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Why Standard Investment Analysis Won’t Work on Mining Companies

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Most investors frequently ask this question: “Where can I maximize my return on investment?” With the price of gold at historic or near-historic highs, mining equities would be a pretty safe answer. However, as in any other area of speculation investors should choose carefully. Developing a gold mine takes a lot of time and a lot of money. From the time a prospective property is identified until full production is achieved can take five years or more. First, the ore body is defined by means of extensive drilling. Then a feasibility studied takes place. Even then, if all the results are positive and production occurs, mills must be purchased.

All of the above factors deny standard investment analysis, simply because there are too many variables.

VARIABLES

Only a small percentage of exploration projects lead to discovery of solid deposits of ore body. Most explorations cost money, while at the same time generating zero share price increase. Paul Mladjenovic summarizes the risk thusly: “In this category you have the smaller companies that are drilling exploring on properties that may or may not prove to be valuable. This becomes the crapshoot for those who want to speculate.”[1]

Assaying risks are the result of using different labs to determine the value of property and subsequent bids. Skewing of results does occur. It just depends on which side of the transaction one is.

Management is crucial to a successful mine. Long-term track records speak for themselves. For example, if you purchased an NBA team and needed a coach, would hire the guy down the street, who’s full of energy and means well, or Phil Jackson? By the same token, if you’re Pershing Gold and you have potential property in Nevada, who are you going hire to run it?

The trading risk revolving around a mine engenders certain questions: Are big institutional investors involved? How many shares trade? And what’s the spread? Mining shares are leveraged to the price of gold. The more it costs to get the gold out of the ground, the less the profit and the accompanying share price. Investors also need to consider the size of the company that owns the mine. If the company owns only one mine, the risk factor increases. If the company owns several properties, the risk goes down, because it’s distributed.

Another variable is whether a company mines or accumulates. Some companies accumulate gold resources with no intention of ever mining, because mining is risky. These companies explore, develop, and decorate themselves to attract partners or find buyers.

WHAT WON’T WORK

An old mining adage states: “If it is not grown, it has to be mined.” That’s a true statement. Investors can choose between paper assets and tangible assets. Throughout history, raw commodities have maintained their value: food, clothing, transportation, heating, and shelter. Another way to put it is like this: agricultural commodities, cotton, oil, natural gas, and lumber. There’s a lot to be said for tangibles, but don’t try to analyze them by using a template. Standard investment analysis works on paper assets, not on mines.

In the present environment, most mining companies don’t provide data for price to earnings analysis. Along with that, there are few mining securities that provide an income stream. The problem is that most investors like to impose standard investment analysis on mining companies. This type of analysis might work to establish a market peak, but it will not work on mining companies. As Rudenno points out in: “For example, share and commodity prices do follow trends rather than totally random and volatile movements. The trick is not to show that a commodity or stock price is in an increasing or declining trend, but rather to predict when that trend will occur.”[2]

The best type of analysis that can be done is rule of thumb, a philosophy that works surprisingly well – the Three L Method: the larger, low-debt, low hedged companies such as Pershing Gold should be favored. This rule of thumb, fly-by-the-seat-of-your-pants method has provided solid results. For all intents and purposes, Rudenno refers to the same thing when he writes, “If charting could make successful predictions, then the market would be inefficient and investors could get something for nothing. Empirical studies such as filter rules, and some would say common sense, suggest that the future movement in a share or commodity prices is not governed by its past movements.”[3] The only difference is that Rudenno calls it “common sense” rather than rule of thumb.

When it comes to investing in a gold mine, take a look how many ounces of gold each dollar buys. This can be used as an indicator, but use it judiciously. For if Pershing Gold’s ore is easier to extract and/or easier to refine, then investors can take that to the bank.

As stated in the opening paragraph, investors want to maximize profits and minimize risk. Because the price of gold has soared over the past year or more, mining is booming. There are myriad companies out there. Pershing Gold is one example. Newmark Properties is another. Remember: imposing standard investment analysis on mining companies does not provide realistic or applicable data. Thus the usual analysis will not indicate whether Pershing Gold or Newmark are good investments. So the investor has to employ the Three Ls.




 

[1] Precious Metals Investing for Dummies, Paul Mladjenovic, page 166.

[2] The Mining Valuation Handbook, Dr. Victor Rudenno, page 262.

[3] Ibid.

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