Gold Investment Basics, Why Invest in Gold?, Gold, Gold and Precious Metals Investing, Other precious metals   Gold Investment Basics, Why Invest in Gold?, Gold, Gold and Precious Metals Investing, Other precious metals 
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Gold Investment Basics

Home > Gold and Precious Metals Investing > Gold Investment Basics

Gold Investment Basics, Why Invest in Gold?, Gold, Gold and Precious Metals Investing, Other precious metals
The following guidelines should help better your understanding about some gold investment basics, and the mining industry in general. Remember, these are basic guidelines and far from complete.
  • When a mining company does not have an independent professional resource calculation for gold or silver or other minerals, be aware that someone is either speculating or guessing at the most critical data point regarding mining industry valuations. Avoid confusing "resources" with "reserves". Indicated and Measured resources are reliable as a resource. "Inferred resources" are quite speculative mineral inventories, so watch out when "inferred" is used. A resource still has a long way to go to become an economic deposit, as opposed to "reserves" which are said to be proven economic and mineable ounces calculated by strict engineering and government rules.

  • It is recommended that 60% of your portfolio be invested in companies already producing gold or silver profitably. Let the other 40% be divided into companies nearing production with impressive projects or defining large and significant mineral resources. Producers must include majors and mid-tiers - your monetary insurance, since they undoubtedly have the right stuff in the ground. Look for mid-tiers with good growth profiles. Junior producers with new projects are also worthwhile.

  • Companies having lots of money in the bank or access to sponsorship from top investment banks is vital in this capital intensive business - always a good thing to look for. Diversify by having at least 15 good companies. Depending on your risk tolerance you could allocate a small portion to grass roots exploration stocks but know that this is the high-risk end of the business.

  • Look for good management i.e., 20 years as mining professionals who have had successful executive positions with large or successful mining companies or projects in the past. Also qualifying are people who ran mid-tier companies or successfully helped bring medium to large projects to production. There are always exceptions, but you had better find out who you are dealing with. Direct mailers touting some gold stock and claiming top management should be carefully checked.

  • Size is very important in this business. The larger the deposit or potential resource the better it is. Small mines are not worth your trouble as there are few institutions that will finance them and fewer companies that may ever acquire them. With gold mines try and look for two to three million ounce and above. 100 million ounces should be your minimum with silver. But this still has to be qualified. When the resource is too deep under the surface, of very low grade (richness), or has one of many other negative reasons it may never be economic to mine.

  • Tonnage important too. Big tonnage operations create economies of scale that could make some low metal values economic to mine. 300 million tonnes (a tonne is 2204.62 pounds and not 2000 pounds as in ton) for an open pit gold mine is big. 10 million tonnes open pit is small. For an underground operation, tonnage can change dramatically. Then grade and mining widths become more important (as discussed later), but a million tonnes would be small. For a base metal open pit deposit, one billion tonnes would be huge, while 20 million tonnes will be small.

  • Grade or richness is crucial. How much bang for the buck are you getting per tonne of rock. If the grades are high enough the above tonnage mentioned becomes less relevant. With a near surface potential open pit gold deposit, 2 grams per tonne (a gram is .03215 of an ounce) would be great. One gram would be fair as long as you don't have to remove too much waste rock to get at the ore.

  • For underground mines, everything changes - depth, the continuity and mining widths of the ore and the vertical or horizontal plane of the ore all become important along with many other factors. Usually if you can find gold grades of 10 grams (about a third of an oz.) or more per tonne across mineralized sections averaging 3-4 meters or more in width, then you are looking at potential winner. Also consider lower grades across wider widths (i.e. 6-7 grams across 10 meters). But these are rough guidelines and subject to many other factors, like depth, vein continuity, overall tonnage and much more. However, the sweet spot in this industry is high grades across wide zones of mineralization.

  • The next important thing is cost per ounce of production. Companies with high costs are more risky as a low metal price market will make them unprofitable, but they will have considerable positive leverage if metal prices go up. A gold mine with $350 costs per ounce, doesn't make much profit at $400 gold, but if gold goes to $450, the mining profit doubles. High cost producers are always a double edge sword.

  • Low cost producers are safer, have lots of cash flow to buy new properties and mines, will have more funds for exploration and development and could eventually pay strong dividends if gold stays in a new high price range over the years (i.e. $450-500). Also note that large mining companies aren’t going to buy-out high cost producers. They are risky and headaches for management.

  • Mining costs are mostly dependent on grades, mining widths and tonnage. Companies operating at high costs (within $100 of the gold price) or that have projects that are likely to be high cost producers should be avoided. High costs equal high risk.

  • A key statistic is cash flow per share if the company is already a producer. Large gold mining companies could sell for 15-20 times cash flow in a good gold market. Mid-tier and smaller producers could sell for 25-35 times current cash flow because of expected cash flow increases - from new mines coming on stream. Here the market is anticipating the future. Beware of high cost producers selling at high multiples of cash flow, because they will get hit very hard if gold has a set back.

  • Companies expecting cash flow from future projects are generally valued using net present value criteria. In this method, the entire future cash flow of a mine is laid out and a value is placed on this cash stream, considering the time value of money. How much is the $500 million dollars that the mine will generate in the years 2008 thru 2018 worth today? The future cash flows have to be discounted in order to arrive at some kind of present value for the projects. A 5-10% discount rate is often used. A lower discount rate is also ok, since gold is an anti-discounting currency (i.e. gold's price should go up with inflation and interest rates hence negating the discount rate - because it will keep it's future purchasing value).

  • Earnings per share is a tricky statistic for miners due to so many non-cash charges and accounting complexities. Cash flow is the king during the years of the life of a producing mine. Take a hard look at the cash flow per share or expected cash flow from projects.

  • Comparables are important - Why would you buy a stock if for every $1 you invest you get $10 of gold in the ground while another company (with very similar fundamentals and resources) gives you $35 of gold in the ground for every $1 you invest? There may be a good reason, but the point is do you know what that reason is? Comparisons are an important way of avoiding overpriced companies. You should compare the basics: grades, tonnage, costs per ounce, costs per tonne, smelter charges (for base metal deposits), reserve or resource value per dollar invested, market cap per reserve/resource ounce, discounted cash flows and the net present values of the mining assets. This will allow you to better shop the market.
Those were some basic guidelines that will help you through all the press releases and some of the direct mail hoopla about all the billion dollar piles out there. However, the more homework you do the better it is.

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