Gold Miners Find a Bottom, Massive Upside

A Perfect Play for Contrarian Investors

Written by Adam English
Posted November 26, 2013

It's getting increasingly difficult to find stocks with untapped potential...

But that doesn't mean they aren't out there.

In fact, there is an entire sector is screaming "BUY!" to value and contrarian investors alike.

And why no one seems to notice? Well, this has become one of the most reviled sectors in the market...

Gold miners as a whole could never match the high-flying performance of pure bullion, even in paper trading.

Just take a look at a five-year comparison of the largest gold miner exchange-traded fund (ETF), the Market Vectors Gold Miners ETF (NYSEArca: GDX), to the most popular gold ETF, the SPDR Gold Trust (NYSEArca: GLD): 

gdx vs gld chart

While the miners didn't see the same soaring performance through the peak, they definitely had the same downside.

This year bullion prices and gold miners have moved in tandem.

I know; it doesn't inspire confidence.

For many, this only inspired fear. Virtually everyone ran for the hills, creating some greatly undervalued companies in their wake.

For this very reason, we have a great contrarian opportunity on our hands...

Bottomed Out

A look at the sector as a whole through GDX reveals a number of signs that the bottom is in — or at least imminent.

A key point came about roughly four months ago and is starting to shape into a divergence from a downward trend... 

gdx chart 112513

As you can see, GDX's basket of 37 miners closely followed this trend for close to a year. Whenever it touched the orange line, share prices of the companies quickly dropped and sputtered... until the trend caught up to them and shares dropped again.

That trend reversed between July and August, and then it broke down. The last time GDX approached the old trend, it spiked up.



Since then, in spite of some movement, GDX has a pretty strong bottom just above $21.00.

On a price-to-book basis, the gold miners are much cheaper than the market at this level, creating a good deal of upside with little additional downside.

If you look at gold miners that do not hedge production beyond a year and a half in the NYSE Arca Gold BUGS Index, the gold mining sector is essentially back to where it was in 2001, before the 12-year rise in gold started.

Pick and Choose

So far, we've been just looking at GDX as a proxy for the sector as a whole.

For that purpose, it does well. But I don't think GDX is the right vehicle for getting back into gold miners...

Keep in mind that while gold miners rise and fall with gold prices, they are still businesses. They have capital investments to make as mines deplete and daunting operational costs grow.

Credit Suisse analysts have taken a good look at the sector and determined that the price of gold is about 3% above a point that will create trouble for some miners in GDX's basket.

If gold spends any time at or below $1,200/oz., a number of the 37 miners in the GDX basket will have to shutter production, scale back on projects to the point where new production doesn't match mine depletion, and limp along through a cash crunch.

If they have a dividend, you can expect that to be cut. Investors and the market always punish a company for doing so (for obvious reasons).

Instead of using such a broad sector ETF, the way to play the bottom of the gold sector is to find companies that will outperform and completely dominate their competitors if gold prices remain low. When the bear market for gold reverses, they'll outperform their peers as well.

To separate the wheat from the chaff, we're looking for miners that are not burdened by particularly high operational costs, and have the free cash and cash flow to survive and devour their competitors.

We're also looking for small miners that are developing projects that are simply too good to shelve.

Gold Miners to Consider

If you're going to look for gold miners that have the cash to survive tough times, Kinross Gold (NYSE: KGC) and Osisko Mining Corporation (TSX-V: OSK) are good options.

Kinross is larger, with over $1 billion in cash on hand, along with a levered free cash flow (trailing 12 months) of more than $900 million. It has taken a beating in recent years, but it has the cash to survive and potentially buyout JV miners.

Osisko is substantially smaller, but it is seeing a much better return on assets and equity than its peers. It doesn't have a whole lot of cash on hand, but the company does have a levered free cash flow (ttm) of $200 million and a low debt-to-equity ratio for the sector. OSK won't take the same hit as many of its peers will if gold prices drop further, and it won't see its profits leeched by old debt when good times come.

As for the small miners that are exploring and starting to develop mines you should consider Gold Canyon Resources, Inc. (TSX-V: GCU) and Roxgold, Inc. (TSX-V: ROX). Both have promising mines in the works.

Gold Canyon's Springpole Gold Project recently received a preliminary economic assessment (PEA) that supports an open-pit mine and milling operation. The estimated cash cost is US$636/equivalent ounce gold (eq.oz. Au) and all-in cost of US$860/eq.oz. Au.

At full production, the company estimates the mine will produce 217,000 ounces of gold and 1,200,000 ounces of silver per year.

Roxgold is exploring three areas in West Africa and is focusing on a high-grade gold discover at its Yaramoko property. The company recently announced an updated mineral resource estimate at one of its best areas...

The "55 Zone," as it is called, has indicated gold reserves of 679,000 ounces of gold with a 15.7 grams per tonne (gpt) ore grade and inferred reserves of 216,000 ounces with a 8.9gpt ore grade.

Average total cash costs in the first five years of production will be $455/oz of gold including royalties. Estimated all-in sustaining costs come out to $681/oz for the first five years. For the full life of the mine, average total cash costs are estimated at $530/oz.

Do Your Homework

There is plenty of risk in investing in the gold mining sector — especially the small JV miners and companies that have yet to start production — as we've seen, since gold prices peaked.

But that doesn't mean the sector should be avoided entirely...

In fact, too many people ditched perfectly good gold miners out of fear in the last year.

Do your due diligence. Carefully research the miners and stay disciplined. Capitalize on their mistake. 

The bottom line is we haven't seen this kind of upside in the sector in quite some time. You aren't going to find anything resembling the same potential value in the irrationally exuberant stock market elsewhere...

Gold miners that can survive and thrive in this market are going to handsomely reward investors that buy their shares today. It's only a matter of time.

Take care,

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Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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