Digging Into Gold Mines

Frank is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I am not in favor of letting daily news affect my long-term investments. Even so, the Cyprus news, with fears on the safety of paper money flaring up, reminded me of the necessity to diversify into commodities. In the following, I will explain my line of thoughts, starting at physical gold and ending up with an investment into shares of the gold miner GoldCorp (NYSE: GG).

As a security against inflation and taxation, physical gold is often named as the most obvious choice:

Gold Price in US Dollars data by YCharts

Based on the historical data, one might be more eager to sell gold rather than to buy it. On a side note, I believe that the Cyprus panic will be forgotten in a few weeks -- the same happened to Italy's election which left the third largest economy of the euro-zone effectively unruled. In my opinion, the latter poses a much larger threat to Europe's political stability than Cyprus, but not enough for me to invest in physical gold at these prices.

Having ruled this out, the next step is to turn towards mining stocks. But how to invest if you are not an expert? Which stock do you buy, if you do not have much insight into the industry?

Invest broadly into the market via an ETF?

It is commonplace that it is hard to beat the market even if you are an expert; so a natural starting point is a miners' ETF like the Market Vectors Gold Miners ETF (NYSEMKT: GDX).

GDX data by YCharts

Since mid 2011 gold euphoria has been fading, stopping the gold rally and sending gold miners to a 40% descend. Is now a good time to start investing broadly into the miners via an ETF?

Besides technical considerations ("falling knives"), it gives me pause that the sentiment towards the sector as a whole still seems negative. I quote Morningstar's Samuel Lee, quoted itself on barrons.com:

"Despite seemingly attractive fundamentals and technicals, the gold-mining sector has terrible structural features that should give the long-term investor pause. Foremost, the capital expenditures are huge and ongoing. Most of the easily mined sources of gold are tapped out or mature, so to keep production going, miners now have to process lower grades of ore, dig deeper, or venture into unstable regions where infrastructure and rule of law are nonexistent or a shambles. Not only that, but major projects often run afoul of unexpected cost overruns or disappointing yields."

It looks as if some consolidation is going on behind the scenes, indicating that not all stocks in the ETF are worth the money. I thus decided to postpone the ETF idea to a later time. One could stop here and look elsewhere, but I decided to do some stock-picking.

Stock picking

To keep things simple, I consider only the market leaders. I require a market cap of at least $10 billion. Size stands here for stability and diversification (into various mines and countries). Also, even if I personally do not have the insights needed to assess smaller competitors, I hope that the market leaders do have this knowledge; due to their size and financial power, they should be able to pick the best mines as targets for take-overs.

This leads me to my second criterion, namely financial power. In order to emerge as a winner from the consolidations, I look for small debt levels (say, a debt over equity ratio smaller than 10%). My naive thinking is that this should reduce the pressure to dump projects that could turn out profitable in the long term; moreover, it should enable the company to benefit from the problems of the competitors. This criterion may be questionable (especially since it rules out Barrick Gold and Newmont Mining which pay nice dividends), but for now I stick to it.

Applying these criteria to the positions in the Market Vectors ETF, the following candidates remain: GoldCorp, Yamana Gold (NYSE: AUY), and Silver Wheaton (NYSE: SLW).

Let us look at the last one first, a silver streamer. The balance sheet looks quite attractive, so it may be worth a second thought. However, according to Fool's contributor Mike Thiessen's analysis, the company (market cap $11.5 billion) "has just 25 employees," which sets me aback. As much as I like sleek and efficiently-run administrations, this looks a bit too sleek for a stable and sustainable business, at least at first glance; hence, I decided to return to this stock at a later time.

GoldCorp vs. Yamana Gold

Let us compare now the Yahoo finance data sheets of GoldCorp and Yamana Gold. Yamana Gold looks a bit more expensive with a trailing P/E of 26 compared to 17. In both cases, the forward P/E is roughly 11 and the dividend yield is about 1.7%. GoldCorp is roughly three times larger, measured in market cap as well as in revenue, and has fewer debts. Based on the balance sheets, I thus favor GoldCorp.

A quick look at the charts:

GG data by YCharts

AUY data by YCharts

The technical picture of Yamana may be preferable to some, but I prefer the perception that GoldCorp is more of a bargain.

Production costs

An (outdated) comparison of the production costs of both companies can be found here. The upshot is that at that time there was no good standard for the comparison of costs, but both companies do apparently well. In a recent CNBC interview, GoldCorp's CEO Chuck Jeannes said:

"... we produced gold last year for $874 an ounce all in, and we'll look at between $1,000 and $1,100 this year. That's a bit of an aberration because we're bringing on a new mine and they're never as efficient the first year as they will be. But that still provides a very strong margin. ... Actually, we expect [the prices] to come down as this new mine hits its stride."

(The term all in refers to a new standard to compare production costs. These are considerably higher than the so-called cash costs which are often cited)

This article reports for Yamana Gold:

"Estimated cash costs for 2013 are forecast to be below $365 per GEO. ... Yamana’s all-in sustaining cash costs for 2013 are projected to be below $800 per GEO."

The term GEO refers to gold equivalent ounces, which implies that "... Yamana conveniently counts its silver production as gold," leading to the question: "This could possibly terrify rookie investors: what does it really mean?" The source is again this article, which continues:

"To refer to Yamana's full year 2010 numbers, it reported production of 1,047,191 GEOs  ... In reality, this was production of 864,768 ounces of gold."

Doing the math on this shaky basis, "$800 per GEO" lies somewhere in the range $950-$1000. But to tell the truth, I simply don't know.

For comparison, the data provided on the web site of market leader Barrick Gold:

"In 2012, Barrick produced 7.4 million ounces of gold at all-in sustaining cash costs of $945 per ounce and total cash costs of $584 per ounce ..."

Similarly, Newmont Mining reports "all-in sustaining cost of $1,149 per ounce" for 2012.

To put things into perspective, it looks to me as if these numbers do depend a lot on the life cycle of individual mines. It might be more meaningful to compare the averages taken over several years, but being a relatively new measure these are not available yet.

Conclusion

While Yamana Gold certainly looks interesting (which was also noted here and there), I vote for size, stability and (perceived) transparency; this leads me to invest in GoldCorp. In the future, I might reconsider Yamana or the ETF. Also, I might reassess the decision to make debt a main selection criterion. Of course, these are my personal decisions, potentially subject to errors of any kind, and I encourage you to do additional research.


Frank Schirmeier owns shares of Goldcorp (USA). The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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