How to Pick A Good Mining Company

March 20, 2002

Mining Share Analysis

One of the most frequent questions I am asked is, "Where can I invest in precious metals to maximize returns?" The answer is not as straight forward as one might expect. Due to the fact that I have paid subscribers that have compensated me for my work, it is unfair to give specifics. However, to drive home a point, our top pick has more than doubled from the time we first recommend it. This is during a time period when gold showed some strength and silver has been flat to weak. As most who visit this site know, the mining equities have been in a bull market and I expect it will continue. There is still plenty of time for an investment in precious metals, but a wise investor should choose carefully ahead of the herd.

Developing a mine involves an abundance of time and money. It can take five years or longer from the time a prospective property is identified until full production is achieved. Mills for the largest mines can cost an incredible amount of money. Think about it. Before exploration can take place, the ore body needs to be defined through a drilling program. Based on results, a feasibility study needs to be completed. Recently, this phase has taken on significant demands based upon current environmental concerns. At every step so far there is considerable risk:

Exploration Risk

Not all exploration projects will lead to discovery. Many won't have enough of anything interesting that would generate share price gains.

Assay Risk

Some companies just release the 'good' assays.  Salting a mine does occur. We only have to look at the Bre-X fiasco to know that drill results do not always “pan out.” This is only part of the story though. For example, suppose you own a rich property, but do not have the financial capability to build a mine. You decide to sell your property. Now the prospective buyer uses a different lab to determine the value of the property and bids considerably less than what your results show. In other words,  in some cases it is beneficial to skew the results depending upon which side of the transaction your interest is established.

Management Risk

Who's got a long-term track record of success? Who doesn't?

Financial Risk
Is the investment sound? How does it measure up against its peers? Is the bookkeeping accurate?

Trading Risk
How liquid is your investment?  Is there Institutional involvement? How many shares trade? How big is the spread between bid and ask?

With many risks come potential rewards. Mining shares are leveraged to the price of the underlying asset gold or silver or both for example. The higher the cost of mining, the greater the ups and downs of profits and thus share price. Profit volatility can be illustrated. Consider the increase in earnings for two different gold mines.

Mine X has a mining cost of $200 per ounce.
Mine Y has a mining cost of $250 per ounce.

Now let us consider the increase in earnings if gold rises from $300 to $325 per ounce.

 Company Profit at $300 Profit at $325


 Mine X $100 $125 +25%  
 Mine Y $50 $75 +50%  
 Gold       +8.3% 

This example illustrates how a moderate increase in the price of gold can produce leverage of varying degrees for different mining companies. In this example, the higher cost producer shows increased leverage over the lower cost producer. This of course is only half the story.

What happens if the price of gold drops from $300 to $275?

 Company Profit at $300 Profit at $275


 Mine X $100 $75 -25%  
 Mine Y $50 $25 -50%  
 Gold      -8.3%  

High cost mines mean high leverage plus high risk.  There are other considerations. For example, how do you determine political risk? What about geographical risk? The topography and climatic conditions may determine when mining activity can take place and when it is impossible. Another factor in geographic risk is how many properties does a company own? If the company holds only one property, then the risk is greater than another company that holds several properties in different countries. My point is that determining the best investment areas for mining companies involves as much art as it does science.

Quality + Safety = Maximum Results

It is important to follow trends. If history is any guide, quality plus safety means maximum results. This has been our philosophy so far. The bigger, low debt, low hedged or lightly hedged companies have been favored over all others. This has proven to be a sound  method. It does not mean that information on possible high flyers are avoided all together. But when smaller and less established companies are mentioned, it is the reader that is required to use discretion. Investors are tempted to apply standard investment analysis to mining companies. This does not work well. Right now a majority of mining companies do not allow for a price to earnings analysis to be performed.  This type of analysis is more useful in trying to determine a market peak.  Very few mining securities offer an income stream. There are some that do. But there are others who have tried and failed. Sunshine Mining Corporation had a silver-backed bond at one time.

If it is not grown, it has to be mined.

The mining business is tough, very tough. Yet mining is important, vitally important. As a member of the Northwest Mining Association, I am familiar with a slogan we have. “If it is not grown, it has to be mined.” Think about that for a minute. I strongly believe that the entire financial complex is shifting from paper assets to tangible assets. It is not difficult to see that raw commodities always have value: food (agricultural commodities), clothing (cotton), transportation (oil), heating (natural gas), shelter (lumber).  Stock prices are based on many factors and influences. A company's earnings should play an important role. Unfortunately, the entire accounting profession and the numbers they produce, including earnings, are questionable. The shift is taking place and will continue for several years into the future.

Getting back to mining stock analysis. A good method is to look at how much silver or gold am I buying per dollar invested. The math involved to find this answer is not really all that complicated. However, it never is an apple to apple comparison. Just because an investor has determined that company X has more ounces per dollar, does not make it a better buy. Some ore is easier to extract, some is easier to refine, other areas are easy to clean up and restore and others are not.

Diversification Still Tried and True

It is important to diversify in the metal area for several reasons. Any investor knows diversification is important and it applies to mining stocks as well. However, having lived through the first secular bull market in the metals, much of what I have written can be discounted by what I am about to write. The best market students study human nature because that is key to understanding how and why markets move.

A personal experience may illustrate better. The year was 1979 and many of the mining companies that I followed were exploding in price. I had a friend that was "late to the party" so to speak, but could not help but get caught up in the excitement. He had asked my opinion of various mining companies and I gave him some of my thoughts. I received a phone call from him about a month later, it was now 1980. He sounded very excited, yet a little relieved. I asked Phil what was going on? 

"Well, you know what you said about choosing a mining company?"

"Yes," I answered.

"It just did not sound right to me, I looked at what you said, but so many of those companies had moved up so much. I finally found one of the American exchange and it was still around two bucks per share. It was named gold something. I bought it and four days later sold it for four dollars per share."

"Great," I exclaimed. "Sorry, but I never heard of that company."

Phil replied, "That is the craziest thing. They weren't a mining company at all. They just had gold in their name. Guess I sold it to someone else that thought it was a mining company too."

So the story goes. Phil was lucky. The point is that in a bull market people can get swept away with emotion. Phil's research was based upon a cheap stock that had gold in the name.  We have experienced a similar situation with the dot com stock issues. Fear and greed  motivate people. In fact, they can motivate normally sane people to do something that they might not ordinarily consider.

As an investor, it is most important to maximize your return while attempting to minimize risk as mush as practical. There are several mining companies that offer ample opportunities for speculation. This is the case now. Near the end of the coming mining boom, there will be several times as many companies. This will be an indication that the investment cycle has run it's course, but I do not expect to witness this for many more years.

Silver has the highest electrical conductivity and heat of all metals.

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