 Advice for Managing Your Gold Stock Portfolio
Kenneth J. Gerbino
Archives
Kenneth J.
Gerbino & Company
Investment
Management
September 21, 2004
A recent report on the budget impact of social security and Medicare
from the Cleveland Federal Reserve Bank, commissioned by former
Treasury Secretary Paul O'Neill states an expected $44 trillion
long-term U.S. budget gap to meet these obligations. Even if
we cut these figures in half, it would most likely require
$1 trillion a year of deficits starting in about five years.
U.S. Comptroller of the Currency, David Walker calls it "chilling"
and Laurence Kotikoff, Chairman of Boston University's Economic
Department states, "The country is absolutely broke." Bush Treasury Undersecretary Peter
Fisher and former Clinton Treasury Secretary Robert Rubin are
all on record stating strong concern. The IMF and The Brookings
Institute back up these numbers, with there own studies, which
are even worse. The repercussions of these imbalances for the
U.S. are so enormous it is difficult to comprehend.
I have never been a gloom and
doomer but the politicians of either party clearly have no way
out. France, Germany and Italy are actually in the same boat
as the U.S. It stands to reason that a period of massive money
creation is most likely in the cards to pay for everything. Inflation
will surely follow. Inflation numbers do not look too alarming
currently (July and August), but the long-term outlook is very
clear and it pays to be prepared in advance.
As more economic stress builds,
gold and gold assets should trend higher as a safe haven for
money. Gold mining companies building reserves and the mines
to extract these reserves should increase their valuations considerably.
A good solid gold mining portfolio is the only investment vehicle
that allows you a monetary insurance policy, and if you chose
wisely and don't speculate too much a growth company portfolio
all in one.
An important tool you should
be aware of for choosing companies is Net Present Value (NPV).
This measures whether a stock is selling for more than it may
be worth in terms of future cash flow. Net Present Value is simply
the total of the cash stream expected from the production of
a mine or mines over a certain period of time. The cash flow
is then discounted at 5% or even 10% for each year in the future
the cash is coming from. In simple terms, at 5%, one dollar of
cash coming in next year only has a present value of 95 cents
today. Cash coming in 2 years from now is only worth 90 cents,
in 3 years only 85 cents etc. It would be the same as taking
90 cents today and investing it at 5%, in two years it would
be worth about a dollar. This is what discounting is all about.
Discounting gives you a hypothetical
value of what a future cash stream is actually worth today, hence
the name net (final) present (today)
value (worth). Since money today is worth more
than money one will receive in 10-15 years, the cash flow is
discounted (reduced in value) to reflect this. This valuation
shows if mining companies are actually selling above or below
the discounted present value from their current cash flow or
their contemplated cash flow form a new mine(s) going into production.
The concept is best explained
by a question - would you pay $10 a share for a stock that owned
a depleting asset (a gold mine) that would only make $10 of present
value cash flow per share from the life of that mine and then
close the mine. The answer is no. That would be the same as investing
$10 somewhere and over 10 years just getting $10 back. You have
made no headway.
Therefore you want to own companies
selling below NPV. For example a company selling
at $5 a share that is currently worth $15 a share NPV. This shows
upside potential. If a mining company is selling above it's NPV
you better hope the company finds more and better projects in
the future. Selling above NPV is ok for an established diversified
mining company, but when you are analyzing developmental or small
and junior mining stocks you better see at least a 2-3 times
upside of NPV otherwise you have arrived too late and the stock
you are buying is probably being sold to you by people who have
done their homework.
Established gold mining companies
usually sell at a premium to the Net Present Value of their cash
stream because they usually have plenty of new projects in progress
and investors expect them to add to their mineral assets as time
goes on and this will increase cash flow and hence the future
NPV. Also, there are plenty of investors betting on gold going
up which automatically increases the cash flow and hence the
NPV.
Also, remember that gold itself
carries some "monetary respect" that can negate any
discounting of future value. This is because if money in the
future will be worth less (i.e. be discounted), then gold would
probably be worth more, thereby canceling the rationale for the
discount. This is why I do not like to use more than 5% as a
discount rate in our computer models when analyzing developing
mining stocks. I also believe since gold is real
money that a zero discount rate should be used for producers.
Some analysts increase the discount rate to take into consideration
political risks or other factors. In other words, a gold company
with a mine worth $500 million of discounted cash flow in Nevada
would only have a $100 million value maybe if it was on the border
between Iraq and Iran. Discounting in this manner is very subjective
and different from a pure monetary/interest rate-discounting
model.
Market Cap. per ounce is a
useful guideline for valuing a potential buy-out of a mining
company. This is the Market Cap of the company divided by the
number of ounces of reserves/resources. The lower the number
the better. Buy-outs are based on resources and reserves in the
ground. A major mining company may pay between $40 and $75 per
ounce of gold resource for a company that is not yet in production.
The price would depend on many factors besides just the quantity
of gold. If a mine is in production then the ounces in the ground
are worth more to an acquirer. Therefore producing mines could
be bought for $100-$150 an ounce of reserves. Always look at
this guideline to see if you are paying too much for the stock.
$20 per ounce or below is a good starting point for value for
early developmental projects.
Another guideline that gives
you a good look at value is a simple calculation that shows what
one-dollar invested in the company equals in terms of mineral
value in the ground. This shows if you are getting some bang
for the buck. It is a good indicator that shows if you are over
paying for recoverable mineral assets. It is a very rough guideline
and is best used for comparing companies. If a company has 2
million ounces of gold resource, at $400 gold, the raw undeveloped
resource is worth $800 million. If the company has 20 million
shares outstanding and is selling at $5 or a $100 million market
cap., then you are getting $8 of metal value in the ground for
every $1 you invest.
Be careful with this one because
by the time mine waste, metallurgical recoveries, capital costs,
dilution of the resource from uneconomic sections and many more
things are considered, the amount of gold coming out of the ground
may only be $2-3, not $8 for each dollar invested. If comparing
similar deposits, one company gives you $30 of value in the ground
for each dollar invested versus $10 for another company, it will
at least point out to you an important value comparison.
Of course one of the most important
stats to look for is the cost or estimated cost of production
of an ounce of gold. Companies that produce gold or will in the
future for $200 or less allow you a solid cushion with gold at
$400.
At this time the large cap
mining stocks are selling at a substantial premium to the universe
of junior and quality developmental (emerging producers) companies,
therefore over-weighting the smaller company sector looks like
a good idea.
A portfolio of 40% large producers,
20% mid-tier, 20% juniors, and 20% developmental would probably
be a good mix for the average investor. I am leaving out exploration
stocks, as these are really investments for an individual with
expert knowledge and who understands the very high-risk levels
of this category.
Look at your gold stock portfolio
as a long-term investment but don't buy overvalued merchandise
and remember to do more homework and take advantage of what looks
to be a very substantial bull market developing for precious
metals.
Please visit our website
for more commentaries on gold, the economy and the stock market.
September 20, 2004
Kenneth J. Gerbino
Archives
Kenneth
J. Gerbino & Company
Investment
Management
9595 Wilshire Boulevard, Suite 303
Beverly Hills, California 90212
Telephone (310) 550-6304
Fax (310) 550-0814
E-Mail: kjgco@att.net
Website: www.kengerbino.com
321gold Inc
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