Oh, how great it must be to move markets at a whim.
If you’ve been keeping an eye on the mining sector, last week was kind of a big deal.
Miners and commodities were off recent lows as news of slowing global GDP growth, particularly from China, faded from headlines somewhat.
Then Morgan Stanley came in with a note from analysts on Wednesday that said the sector is “attractive” and valuations are at historically low levels.
Describing what could be a “sharp reversal from the experience in the last 18 months,” the analysts suggested commodity prices rising 19% by 2017.
Equities exposed to the sector are expected to outperform, as a result.
And so the masses piled in across the board. It didn’t really matter what the company’s operations or books looked like.
If it ripped stuff out of the ground, it was a winner. Especially the big names that have taken a beating this year:
- BHP Billiton — down 21.6% year-to-date, up 8.3% since last Wednesday
- Anglo American — down 42.5% year-to-date, up 14% since last Wednesday
- Rio Tinto — down 15.5% year-to-date, up 9.6% since last Wednesday
I am wary of following any information that Morgan Stanley oh-so magnanimously shared with us lowly peasants.
Morgan Stanley is in the business of making money. Sometimes it makes money for clients, but only so it can make even more money. Sometimes, it’ll burn everyone, as long as it makes money.
No matter what, it isn’t interested in helping us unless it helps itself more.
However, I also believe the potential is there for such a large gain through 2017.
So what to do? That’s simple, do the homework. I took a general look at gold miners in particular over the last week, and two are going straight to the top of my watch list.
First, let’s take a look at how I zeroed in on them using three key criteria, then let’s look at the companies themselves.
Evaluating Gold Miners
Today, we’re essentially bargain hunting.
Gold miners took a beating that they couldn’t avoid as gold prices dropped. However, some have adapted far better than others.
We want to single out these companies that are outperforming their peers and aren’t saddled by the past.
Operations costs have been slashed out of necessity. Exploration has slowed to a crawl to keep enough cash flow in place to pay the hefty bills associated with intensive mining.
Capital expenditures alone have seen a collective 50% cut since 2012 to keep profit margins positive.
According to a Gold Fields Mineral Services Ltd survey, gold miners’ average all-in costs, including interest and extraordinary costs, were close to $1,208 per ounce in 2014. The average gold price was $1,260 per ounce.
The margin was razor thin last year, and the pressure has remained with gold prices going even lower in 2015. Though the low-hanging fruit for cost-savings are gone, the sector as a whole needs to cut even further.
Thus, the most important factor in our search is an ability to generate cash flow and profits while gold prices are down.
After that, we want to find companies that aren’t burdened by an additional headwind from massive debt. Just look at Barrick Gold Corp. in recent weeks to see why.
Finally, we want companies that are able to increase their reserves in this adverse climate. A lot of gold miners are barely exploring or spending money to replace the gold they are constantly selling.
Ultimately, this lack of spending will have to be addressed. With how capital-intensive mining is, future financial — and thus stock — performance will be hindered if companies have to pay more for mines in the future when gold prices are higher than they would be today.
After all this, two stocks stand out for me. Neither are massive companies, but there is a nice spread between them in market capitalization and share prices.
Two Gold Miners to Watch
The first gold miner that I’m watching closely is Agnico Eagle Mines Ltd (NYSE: AEM). Agnico sports a $6.17 billion market capitalization, shares are trading at or around $27.80, and it offers a 1.13% dividend yield.
All-in sustaining costs (AISC) for Agnico are expected to fall between $870 to $890 for all of 2015. This isn’t the lowest you can find out there, but our second and third criteria push Agnico up to the top of my list.
It is one of the few miners out there that increased reserves while lowering AISC last year, thanks to its purchase of a 50% stake in what was Osisko Mining’s Malartic mine in 2014. Reserves jumped by 18%.
For those that might remember, I talked up Osisko as a buyout target two years ago largely due to the fact that it was producing gold at very low AISC. By the time the deal was struck, its share price was up a good 80%. I really wish I threw more into that play, but I digress…
Agnico’s free cash flow yield of about 4% over the next two years is great compared to its peers. Even better is its debt-to-market capitalization at 20% (the market cap is about $6.15 billion). For comparison, here is what the major gold miners look like:
Agnico used some of its increasing cash flow to pay off debt this year as well. When another good mine like the Malartic mine ends up on the auction block, Agnico will be in a great position to capitalize on the opportunity.
The second company I’m watching is OceanaGold Corp. (TSE: OGC). This company has a market capitalization around $1.4 billion, shares trade for around $2.37 (Canadian), and it offers a 1.69% dividend yield.
OceanaGold’s AISC is expected to fall between $770 and $840, making it one of the lowest-cost producers of gold in the world.
Newmont Gold has had to shed properties to fix its books, and OceanaGold picked up the Waihi mine in New Zealand.
Though the gold produced at this mine is cheap (AISC of $650 to $680), the mine is going to reach the end of its life in a couple years. Its Reefton and Macraes mines will likely be shut down in the next couple years as well.
OceanaGold recently moved to fix this reserve problem. Shareholders approved an all-share offer for Romarco Minerals Inc. Though the deal was costly, it boosted reserves and ensured that a drop in production won’t occur.
There is going to be more debt in store for the company going forward as it develops the Haile mine it picked up from Romarco, but once the deal is done, it will have about $200 million of debt, which would translate to a debt-to-market cap ratio around 30%.
Plus, if all goes according to plan, the combination of both companies should result in an attributable production of 540,000 ounces gold in 2017 at an all-in sustaining cost per ounce of just $533.
In short, OceanaGold is looking at a couple years of very strong profits, with the potential to improve long-term production at very low all-in costs through exploration and new mines.
Keep Your Eyes Peeled For Deals
These are just two companies that are on my radar. To keep things simple and concise, I didn’t go through the full due diligence an investment demands.
However, both illustrate that even with gold being battered for several years, there are companies out there that are strong enough to survive, and even thrive. You simply have to dig deeper than the surface.
An investment like the Market Vectors Gold Miners ETF (NYSEArca: GDX) is a natural way to compare the gold sector to other investments. After all, it tracks companies that produce something like 97% of the world’s new gold.
But I wouldn’t touch it in today’s market. There is too much debt, and the profit margins simply aren’t there to justify the risk.
Take a look at this year-to-date chart to see how these two companies fared against the ETF:
You could be down 14% with GDX, or be up 11% with AEM or over 17% with OGC.
Instead of exposing yourself to the dismal average in the sector, look for miners with:
- Low all-in sustaining costs,
- Increased reserves that will generate future production and profits,
- and low debt with good cash flow that can capitalize on good mines sold by bad peers.
Agnico Eagle and OceanaGold are great places to start, but there are others out there for us, with plenty more to come down the road.
