The Hunt for Production Gappers Is on — Gold Stocks to Buy
Today, on the off chance that you agree with my analysis and expect an extraordinary gold boom to begin as the pandemic winds down, we’ll look into which gold stocks to buy.
There are three broad classifications for gold companies, plus an oddball. But, as you’ll discover, there’s a very specific twist that I think you should be hunting for right now. As I am.
Let’s begin with the classic explanations…
Four types of gold stock
Producers are, believe it or not, companies which mine and sell gold. This may seem like a truism of all gold stocks, but once you consider what a developer and an explorer get up to, you’ll understand why it’s worth contrasting them to illustrate the completely different risks and exposures to the gold price. Not all gold stocks benefit equally from a rising gold price.
A producer benefits from a gold bull market in a very particular way. The gold they sell generates more revenue than anticipated. This is often paid out to shareholders as dividends. Mine lives can be extended too, as less economical parts of deposits suddenly become profitable.
The point is that these shares experience earnings growth, a bit like any other company experiencing success. That’s not quite true of our other two types of gold stocks.
The downside for producers is that they sell their gold at the low prices early in the bull market. And when it comes time to acquire their next project…well, they’re going to be paying higher prices for the deposit.
Developers are in the business of preparing a proven gold deposit for mining. This is where the real magic happens, if you ask me. Because every gold deposit has a myriad of ways of being mined. Figuring out which is the optimal one is damn hard.
Gold mining companies are price takers. They can’t set the price of their gold, unlike Microsoft or Harvey Norman. This means they can only really compete on cost. They try to drive their costs as low as possible to eke out more margin. At the development stage, most of the decisions that impact future costs are made. And they’re hard to change thereafter, so it’s crucial to get it right.
Developers have vast capital costs to deal with as the mine is built, but no revenue yet. This is a fragile time for a miner to be in. The risk of having to issue more shares is always on the horizon and threatens to sink the share price because of dilution.
What about exposure to the gold price? Well, at any moment the gold price could fall, making the mine uneconomical or causing financiers to withdraw from the project. Or a rising price could blow the feasibility study’s expectations of profits out of the water. If the mine is close to production, developers benefit from an increasing value of the mine, but not in terms of cash flow.
The real risk to the developer, in my view, remains whether they can find a way to get at the gold at the low cost they’d hoped for. This means developers are quite exposed to the gold price, but it’s only one consideration.
Explorers are an odd lot. Because the risk of finding gold dominates the risk of the gold price. In other words, gold explorers face a very different set of risks to producers.
Of course, the gold price matters, but what matters far more is how much gold they find. And that’s the simple version. ‘How much gold’ is a highly complex concept.
Finding a lot of gold deep down in the earth, which is not concentrated in high grades, is worth less than a small gold find at high grades near the surface, for example. Finding gold near existing mines or infrastructure is more valuable than in the middle of nowhere because of the setup costs. Different types of rock affect how much of the gold can be recovered and at what cost with what sort of beneficiation plant. Then there’s the uncertainty of exploration drilling — is it giving a fair picture? Unlikely. Could you do a puzzle with most pieces missing? That’s what explorers are in the business of doing.
Striking gold is not a simple binary outcome. But the point is that these details of the gold find are the cause of gold explorers’ price gains, not the gold price.
The exception is once an explorer has established a decent deposit. Then the gold price plays a crucial role in several ways. First of all, a rising gold price can make a marginal gold find viable. Or sink one. We’re talking binary outcomes — whether the mine ever happens at all or not.
Theoretically, selling tomorrow’s gold at tomorrow’s prices is also not a bad position to be in. Unlike producers, developers and explorers will be selling their gold at the higher prices once a gold bull market gets going. Gold in the ground is worth more, in that sense. The delay ends up being a good thing.
A fourth type of gold stock is a royalty company. These firms raise capital and invest it in the gold mining projects of miners, but they don’t do any of the dirty work themselves. They usually take small shares of a large number of mines.
This has a lot of benefits for investors. It’s a way to diversify across hundreds of projects in one share purchase. If something goes wrong at a mine, it will have a small impact on overall returns. In the end, investors can get good exposure to the gold price itself while mitigating other risks through diversification.
Those are the four types of gold companies. Not that many companies fit neatly into a single category. Most large gold miners are undertaking all three activities. Their production revenue pays for development and exploration of upcoming projects.
Because mines are inherently depreciating assets, miners are forced to always be on the hunt for their next project. If they get the timing wrong and their producing mines dry up before the next mine is up and running, the company can run out of cash. Which brings me to the type of gold stock I recommend you invest in. I call them…
Production gappers are gold mining companies which don’t have enough gold production revenue to pay for their development and exploration expenses. They are dying, despite having promising projects nearing production.
The mistake is one of timing. Gold miners need their up-and-coming projects to begin production before their existing ones deplete. If there’s a production gap, and cash dries up, that’s when I believe investors should strike.
The share price will have fallen in anticipation of, or on the news of new shares being issued to tide over the company’s cash flow drought. But in the near future, the up-and-coming mines will begin production and the cash flow will begin. The temporary risk of financing is your chance to get in on the cheap before cash flow returns.
Thanks to COVID-19, a lot of developers had to shut down operations. Their projects got delayed. And their cash dwindled. Which means there are production gappers to be found right now.
Until next time,
Editor, The Daily Reckoning Australia Weekend
PS: Australian real estate expert, Catherine Cashmore, reveals why she thinks we could see the biggest property boom of our lifetimes — over the next five years. Click here to learn more.