When I look for investments, here are some factors/characteristics that I would look at.
For the purposes of this post I will use gold mining companies as an example to illustrate why these factors are worth considering when making an investment decision.
1. Companies I could hold/own forever
Gold mining companies don’t make great businesses over a long period of time. A lot of what dictates the success of the mining company is the price of the specific commodity/mineral that is being mined/explored. There can be prolong periods of weak commodity prices which can force mining companies to operate at a loss and sell at a loss to offset some of its operating costs.
To make matters worse, the actual commodity prices usually outperform the mining companies itself. In other words, historically it’s better to hold the physical commodity than the mining company and this after you take into account the storage costs associated with storing and securing the commodities in an expensive vault. If you think about this, it makes no logical sense, when there should be some kind of value/profits derived from being the producer of the actual commodity.
Here’s a chart comparing Gold Bullion prices to the HUI Gold Miner Index (performance of America’s 15 largest unhedged gold mining stocks):
2. Companies that are not highly leveraged
Mining companies rely substantially on debt and equity financing to sustain its operations. Due to the nature of its business, it’s common to see these companies raise money at different stages throughout the mining cycle:
- Exploration – This is where mining companies lease/own mining rights to land and begin hiring geologists. The geologists will take samples of the land and literally speaking poke holes in the ground in hopes of finding an area worth considering for mining. They will use geo-thermal imaging equipment to select areas with greater potential of mineral deposits. From working in the investment industry, I’ve come to learn that there’s millions of dollars that are spent every year to poke holes into the ground with many holes ending up not being an area worth exploring further. This is by far the worse stage for miners and there is no money being made. Any money raised or borrowed during this time is used to sustain this phase to cover staffing costs, specialized equipment, and costs associated with poking holes on the ground (did I say this yet?). A lot of junior mining companies go bankrupt and become worthless during this stage.
- Site Design and Planning – This is the stage where there’s reasonable belief that the mining site is worth exploring further which leads to the preparation of site drawings and the gathering of permits to build a full scale mining site. Again, there’s no money being made and there’s more and more money that’s being raised and diluting or decreasing the percentage of shares you own in the company.
- Site Construction – This is the stage where roads, a processing facility, and employee lodging is built as mining sites are often in rural sites. Again, surprise, there’s no money being made.
- Production – This is the stage where the ores (rocks) containing mineral deposits are extracted from the ground. There are fewer and fewer mineral deposits in the world with high grades (% concentration of mineral deposits in the ground) which involves digging and pulling out more areas to get that same amount of minerals that would have been available in the past. From the time the ores are extracted from the ground, it has to go through the processing facility whereby the minerals are extracted from the ores and transported to a smelting facility where the minerals could be melted and moulded into coins, bars, etc and made available for sale. Although this may seem like an opportunistic stage because there’s sales occurring, it’s dependent on the commodity prices at the time of sale which may or may not be at a profit. At this point, it’s often too costly to temporarily close production until commodity prices return to profitable levels.
- Closure/Reclamation – When mining is complete, there’s usually a responsibility of the mining company to restore the site to environmental standards. A lot of the mining sites are taken place in South America, Asia, and Africa where environmental laws are not as stringent in Canada. Tailings (mine dumpings which are extremely toxic) are sometimes thrown into rivers that provide drinking water to neighbouring communities. This can lead to birth defects, deformities and even sometimes death to nearby communities. Initially what seemed like an easy way out for companies, leads to litigation claims against these companies which can drag on for years.
3. Companies with positive cash flow or potential for positive cash flow
Mining companies usually burn through tons and tons of cash. The rate at which it burns through cash to cover its overhead costs (rent, salaries, and other operating costs) is called it’s “burn rate”. In my previous role when I was working at an investment brokerage, I would see junior mining companies reach out to our investment advisors to get our clients to invest in their company to cover their senior management salaries they couldn’t afford to pay.
4. Companies that are not affected by geopolitical risk
Mining companies often operate in remote high risk areas in South America, Asia and Africa where there is political instability. The government can potentially take away the land from the company and there could be little recourse available for the companies themselves. If the mining companies operate in war torn countries, they could even be at risk of being robbed which can greatly disrupt operations.
We don’t hear it in the news, but this should not at all sound surprising.
I hate to bash gold mining companies in general because over 75% of gold mining companies are headquartered in Canada.
I share this story to show you how even if you selected the best run gold mining company with tons of research, the odds are stacked against you to find a company where the stock price will perform well over time.
Is it possible to make money when investing in mining companies? Yes – of course there is. However, most of the time it’d be driven by a lot of luck which is a form of gambling not investing.
If you use these four factors to guide your investment decisions, you’ll be able to stick through your investments over a long period of time no matter what is going on. If the investments fall in price from what you initially paid for it, you’d be confident, and have the strength to buy more because it’s going on sale not because the company is doing poorly.
*Note: it’s important to diversify your investments and own companies over all sectors which includes a small portion in gold mining stocks to help reduce the risk of your overall portfolio. (I’ll talk about this more in later posts)