Want to know the secret to a 669% gain in gold stocks? I'll tell
you in a second, but first, some background...
If you don't know what gold stocks are, they're pretty
straightforward.
Gold stocks consist of the gold miners, the companies that actually
pull the yellow stuff out of the ground. I prefer gold stocks to
bullion for a couple of reasons.
For one, many miners pay regular dividends -- whereas, to
paraphrase Warren Buffett, gold bars just sit there and look at
you.
But more important -- gold stocks
offer
considerable
leverage
over owning physical bullion. As the price of gold increases,
production becomes more profitable, justifying a higher stock price
for gold stocks.
That's not to mention that when gold prices increase, the miner's
reserves also become more profitable. Because miners often have
reserves equal to 10 times their production rate, it's easy to
extrapolate the total
profit
increase from a rise in the price of gold.
But, that said, this is the part where most investors mess up.
See, novice investors tend to think that if gold is poised for a
big move, then any gold-mining stock will take you along for the
ride.
But that simply isn't the case.
Takeshares of
Novagold Resources (AMEX:
NG
)
and
Buenaventura Mining (NYSE:
BVN
)
for example. In that past five years, Novagold has lost 10% of
their value during agold bull market . Meanwhile by comparison,
Buenaventura Mining has advanced 207% -- and it sells the exact
same metal.
Clearly, there are some attributes that separate the pedigreed
thoroughbreds from the rest of the field. Specifically, there are
five main criteria I use to evaluate a prospective metals company:
extraction costs (the lower the better); production rates
(preferably rising); reserve base (ditto); areas of operation (be
cautious of geopolitical trouble spots), and
hedging
(ideally none in a rising
market
). But today, I want to look at one of the most important --
extraction costs.
See,
commodity
producers brings their wares to market for the same price. If gold
is fetching $1,700 an ounce, then you're going to sell it for
$1,700 an ounce.
Therefore, it stands to reason that the biggest gains will go to
the producers that can dig it up the cheapest. The leaner and more
efficient the company, the more cash it pockets for every ounce
sold.
Take Canadian precious metals miner
North American Palladium (NYSE:
PAL
)
for example. It extracted 2,976 ounces of gold from its Sleeping
Giant site last quarter. That gold production brought in $5.6
million in revenue.
But unfortunately, the cash costs (on-site
operating expenses
per unit of output) were $1,869 an ounce. This means the gold cost
$5.6 million ($1,869 times 2,976) to produce. In other words, the
gold mine operated at the breakeven point.
At the other end of the spectrum is
Goldcorp (NYSE:
GG
)
, which is sitting atop some of the highest-grade mines on the
planet. At the prolific Red Lake site in Ontario, each metric ton
of raw ore relinquishes about 68 grams (2.4 ounces) of gold --
that's 10 times the 6.7 grams/ton of Sleeping Giant.
Goldcorp can currently get an ounce of gold from the ground to the
market for $553. But this doesn't include copper, silver and other
metals that are found in the company's mines. After you include the
sales proceeds from these by-products (standard practice in the
industry), the cash costs fall to just $185 per ounce.
In 2011, the company had an average sales price of $1,516 per ounce
and netted $1,331 per ounce in profits, for a sky-high
margin
of nearly 88%.
It's no accident that Goldcorp, which has some of the lowest costs
and strongest
operating leverage
in the industry, has delivered the biggest gains for stockholders
-- 669% in the past decade, versus 294% for its peer group and just
27% for the Dow Jones Industrial Average.
This isn't a difficult concept, and it doesn't just apply to gold
stocks. All other things being equal, if a commodity sells for $100
per pound, then you're better off with a low-cost producer that can
retrieve it for $60 per pound than a competitor who must spend $70.
Risks to Consider:
But keep in mind, costs can change dramatically from year to
year or even quarter to quarter. So it's important to understand
what's driving the cost advantages. Maybe it's favorable geology,
superior extraction techniques or
vertical integration
(mining is energy intensive, so some companies actually generate
their own power).
Whatever it may be though, any cost advantage/disadvantage is
sure to affect the company's profit margins. And you can bet that
anything affecting how much money the company is making will be
reflected in its stock price.
Action to Take -->
So if you're shopping for gold stocks, or any commodity producer
for that matter, make sure to focus solely on those with the lowest
extraction/production costs. The cheaper a company gets its product
to the market, the more money it and its shareholders are going to
make.
-- Nathan Slaughter
Nathan Slaughter does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of PAL, GG in one or more if its "real money"
portfolios.