Even If Gold Hasn't Bottomed...

Good mining stocks could offer good gains, says this senior analyst...

MATTHEW O'Keefe, vice president and senior analyst with Dundee Capital Markets, says big gains – 50% or greater – in mining equities can come when stocks get rerated.

That typically happens when explorers make a significant discovery, developers turn into producers, and producers become even bigger producers. In this interview with The Gold Report, O'Keefe discusses the opportunities in metals and mining.

The Gold Report: Some market experts believe central banks have no more bullets left in their attempts to stimulate global economic growth and that could lead to a worldwide economic downturn. What is Dundee Capital Markets' outlook over the next 18-24 months?

Matthew O'Keefe: The strength of the US Dollar is still a headwind against a rising gold price. With the expectation of US interest rates rising and US economic data pointing to a stronger Dollar, there is not much conviction that we're going to get a major uptick in the gold price in the short term. Interest rates have been held down longer than anyone expected. The next kick will likely be in December when the US Federal Reserve is expected to raise rates. What could strengthen the gold price are geopolitical concerns such as increased tension between China and the US as the US puts more patrols in the South China Sea or on heightened concerns over Russia's involvement in Syria.

TGR: Can investors make gains in the gold space without the broad market turning bearish?

Matthew O'Keefe: There are several different investment theses to look at in gold. The majority of investors who go into precious metals are there because they want gold exposure as a natural hedge against a US Dollar crash or geopolitical risk. Investors don't generally get into gold stocks or any metal stock unless they believe that the commodity price is going to go up. Having said that, there are other ways that companies can drive value. Growth is one way, so we look for companies with an increasing production profile. Another good strategy is to look for companies that can lower costs, increase margins and produce free cash flow.

On the developer side – an area that we quite like – a company can add value by derisking its projects and moving from explorer status, which tends to trade at a discount, to producer status and getting a rerating. In those scenarios, companies don't need the metal price to go up or down. They just need to maintain investor confidence and go through their natural development cycle.

TGR: Can investors make 50% or greater gains in the absence of a [broader equity] bear market?

Matthew O'Keefe: Again, it has to do with getting a rerating. Fifty per cent is tough in any market, but if there's an exploration component and/or you're graduating into a whole new category of gold company – going from an explorer to a producer, for example – you can expect some significant gains. Right now, developers are trading at a half net asset value (NAV) basis, and junior producers are trading at almost double. So, yes, you could expect 50% or so gains on crossing that threshold, and those companies' stocks will typically start to run up as they get within six months of cash flow. That's when stocks tend to get rerated, over that one-year period from preproduction to established production. Sometimes it takes a little longer. Of course exploration is the highest-risk gain, but if a company makes a big discovery or dramatically increases its resource, it should get a fairly large bump in its share price.

Because this is such a volatile market and there is still a lot of uncertainty, most investors would be better off not swinging for the fences so much as picking solid gold or silver companies with strong balance sheets and that are producing metal well below the spot price, giving exposure to any upside in metals prices but also providing some downside protection. Our preference would be for companies with a growth profile or other catalysts that add value in the absence of a gold price move.

Investors who want to trade actively can play the leverage game. Companies that have fully loaded costs of production right around that of the metal price sell off faster when the metal price drops. But when gold and silver prices move up, and these companies move back into cash flow positive territory, you can get a major stock price swing and you can trade around those.

TGR: Does your gut tell you precious metals investors should be long?

Matthew O'Keefe: Investors should be long in this market. We're getting the sense that gold has found a bottom here. We're starting to see more interest in gold across the landscape, maybe not buying interest just yet, but interest in reaffirming what names are out there and who's where on the valuation side.

TGR: Is this as close to a blue chip stock in this space as it gets?

Matthew O'Keefe: This is the one we point to if you want a "safe" way to play the metals space (which is inherently high risk). Tahoe is as good as it gets because it has top management, a long-life resource at Escobal and growth. It has a dividend, so you get paid while you wait, if you will, for metal prices to take off. And there's internal growth, which should add value with time. Management still wants to do mergers and acquisitions so we would expect in the next 12 months that Tahoe would bring something else into the fold, possibly a development-stage asset, so it wouldn't cost it a lot. The company would be able to build it out of current cash flow. Tahoe has virtually no debt, so it could lever on the production of the new asset, if it wanted to.

TGR: What are some differences in this bear market versus others you have witnessed?

Matthew O'Keefe: Too much leverage can get you into real trouble. That's been the biggest problem with the gold space and the biggest difference. In the early 2000s, the last time the market was really down on gold, companies were struggling, but they weren't levered so much that they would run the risk of breaching their covenants, whereas now a lot of companies have loaded up on debt that they've had to deal with. Debt has to be managed very carefully. Valuations and investment theses also have to be rethought. You have to think about what is the best story over the longer term and what is the best story to trade around, rather than just what is the best story.

TGR: Is there anything else you'd like to add?

Matthew O'Keefe: There's still opportunity in metals and mining, I would say particularly now because valuations are a lot lower than before. Sticking to the principles of a strong balance sheet, strong management and good assets with growth remains central to our investment thesis. We do our best to identify names that fit those criteria. Be careful and be patient.

TGR: Thank you for your insights, Matt.