Risk & Returns on Junior Gold Miners
The plunge in Gold Mining and other junior miners has tested the mettle of resource investors...
SENIOR MINING ANALYST at Vancouver's Haywood Securities, Joe Mazumdar adheres to certain fundamental metrics when reviewing the pedigree of a junior gold miner or other exploration stock.
Here in this interview with The Gold Report, Mazumdar explains why some junior gold miners are positioned to do better than some majors in the current geopolitical climate. The key to unlocking golden opportunities in Gold Mining then lies in finding firms with experienced management and adequate cash flow – those that will enjoy mixed-source financing even with Gold Prices shifting...
The Gold Report: Let's cut to the chase, Joe. With the stock prices of Gold Mining companies in free fall during the past year, why should investors stay the course?
Joe Mazumdar: One of the underlying fundamentals driving the gold equity market is what investors believe about the future supply and demand for gold. With respect to supply, global gold production has grown at a compound annual growth rate of 3% over the past four years despite a 15-17% annual increase in the Gold Price. We note the risk of constraints on future production, which include the paucity of large deposits for majors to replete their reserve base, operating and capital cost escalation, skill set shortage and increasing geopolitical risk, not to mention the current financing environment.
We've seen the Gold Price in various currencies go up 5-18% since 2011. In the Brazilian real and Indian rupee it's been up as high as 30%. Gold's appreciation has been problematic in countries such as India that traditionally support gold via physical demand due to high local prices. Consequently, a higher proportion of the physical gold demand has migrated to China, where the price appreciation has been more modest due to the strength of the currency. Overall, with gold fluctuating around $1550-1600 per ounce, we're seeing net speculative positions reduced to the point that if we do have positive news on the gold front, such as another round of quantitative easing, there is a lot of room for these positions to rise and provide a significant lift to the gold price.
Currently, long-term investment demand for gold is being supported by exchange-traded funds. For diversification purposes, gold is being purchased by central banks. In many emerging markets, the proportion allocated by central banks to gold is rather low compared to the Western countries. Therefore, the potential exists for sovereign nations to further diversify their reserve base into gold. Volatilities are down off of the highs of the third quarter 2011, and closer to long-term levels. Lower volatility would increase gold's appeal as a safe-haven asset.
TGR: What strategy should people considering Gold Investment employ in an uncertain market?
Joe Mazumdar: If you think Gold Prices will continue to move sideways, you should lean toward dividend-paying gold stocks, seniors to intermediate firms with low cash costs and a diversified asset base, predominantly in a low geopolitical risk jurisdiction, that are currently producing gold. If you think gold is headed up, then we advocate for leveraged plays, which come with a higher risk profile and include gold explorers, developers and junior producers. Notably, junior gold miners are trading at betas to the Gold Price of 1.5-1.7, on an annualized basis, over the last quarter.
TGR: How do high interest rates affect the price of gold as compared to currencies?
Joe Mazumdar: Interest rates vary globally as the global economy over the past few years has been running at two speeds. Western countries, which are combating anemic growth, have experienced protracted periods of low real interest rates; emerging markets are still battling inflationary pressures that have led them to maintain higher interest rates. Currently, risk averse investors seeking shelter from the sovereign debt crisis in Europe have sought out US bonds, in particular, pushing yields down while driving the US Dollar higher. The higher US Dollar has driven commodity prices lower in US Dollar terms. Investor interest in low-yield, safe-haven assets lies in protecting their investments rather than seeking higher yields in riskier jurisdictions. Gold's ability to compete for a slice of the demand pie for safe-haven assets will, I believe, be important over the near to medium term.
TGR: What are the key indicators of a Gold Mining company in trouble – the signs of a management that may not be able to weather the downturn in stock prices and restricted access to development capital?
Joe Mazumdar: In a nutshell, developers and explorers that are not producing cash flow are in danger. Important indicators to look for include the company's current cash position, the catalysts coming up and whether or not the firm has the cash to deliver the catalysts. Then we ask: Will the catalysts impact the stock positively? Where is the project located and what is the permitting environment? Are there social-license-to-operate issues? Is there a technically savvy management team? Can the team convince the debt market that it can deliver on its execution plan?
Management is the key to success for developers in the junior gold miners market. Possessing an in-situ resource alone in the current environment may not be attractive unless there is a competent management team that has the capacity to get the project permitted and is technically competent enough to execute the development and production plan. These management teams can provide access to alternative financing streams. If the skill set of the current management team seeking to progress a development project lacks development and/or operations experience, the stock is not going to go very far right now.
Although we believe it's a buyer's market for development assets, we are seeing more acquisitions of producing assets. Well-priced producing assets present less risk of permitting or social-license-to-operate issues and capital-cost escalation than a development project.
TGR: When is it generally prudent to sell holdings in a troubled company?
Joe Mazumdar: Many believe the market will turn, and we believe it will, but the time frame is uncertain and in the long run we're all dead. Currently, we have noted the longer-term investors are willing to increase positions in equities within their current portfolio but less willing to take on new names. Short-term investors continue to pursue opportunities to reduce their position and sell into liquidity events such as a resource update or drill results.
TGR: How do you find companies to recommend?
Joe Mazumdar: We lean toward companies with assets primarily in low geopolitical risk jurisdictions with infrastructure. Infrastructure is critical as it impacts capital (roads, power lines, transportation, remote camp, for example) and operating expenditures (diesel versus grid power, for example). The grade of a deposit may look great, but if it doesn't have power from a reliable grid and requires diesel, for example, it may only deliver weak margins and require higher capital expenditures.
Processing one gram of ore only works with inexpensive and reliable power such as in areas of Ontario and Quebec. If, however, the company needs to build a 100-kilometer power line, the capex quickly becomes unreasonable and is at risk to escalation. Once we narrow the jurisdiction, we seek the higher-grade deposits with a similar mining method (open pit versus underground bulk versus underground selective) within the area, which provides ample cushion for potential cost over-runs.
A metallurgically simple ore body that can deliver recoveries in the 90s is desirable. We either seek companies that can provide assets that can generate a good margin with a manageable capital expenditure requirement or one with an asset that would provide a merger and acquisition target for a major to intermediate producer seeking to replete its reserve base.
TGR: Let's talk about geopolitical risk. Is it increasing worldwide?
Joe Mazumdar: I believe that major gold corporations should be concerned, if they are not already, with their geopolitical risk profiles with respect to current and future production. They need to diversify – whether it's the South African companies that need more assets outside of South Africa or other companies that have a bit too much of their production profiles based in high geopolitical risk jurisdictions. With all of the news about creeping nationalism, higher tax revenues, royalties, ownership and overall increasing geopolitical risk, firms need to mitigate the risk by investing more in increasing current production and reserves in lower geopolitical risk environments. The amount of global gold production in low geopolitical risk jurisdictions – such as the US, Canada, Australia, Chile and some Scandinavian countries – is just below 30%.
TGR: Back to the majors: what cost-benefits do senior companies generally use to assess the merit of repleting gold reserves?
Joe Mazumdar: In the end the acquirer should be convinced that the project is accretive on either a near-term cash flow or longer-term net asset value per share basis. The recent trend in M&A has been for production over development projects as the latter carries the risk of capital escalation, execution and permitting risk, among others. Hence, what appears to be accretive on a NAVPS basis one day may not be the next day.
Previously there was a lot of pressure from the investment community to show growth. The problem is when you're producing at levels of 4-8 million ounces, it's difficult to show 3-5% annual growth rates. Currently, the investing community has shifted its collective focus and reverted to production at steady-state levels with dividends over concerns of escalating capex and delays with project development either organically or via acquisitions. Nonetheless, for majors a lot of ounces must be repleted on an annual basis just to maintain production levels, let alone grow them. I don't believe that any company wants to show a declining production profile to the market.
TGR: Any final thoughts on the market situation?
Joe Mazumdar: In the near term, financing constraints will continue to be an issue effectively restricting the volume of news flow from many junior mining equity plays. We anticipate that many will reduce their burn rates and push their catalysts back while re-benchmarking expectations.
But I still see opportunities for companies with well-managed assets in low geopolitical risk jurisdictions that can produce near-term cash flow to be financed. We note the trend toward more debt financing and away from traditional equity financing. If the capex is manageable, say, in the $100-200 million range, other alternatives to finance the project may be available such as vendor financings, selling of royalty, streaming off byproducts, doing some debt and a smaller proportion of equity. We acknowledge that a junior gold miner developer with a large capex requirement (over $500 million) may be difficult to finance in the current environment.
TGR: Thank you for your time, Joe.
Joe Mazumdar: You are welcome.
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