An Introduction

"Which gold stocks have the best leverage to robust precious metals prices?" asks Frank Holmes. In order to find the diamonds in the rough, he analyzes their 5 Ms, i.e. Market cap, Management, Money, Minerals and Mine life cycle which are presented below.

1) Market Cap
Market cap is simply the number of shares outstanding multiplied by the stock price.

• If a gold company has 10 million shares outstanding at $1 per share, for example, the company is valued at $10 million but if the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (1 million ounces in reserves X $25 an ounce). If the company’s market cap is only $10 million, it may look undervalued. Accordingly, if the company’s market cap is $50 million, it may appear to be overvalued.
• For larger gold companies, an investor can measure a company’s market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation.
• For junior mining companies we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.

2) Management
Essentially, management of mining companies must have both explicit and tacit knowledge to be successful.

• Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?
• Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?

Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors.

• Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.
• Some of the most successful company builders in the gold-mining industry are what I call the “financial engineers” – people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.

3) Money
Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow.

• A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis. We call this the “burn rate”—how long will the company’s current cash levels last before it has to return for additional financing.
• Exploration reserves are generally valued at one-third the reserve values of a producing mine—if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce. There is an old rule when it comes to exploration companies: don’t pay more than two times cash per share if there are no proven assets in the ground.

4) Minerals
Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share.

5) Mine Lifecycle
There are many delays and disappointments during the development and operation of a gold mine. Input costs can rise out of control, labor workers can strike, and political/environmental policy shifts such as higher taxes or stricter environmental regulations can shrink margins.

Stock Price Movement Phases

During the exploration and development phase, the price of a gold stock often follows a course that ends up looking like a double-humped camel:

1. First there’s euphoria over exploration results that are better than expected. The stock price rises as investors race to buy shares.
2. Then reality sets in – this gold discovery is still years away from being an actual producing mine. At this point, there’s a huge correction in the stock price.
3. Assuming the company continues down the path to development, its share price drifts sideways until around six months before the first ounce of gold is expected to be produced.
4. At this point, the stock begins a strong new leg up when a more sophisticated set of shareholders come into the market.
5. Eventually the price drops off and
6. then levels as the speculative money moves on to the next hot opportunity and the company transitions from explorer to producer.