Gold Mining Shares

I have set out under My Investment Philosophy the guidelines that help me to select growth shares. The key criteria are strong present and future growth in EPS, a relatively low PE ratio resulting in a low PEG, strong cash flow in excess of EPS, little or no debt, positive relative strength in the previous year and no substantial selling by directors.

For gold mining shares I have had to develop different criteria which I hope will be of interest to you. First, it is important to understand the characteristics of what might be called the ideal gold mining share. These are my suggestions:-

The deposit to be in a reasonably safe political territory. For example, nothing in Russia, Venezuela or any country with the word ’stan’ in its name.
A strong resource position. Reserves are of course the ideal but NI 43-101 compliant resources are sufficient in most cases. Often there will be a combination of the two. Check the total number of ounces of gold against the market capitalisation of the company – the cheaper per ounce of gold the better.
No serious environmental problems on the horizon.
A strong balance sheet with cash, little or no debt and no major future capital liabilities.
Future production to be unhedged.
Strong cash flow on a multiple (PCF) below the average of its peer group.
Although it can be difficult to tell the quality of management, a good CEO with a meaningful stake in the company is clearly very desirable. Many investors would argue that this criterion should come first. However, with my first six criteria in place it is less necessary and without them even the best management would have an almost impossible task. Also a company possessing the first six criteria would be highly likely to be taken over if management is poor.
Rising gold production with a long life.
The cost per ounce of gold produced and the grade are critical factors. High cost (low grade) producers are obviously vulnerable to downswings in the gold price but they offer much greater leverage on the upside. My key criterion of strong present and future cash flow tells me that the cost per ounce must be comfortable for the company but clearly with high cost producers a firm eye has to be kept on the gold price.
A very prospective deposit open to further discoveries in all directions including depth.
A relatively small market capitalisation on the principle that elephants don’t gallop and fleas can jump 200 times their own height. Also small caps are less well-researched and are more likely to be taken over. From say $20m to $250m would be my preferred range but up to $500m is fine if justified by the fundamentals.

Just as there are very few growth shares which measure up to my requirements, there are very few gold mining shares which meet my criteria set out above. However, knowing exactly what you are looking for is a great help when it comes to making almost inevitable compromises. For instance, if a gold mining company met all of my criteria except that it had a small amount of debt that would be acceptable. If the mine had a very short life or was in an unsafe political area that would be a turn-off. The key point is to fully understand what constitutes the ideal and then to develop a technique for knowing when and how much to compromise.

You will have noticed that I have not mentioned pure exploration companies which are much riskier. As I have explained, I usually limit my downside risk by investing in companies with existing production with a highly prospective deposit. Other points to bear in mind with exploration companies are that if successful they would have to raise capital to determine feasibility and to obtain environmental approval which can be difficult and take a very long time. They would then have to raise a further massive amount of capital to go into production.

However, in spite of all these caveats, a company which is moving from exploration to development (and as far as one can tell looks very likely to become a substantial mine) could multiply your money many times. You could lose it too because this kind of share, although very tempting at times, is much riskier and far more difficult to value.

Jim Slater