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Choosing the Best Gold Mining Stocks

There are many contributing factors to consider when determining the overall value of a gold mining company. The following criteria should be acknowledged before making any investment decisions within the gold mining sector.

Diversification

As a general rule, investors are often warned ‘not to put all their eggs in the one basket'. The same rule should apply with gold stocks. It is prudent to spread the risk and select more than one company. Furthermore it is recommended that investors look for a good balance of producers, developers and explorers. The least risky of the three are the gold producers. Investment in developers and explorers is higher risk but potentially higher return.

Gold mining companies themselves typically have a diversified portfolio of land holdings between exploration projects, development projects and production operations.

A diversified portfolio of projects serves many purposes as it hedges against risks such as legal, geopolitical, environmental, market, and grade variations between tenements. Grade is measured in grams per tonne and can vary significantly between location and depth. The higher the grade the better since low grades can render a project economically unviable. For this reason, assets are constantly being re-evaluated.

There have been numerous examples of promising gold companies (with ONE potentially brilliant resource) that have come and gone due to resource downgrades, political and/or environmental factors.

So when considering gold companies as investments, try to avoid banking on one single asset. If the single asset seems compelling enough to attract your attention, attempt to undertake some due diligence on this asset to ensure that there are no strings attached in terms of future viability.

Longevity

Due to the fact that gold producers have revenue generating activities from economically recoverable gold, they need to be measured differently than the explorers.  Producers are in a class of their own and should be compared and measured in terms of mine life.  This is measured by looking at existing or future production rates against existing reserves. For example, if a particular mine is producing 50,000 ounces of gold per year at full production and it has 500 000 ounces of reserves, it has roughly a 10-year mine life remaining.

Note: This may also be applied to mines under development as usually the feasibility studies have extensive mine-life projections.

Once a producer's resources are depleted, (and if there is nothing else in the pipeline) they are finished.  The top gold producers average approximately 7 to 12 years of production and because longevity is an important measure for investors, the producers that are able to boast the longest ‘mine life' tend to perform better in the markets.  Longevity is an issue faced by all gold mining companies so it is crucial that a company maintains good exploration and/or development programs.

Exploration

Gold being one of the rarest minerals on earth is becoming increasingly difficult to discover sizeable deposits.  Gold companies need to be constantly exploring in order to establish new mines and maintain longevity.

Apart from acquisitions, successful exploration is the key to extending a gold producer's longevity and renewing reserves.  For explorers, successful exploration is what is required to develop into a producer themselves and/or allow them to profit from asset sales.

Operating mines have expensive infrastructure in place and this makes it easy to exploit the existing deposit and the surrounding area.  Processing plants, smelters, refineries and waste facilities are the biggest expenses in constructing a mine. It is quite common that exploration programs reveal that previously discovered deposits extend further out (or down) than originally projected.  Alternatively there might be another mineable deposit within close proximity of an existing one.  Making use of existing infrastructure is therefore a huge for advantage for any gold producer.

Political

Politics and geopolitics now more than ever have an impact on global commerce. In terms of investment security, this gives countries such as Australia and Canada a huge advantage as they arguably offer the least political and sovereign risk.

Fact is, gold deposits are discovered and mined in all corners of the globe. No matter how attractive the operation seems, it is important to understand that many unpredictable factors may adversely impact a gold mining company.  If a project exists within the borders of a country or even a region that is the least bit unstable, the company risk rises dramatically. Therefore in terms of risk you cannot go past Australian Gold Mining Companies (and Canadian Gold Mining Companies) when considering an investment in the gold sector.

Hedging

The common practice of forward selling exists in many commodities markets.  This is also referred to as ‘hedging' and basically means that a buyer and seller can agree on a fixed price for the commodity that will exchange hands in the future. These forward contracts are designed to hedge future volatility risk so that the supplier can better manage their production and cash flows and so buyers can better manage their expenses and forecasting.

Hedging has become a disadvantage for producers in this gold bull market.  This is due to the huge opportunity cost in selling forward future gold production.  Forward contracts with average prices below spot gold prices can lead to losses that ultimately penalize shareholders.

Note: There are some circumstances where moderate hedging is acceptable.  For example, a company may have moderate hedging as a result of a merger (or acquisition) or a company has minor hedging due to project financing obligations.

Gold producers are often forced to finance debt for the construction of a gold mine.  Due to the nature and volatility of commodities markets, banks and financiers lending the money take on a perceivably greater-than-average risk.  As a condition of the loan or credit facility, the lender typically requires a percentage of future gold production to be sold forward so they can ensure repayment of the loan.  This is another example of an acceptable form of hedging as long as it is a small portion of its annual production and reserves.

Leverage

A strong balance sheet is obviously a less risky proposition compared with a weak balance sheet.  The debt-to-equity ratio is a very good indicator of a company's financial leverage in terms of financing its assets.

Manageable leverage is very important for a gold miner to be profitable and even more so for allowing them to capture some of the legendary gains available in a secular bull.  Leverage must be carefully and thoroughly examined for gold companies that produce gold and for those that are in the development and construction stages.

Additionally, cash is king in business, and it is crucial to know how much there is and where it is sourced from.  Producers have an obvious revenue stream however non-producers invariably require cash to be sourced from equity offerings.

Cost Management

Cost management is crucial in the gold mining industry.  As is generally the case in business, the better you manage your expenses the more profitable your business is going to be. In terms of gold production, the lower the cost per ounce of gold produced, the higher the profits will be.

The optimal gold mining stocks to invest in are those with very low cash costs and minimal hedging.  Finding these stocks isn't always easy especially when operating costs have been rising in the gold mining industry.

Note: The key difference between a reserve and a resource is economic viability.  Simply, if an ounce of gold costs less to produce than what it sells for at market, it can be classified as a reserve ounce.  So as the price of gold continues to rise, lower-grade ore (i.e. ore with a lower gold content) becomes profitable to mine. This implies that gold producers may now be willing to fork out higher operational costs which would not have been viable in the past. This strategy promotes the longevity of a mine however it comes at a cost in the form of reduced profits.  This is not directly beneficial to the shareholder however for the mining company it ultimately extends the life of a mine and conserves its high-grade reserves.

Final Word

It would be prudent to acknowledge other factors such as the corporate history of a company, past results, environmental problems and the management team. There are various sources for this information such as websites, magazines, books, forums and industry professionals.

Hopefully the information contained within this article has helped in refining your stock selections.  There are many decent gold stocks out there but as with any investment, you have to sort through the ordinary to get the extraordinary.

Gold mining stocks offer investors excellent exposure and leverage to gold.  For investors and speculators who want to realize truly irresistible gains through individual stock selection, research will reward the diligent.

About the Author

Independent Research Analyst, Investor and Gold Enthusiast. I have many years of experience in compiling and analysing the pertinent data and facts relating to the world's largest and most stable gold producers.

If you would like a copy of the 'Top 20 Gold Producers Report' please visit my website at:

http://www.goldspecs.com (Canadian Gold Miners) or,

http://www.goldbeaver.com (Australian Gold Miners)

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