John Doody: The Falling Knife of Mining Stocks Has Hit the Floor
Look across the universe of equities these days and it's hard to find a stock sector more thoroughly hated by investors than precious metals mining companies.
They are supposed to act as leveraged investments on the price of the precious metals. However, on average, the sector has underperformed the price action in gold in silver over the past several years. In fact, many miners have been absolute widowmakers.
On top of that, as the stock market has powered to new highs over recent months, many miners and mining indexes have sunk to multi-year lows.
This week, Chris talks with mining analyst John Doody of GoldStockAnalyst.com. They discuss the reasons why the mining sector has performed so poorly to-date (poor management, poor cost accounting, an over-focus on expansion vs. ROI) and whether investors can expect more of the same – or are there better days ahead?
John is of the mind that the industry is becoming better focused on the right priorities and could well return to it's historic performance versus the underlying metals. But whether it does or not, he remains convinced that there are individual well-run companies that offer exceptional returns for those that do the homework necessary to identify them. History has shown that good mining stocks can generate dizzying returns to investors - the challenge is finding these needles inside the much larger haystack of ventures that won't pay off.
John advises looking for those companies that:
- Are proven producers or are very near commencing production (avoid unproven exploration plays)
- Have big existing cash flows or are projected to grow their cash flows quickly in the next few years
- Compare favorably to their peer group on the following ratios:
- market cap/ounce in reserves
- market cap/cash flow
- net margin
- Do not dilute their share base (this has been a huge problem in past years)
- Report an "all-in cash-cost" in their accounting. $900 or less is desired.
In short, John sees the industry as oversold and expects both a general recovery from here, and a major upside for well-managed miners. For those with the fortitude and discretionary risk capital (consider investing in mining stocks to be like going to the casino), there are some great bargains to be had at today's low prices.
Click the play button below to listen to Chris' interview with John Doody (30m:28s):
Chris Martenson: Welcome to another Peak Prosperity podcast. I am your host, of course, Chris Martenson. And today we are very pleased to welcome John Doody to the program. John is Editor at GoldStockAnalyst.com and one of the best-known experts on gold mining stocks. While the price action in precious metals has been lackluster over the past year and a half, the mining stocks as an asset class have performed miserably. And in March of 2013, the HUI Gold Bugs Index sits at a lower spot than at any other time over the past three years. You’d be hard pressed to find a more out-of-favor industry with investors at this time. Does this mean we should be walking away? Or does this give us special opportunities?
I’ve invited John on to discuss why this is and whether these miners may now be poised for a strong rebound from here. And we’re also going to talk about the recent developments in Cyprus and what they might portend for precious metals. John, thanks so much for taking the time to be with us today.
John Doody: Hi, Chris, I’m glad to join you.
Chris Martenson: Fantastic. Let’s start right at the top where those mining stocks traditionally act as leverage plays on the precious metals. But over recent years, they have not performed as one would’ve expected, given the upward march in gold and silver prices and the impact of quantitative easing (QE) on stocks, in general. So John, what are some the reasons they’ve underperformed here?
John Doody: I think the first reason is that it’s a misnomer over the last decade that stocks have underperformed for you. The mining stocks are not a monolithic, all the same characterization. It’s a stock picker’s market, like most stock markets, and you can find good stocks that have done well that have had growth and dividend growth and production growth and share-price growth. Over the last twelve years of this bull market, our stocks were up an average of 1,200%. And I would say that we’re the only newsletter in the world that has an audited track record. So we hire an independent auditor to come in and look at our trades – which aren’t that many – every year. So I’m not smoking something when I’m telling you how our track record is.
But there is no question that the average stock has not done well. And part of that’s because a lot of decisions were made by management, so the average stock wasn’t there anymore. Barrick got rid of their top guy, Kinross got rid of their top guy, the top guy at Newmont has been eased out, and I think that companies are slowly getting the message – or maybe quickly now – that shareholders want returns to shareholders, not growth for growth’s sake alone. So over the next few years, I think we’re going to see the mining companies much more financially disciplined. And even in the last couple of years, we’ve seen them start paying dividends, which they never did before. Dividend was a waste of money as far as what they thought. But you can find gold stocks yielding; I think Newmont’s got a 4% yield. One we like, GORO, has got I think it’s a 5% or 6% yield at the moment. And the typical gold stock is yielding somewhere in the 2% to 3% range.
So I think owning a gold stock with good growth prospects and discipline to growth prospects and a 2% or 3% yield is a lot better than having your money in the savings bank for 0.2% yield.
Chris Martenson: Oh, absolutely. So let’s talk about what some of the, let’s say, financial prudence has instilled in the mining sector. One of the things that bothered me personally as a mining stockholder for a while was share dilution. And another was what I thought was relatively weak cash flow from operations, given the expansion of the price of the metals. Are those a couple of examples of the things that you’re tracking at GoldStockAnalyst.com when you do publish lists of, say, the top ten, top fifty companies when you’re looking at things? What are you really looking at in mining companies on a fundamental basis?
John Doody: That’s what we do – fundamental analysis. We’re not momentum players, momentum investors. We track essentially sixty of the largest gold-mining companies that are publicly traded, and these are all producers or near-producers. We’re basically number crunchers, and these are the companies you can get numbers from. You can’t get numbers from an expiration company because all they’ve got is drill-hole data, which doesn’t mean much until you put it into a mining plan.
And so we track the mining companies and their data, and we look at basically how the marketing is valuing a company’s ounces of reserves, what’s the market cap run for reserves, what’s the market cap for an ounce of production, and also, what’s the market capitalization multiple of the company’s cash flow. So cash flow is based on the gold price minus the cash cost to produce an ounce. That gives you its net margin and mix per ounce, and we track that on a pretty tight basis. So we’re interested in companies that can either have big cash flows now that’s going to continue to grow them, or companies that will have growing cash flows as their expansion projects come into play.
And we’re very focused on companies not diluting their share base. We don’t like companies to sell shares unless it’s necessary. We prefer them to sell shares rather than hedge, for example. Everything’s got a tradeoff in life. But companies have finally gotten the message. And most acquisitions that were made in the last decade were made for shares, and these share payoffs that didn’t pay off, they used to have a lot of shares, Kinross being one. It issued shares worth over half the value of the company. There was a $7 billion acquisition at the time. And Kinross has written down almost $4 billion of that acquisition because a mining property, while it’s an okay mining property, has not turned out to be a million-and-a-half-ounce-a-year potential producer that they thought when they bought it. It’s probably going to end up being a half-a-million-ounce-a-year producer. And that cost the President his job.
So companies are getting the message that they have to husband their shares in the same way that they husband their cash. And I think that over time, with this change of philosophy in the industry, it is uniform that investors will start seeing a payoff. And we’re lucky now – for new investors to the arena, anyway – that they can get in when the stocks are down, and it’s looking like up from here as opposed to buying at the top. Like buying in Apple at 700, for example, last September – and of course, Apple trades about 40% lower, in the low 400s. We’re at the Apple stage, trading lower now, and for new investors coming into the market, there’s plenty of upside that we see.
Chris Martenson: I do see that on the HUI Gold Bugs Index. I mentioned before on the weekly, it’s in oversold territory for the first time in a number of years, suggesting that yeah, there might be a bottom here.
Now John, you mentioned a bunch of very interesting things in there. The first one I’d like to dig a little deeper into is, you mentioned that cash cost per ounce is something you track. I know in general, mining costs have been going up across the whole mining sector – not just gold and silver, previous metal miners, but everywhere. What kind of trends are you seeing in the cash cost per ounce, understanding that that could be part inflation and also, in some cases, partly due to the fact that maybe ore qualities are not as high as they’ve been in the past?
John Doody: Yeah, there are a couple of things that come into that. In the first place, it’s traditional in the mining business when the gold prices are high – to the extent you can, and you often cannot do this very much – you want to produce from your lower grade ounces then, because those ounces are profitable. And you want to save your higher-grade ounces for the time when prices may not be so favorable. But you probably can’t change much more than 10% of your production profile, because particularly in an open pit, you basically have to mine everything there is in order to go deeper. But sometimes when you’ve got an underground mine, they can bypass an area where they know it’s high grade to take a lower grade area.
So in a sense, some of the rising costs, probably it’s a good business practice to use the low-grade ounces that you can produce now when prices are high, because you’re going to get a reasonable margin on them. And if the prices fall back, you’ve got the higher-grade ounces that you can produce later.
But you may be interested to know that on the sixty miners we tracked, the average cost for an ounce of production for 2013 is $710. And the reality of it is, that’s not all, because the number of costs that go into any mining operation at the mine site, like sustaining capital has to be invested, and expiration that typically are not included in the cash cost of an ounce of a mine. But they have to be incurred in order for the mine to continue on. So probably the real cash cost to operate a mine is somewhere in the range of $1,100 or $1,200 an ounce, which is not as much of a margin as you might think, given where the current gold price is.
But the miners are slowly adapting what they call “all-in cash-cost accounting.” Because one of the problems you have as a miner is that you’re operating in a country that might have some ability to change its royalties or its tax structure in a way to capture what [the government thinks] are windfall profits that the miners are earning. Profits have been okay; they’re not windfall, because the way of reporting purely the cash cost per ounce doesn’t give any weight or any value for the other costs that have to be incurred to keep the mine operating, otherwise it’ll just run out of ore. And so this all-in cash-cost is an attempt by the industry to capture that. And while we generally like miners that have a cash cost per ounce of under $400 an ounce, we like miners – and they don’t all report this way yet – but we like miners that have an all-in cash cost of twice that, around $900 an ounce.
Chris Martenson: That sounds perfectly reasonable. We see the same trend, obviously, in petroleum exploration companies. They can get a barrel out of the ground for $X, but then it’s $X plus $Y, meaning you have to get it to market, you’ve got to refine it, there’s all kinds of things that have to happen. So I’m glad to see that kind of all-in accounting is starting to place here.
And in terms of the hedging that you mentioned before, obviously that was a really big deal a number of years ago. Is the general trend that companies have certainly walked away from hedging to some extent? Or are they mostly out of hedging?
John Doody: They’ve all walked away. There’s nobody hedging. I shouldn’t say nobody, but there’s very, very, very few companies doing any hedging. But what they are doing is a different form of hedging, which is selling a stream of output. For X number of dollars upfront, they’re selling a stream of output. And generally they do this on byproducts so it’s not so onerous. It’s not like hedging the price you’re going to get for your gold or your silver. If you’re a gold miner, you might hedge or sell a stream of your silver production, and the same might be true if you’re a base-metal miner selling a stream of your silver production. That’s been a big reason behind Silver Wheaton’s success.
So as long as the gold mining companies don’t start selling off a portion of their gold production in the form of a stream, then I think the market will accept it. But of course, the old hedging methodology was that you locked in the price of your output – your gold – at some number like $400 an ounce, and you figured you could produce it at $250 an ounce and you’d have that cash margin as profit. But that caps the upside for the gold miner, and investors walked away from companies like that. And they’ve all learned that lesson not to do it.
Chris Martenson: That takes a lot of the leverage right out of it. Then you’re pretty much just in a depleting industry. Your mine is depleting, and you just have the cash basis, and you can just calculate all of that. It’s more like a bond at that point, right?
John Doody: Yeah, or the Australians were always big hedgers. For them, it was all about cash flow, and they could’ve cared less whether they were mining gold or coal.
Chris Martenson: Right. I’m certainly glad to hear that hedging is down. And so for the ancillary streams, they’re doing what sounds like forward sales. That sounds good. Who are they selling that to?
John Doody: The three major buyers are the royalty companies, and the royalty companies are big companies. Silver Wheaton’s got a $20 billion market cap. And Franco Nevada and Royal Gold are basically companies that started out investing money in companies that had an interesting project, then giving them money to do more drilling, more exploration. And they sort of grew into this – almost a – financing mechanism, like Franco just did financing for a mine in Panama. They’re going to put up a billion dollars to get basically 100,000 ounces a year forever, virtually, and certainly for anybody listening to this call, including us, at a price of $400 an ounce. So it gives a pretty good leverage to the upside of the gold, and they’re locked in at a price of $400, which gets a modest inflation adjustment over the years. But it gives them the upside on the gold. They’re glad to do it because their partner is a copper miner and the billion dollars that they’re putting in is financing 20% of building a mine.
Chris Martenson: I assume that’s secure as long as that copper mine continues to function.
John Doody: That's right. The contract for the royalty is secured by the property, not by the company that’s mining it.
Chris Martenson: Excellent, excellent. So now that we’ve heard about companies getting a little more fiduciary responsibility and starting to shepherd their shareholders as carefully as they’re shepherding their mine outputs, John, I think many are wondering if the miners have finally bottomed as an asset class, given how low sentiment is currently, and with precious metals looking like they’re bouncing off of recent lows. Do you agree? And if so, what do you foresee for the miners for the rest of the year?
John Doody: Timing is always the hardest thing to predict in any kind of investment, particularly when you want to buy something at a good price. So that often means you have to be early in order to catch some kind of a good price, and we believe in being early. Our time arrives and it’s two to three years, not two to three months, as investors sometimes like to have.
So one factor that we look at in valuations is, as I mentioned this earlier, this concept of market cap per ounce. What’s the market cap of the company, which is the number of shares times the price of the stock, divided by its P&P reserves – proven or probable reserves – which are the only ounces the FTC lets the company talk about? Those are there to a greater certainty than other classifications of ounces. And the market cap for an ounce of gold reserves right now – this is off the front page of our latest issue of GSA Top Ten – is $206 an ounce. At the low point in the market crash, when all the gold stocks fell, everything fell, the price per ounce was over double that. So the $206 an ounce is a number we haven’t seen in this whole bull market since 2001, when gold itself only sold in the $200 an ounce.
We had valuations of an ounce that were higher than the current $206. So we think this is a pretty good indication that the market is really washed out. And if nothing else, investors – sophisticated investors – could start arbitraging this, and buying companies that are selling with a low cash cost or low market cap per ounce of reserves, and shorting the metal itself, and they could be arbitraging the difference at some point. And three times in the last bull market in the last decade, an ounce of gold sold at 38% of the gold price. Right now the $206 represents 13% of the gold price. So the difference between the 13% and the 38% peak that was reached three times in the past decade is an arbitrage. I don’t think people are going to short gold, but I think it’s a factor investors should look at and thinking that even if the gold price remains the same or stabilizes in this area, there’s plenty of opportunity for the valuation to increase.
Chris Martenson: So we’re sitting at an all-time low when we look at market cap divided by P plus P, proven and probable reserves. So $206 an ounce; yes, that seems fundamentally low. Again, how many times have we hit this level in the past?
John Doody: We hit it three times in the last decade.
Chris Martenson: Three times. And what was the performance after that period of time over the next two to three years, which is your horizon?
John Doody: Higher. We’re at 1,200% over the decade.
Chris Martenson: Right. Excellent. So you track sixty companies, and I assume you have them all organized in terms of some sort of a priority list. There’s some you probably favor at the top. How would you recommend that people who want to have exposure to gold mining shares but don’t currently – how would you recommend they go about doing that? Would that be in individual shares? Is there an index that you steer people towards? How does somebody get started?
John Doody: We think that our performance beats every index – beats the XAU, beats the HUI, beats gold brick bullion itself. Because in tracking these sixty stocks, we’re able to identify companies that are undervalued versus their peers. And we think ultimately, over time, value will even out. And the result of this sixty stock study is what we call our Top Ten – the Gold Stock Analyst Top Ten. And we actually publish three newsletters. One covers all sixty stocks, so that’s called GSA Pro, and that’s geared more towards the investment advisor, investment professional.
And most retail kind of investors are not interested in the fifty stocks we cover that are not currently in the top ten. They only want to know about which ones we’re recommending. And so the second publication is GSA Top Ten, which talks about only those top ten stocks. It’s a little bit more for the retail customer. And it’s that top ten portfolio that we tell people to buy, equal weighting and all.
The biggest mistake that gold stock investors make is they buy one, which is the absolute worst philosophy. Because this is a risky business. So stocks are volatile, Mother Nature is a risky mother to this whole thing, and the politics are risky. We avoid stocks in risky areas. Some Indian tribe in Canada can make troubles for some mine up there, and people think about Canada as being relatively risk-free in mining, but there are also issues that could come up.
So the way that you minimize that risk is you diversify by owning ten stocks. And in an era of Internet trading and $7 transaction costs, the cost to own ten stocks is pretty trivial. And that’s how we’ve been able to establish our performance. Of course, we frequently get some home runs out of that ten. But we get lots of singles and doubles and triples and it’s that small-ball baseball term that we find that gives us the track record that beats everybody. There’s absolutely no mutual fund, no index, no bullion, no nothing that can top our track record. That’s why we have a pretty big subscriber base.
Chris Martenson: Excellent. Can I assume that the South African mining troubles that recently were all over the news did not affect anything in your universe at this point?
John Doody: No, we have recommended South Africans in the past, but they’re probably going to ultimately nationalize the mines. We follow the stocks, but we don’t recommend them.
Chris Martenson: Okay, got it. So let’s talk about what’s on a lot of people’s minds these days, the recent developments in Cyprus. It’s really hard to see the move there as anything other than a new chapter in fiat wealth confiscation – or just wealth confiscation in general – which should draw a demand, you would think, for physical precious metal. What implications do you anticipate this will have for metals, and then the miners?
John Doody: I think it starts out as positive, but I don’t think it’s going to be the driver of last resort that’s really going to set everything on fire. If you’re in Europe, you can always put your money in Switzerland or in Germany and nations that don’t have the same problem as Cyprus has. I think the reason that Cyprus is a big money haven for Russian oligarches, where they’re taking the ill-gotten gains off it – and one way or another, they’re usually ill-gotten in Russia – and put the money offshore in Cyprus.
The Germans, basically the power behind the European Central Bank (ECB), are not going to bail out the Russians. Russia split the company in half and controlled East Germany for decades, and I don’t think the Germans have a lot of sympathy with the Russians. And if they’ve got to pay more for the cost of their transgressions, they’re just giving up ill-gotten gains, for the most part. No, I think Cyprus is between a rock and a hard place, because the Russians have loaned them over three billion – again, was it dollars or euros? – a big number, anyway. And Putin’s not happy when all of his buddies are getting a haircut on their money.
The biggest mistake that was made in all of this is that they violated the €100,000 insurance level. It’s like the insurance level at our bank’s $250,000. Small depositors are insured up to €100,000 in the euro system. And this wealth tax, this confiscation, is impacting them, too. And I think that’s a big mistake.
Chris Martenson: So one of the things that we’re tracking here is the possibility that the bailouts are clearly out of room at this point in time. Germany, for a variety of reasons, is perhaps not having a lot of sympathy for the particular investor class in Cyprus. But Germany seems to be out of patience for sending their savings to the Southern zones. And Cyprus was small enough that they thought they could ring-fence it and try this out. But if it turns out that there’s a jumping of attitudes across the borders, potentially, investors might think, Would I keep my money in an Italian bank or a Portuguese bank or a Spanish bank? And those are all good questions, because to me, there’s a lot of insolvency that’s just very obvious. Just a crayon and a napkin and you can figure out how insolvent some of these countries are. And the only way that that gets undone is through very rapid return to economic growth. We don’t have anything in place that’s going to give us that.
So there’s this chance for systemic risk. And I go through all of this, John, because in my world, I’ve found that the price of gold correlates best with financial uncertainty as an inverse function and a little bit less so with inflation. How do you see the price of gold going forward given all the effects of QE? Inflation is muted, but still, we don’t know if there are insolvent countries out there. Japan is printing. What are you looking at in the price of gold? Do you track that, and is that a part of the formulation?
John Doody: Our primary metric is the real interest rate. What do you get on a risk-free return on your money after inflation? If you want total safety in your money, it used to be that you put it in the bank, and I think it probably still is in the United States. You get an infinitesimal return. And if inflation is low, like currently 2% a year, it’s still a negative return. You put $100 in the bank in the beginning; you have $98 worth of purchasing power at the end of the year.
And it’s interesting –when this Cyprus thing came out, I started thinking, what kind of confiscation tax have people paid just by inflation over the last few years? If you go back to when the first QE started in November of 2008, and you roll the inflation numbers forward, the rate of inflation has been about 9% in the United States. So if you had $100 in the bank in November of 2008, you’ve got $91 worth of purchasing power now. Nine dollars of your purchasing power has been confiscated by the government’s inflation. So maybe we’re just as bad off as the Cypriots are; we just don’t realize it.
Chris Martenson: It’s just that they’re doing it a little bit more above the table, and of course, that’s made people mad.
John Doody: Quicker.
Chris Martenson: A little bit quicker and a little bit more certain what’s happening. But you’re absolutely right. So negative real interest rates do correlate very, very well with gold price appreciation. So I guess this just feels like a perfect world to really support aggressive gold demand. And what I’ve been tracking – and it was Eric Sprott that brought this to my attention – was really the extraordinary mismatch between mining output and physical demand for gold that occurs each year and that has to be made up from somewhere. And of course, rising prices is part of that component, but still, the gold has to come from somewhere to make up that. Are you looking at overall supply and demand of gold as one of the leading indicators here?
John Doody: It’s really on the demand side. One thing that helps fill that match is scrap. People do scrap their gold. And whether it’s from dead people’s fillings, or jewelry turned in, or whatever, it is tracked by the World Gold Council, and those are the numbers we use.
But there’s a part of the demand that’s not really studied enough in the States. We think that we’re all centric about the United States; we think this is the hub of the universe. In the gold universe, the hub is China and India, and they represent over half the gold sales every year, half the demand. And there, it’s particularly important to look at what their tax policies are, what’s their real interest rate situation. And in the last couple of years, India and China have not had so favorable a situation for gold prices. India has no gold mines, but it represents about 25% of gold demand. All gold has to be imported, and that just wreaks havoc with their balance of trades. So the Indians try to slow down gold demand with an import tax and by making the price higher, but all that does is encourage smuggling, which doesn’t really show up in the numbers, it’s not tracked. And China – China’s had its own issues with real interest rate. It depends where the inflation rate is and what their interest rates are. But the real interest rate in China was much higher a couple years ago than it is now.
And so I think we, as gold investors, have to pay more attention to that half of the world. Because it’s their half, their demand factors in. It’s not just what happens between hedge funds in the United States or the UK that influences it. And I’m a big believer in the China Surprise Theory, that we’re talking to the miners that have Chinese mines. No gold in those mines in China leaves the country. And China is a gold importer. And so between the domestic demand and hidden central bank demand, the Chinese central bank only records its gold holdings every five years. The next potential reporting period is 2014, and that’s not engraved in stone anywhere. That’s just been their history. They could choose not to report in 2014. But if they do report in 2014, I think we’re going to see a big jump from the roughly 33 million ounces of gold that they hold now in reserves, which is only about 1% of their total foreign exchange reserves, to something much more like 100 million ounces or something. All that gold that’s going into China, coming from their own mines – they are the world’s biggest mining gold producer. And the stuff that they import is going somewhere. It’s got to be going to the central bank reserves, as well as wherever people keep their own gold.
Chris Martenson: It’s absolutely a big story. We’ve been tracking that West-to-East flow, and it was kind of an interesting tidbit that I’m sure you saw, that the United States’ trade balance in the last reported month was a little bit better than expected, in part because – if I have the number right – about $1.8 billion in gold got shipped out. So there was enough to dent the U.S. trade deficit figure. And so gold has been flowing from West to East, and that’s something we’ve been tracking, as well.
So we’ve been talking with John Doody of GoldStockAnalyst.com. John, is there any other way that people would follow you or track you besides going to that site and checking you out?
John Doody: Well, we’re a subscription-based newsletter. We only get money from the subscribers; we don’t get anything from the companies we cover. A little bit unique in the mining business, particularly in the gold-mining business. And we’ve been around since 1994. We have the only audited track record in all of newsletters and it’s posted on the website and updated every year. And the sample issue is on the website. We publish three newsletters – GSA Pro, GSA Top Ten (which is by far the biggest one), and Silver Stock Analyst, which looks at a universe of 25 silver miners – all either miners now, or near-miners in the sense that they’ve got a feasibility study that shows the ounces are really there and they’re getting finances to go into production. And we use the same metrics that we look at in gold – the market cap per ounce, the silver reserves, market cap runs of silver production, and operating cash-flow multiples to figure out who’s undervalued there, as well.
Chris Martenson: I’m certainly intrigued, and I hope if anybody else is, you would go to GoldStockAnalyst.com and check it out – the GSA Top Ten silver stock analyst or maybe even the GSA Pro. They all sound intriguing to me. I’m a fundamental guy at heart, so I love talking with somebody else who shares that view. I don’t do any momentum trading or any chasing of trends or speculating; I just love good hard numbers. It sounds like that’s the work you’re doing, and I’m a big fan of that. And John, I really want to thank you for your time today.
John Doody: It’s great being on with you, Chris, and I look forward to doing it again.
Chris Martenson: Fantastic. Me, too.