:

  • Total all assets, subtract liabilities, and see what is left for share holders.
  • Compare market cap to reserves
  • Look for a company with reserves a minimum of 8 years of mine life, good reserves and a track record of bring resources to production. Discount 40% to 60% of reserves and 90% of resources for valuation.
  • Look for positive cash flow.
  • Look for indications that you can live with management decisions.
  • Compare a number of companies against each other using above criteria

In the case of exploration companies, you may see very little left over for the stock holder. Buying exploration companies is akin to gambling. It is for experts and those who can stand to loose many bets waiting for the big one to pay off. They are typically very volatile. But pay off they can, and this is why people continue to buy them.

IV Technical Analysis: specific stock

Intelligent investing suggests that the investor is familiar with one or more forms of Technical Analysis (TA). TA is based on historic price action and is used to identify probable near to mid term price performance. There are too many flavors of TA and they are too well described for this article to add anything of value.

Many rely solely on FA or TA. I don't recommend it unless you have the time horizon of Buffett and can wait for year before selling. TA can suggest weather the stock is overbought or oversold. Its good to buy when oversold and sell when overbought.

In summary

  • Pick a sector with strong fundamentals. Where "should cost" is greater than current cost of the underlying asset; gold for example.
  • Consider a good number of stocks. Compare each fundamentally to get a feel for relative values.
  • Weigh company net asset value as roughly 50% and all other factors 50%.
  • Never invest in a stock where you do not trust management or operate primarily in politically unstable nations.
  • Pick a few stocks with good fundamentals that are currently undervalued.
  • Consider using TA to pick entry points (optional)
  • Periodically review fundamentals of stock and sector. Sell when fundamental value is achieved.

Neither FA nor TA is an exact science. Each has a human element that requires judgment and interpretation. Two can look at the same data or chart and get differing results. You should start and analyze a number of companies and compare your result to others. After a while you will develop your own style. Who knows, you may be the next Buffett (Editor's Note: Warren Buffett is the world's second richest man, and he made it all in the stock market)!

Whatever you do, don't invest in stocks in bad sectors. There are certainly short-term plays that may be profitable, but that is trading, not investing.

Good luck and good investing.

Scruffy

February 25, 2007

Palladium, platinum and silver are the most common substitutes for gold that closely retain its desired properties.