guest commentary

When it Comes to Gold, It’s About Choosing the Right Companies

• by Lila Manassa, CFA
• June 03, 2009

Historically, our strategy at Federated Prudent Bear has been to maintain an allocation to resources stock investments, predominantly in the precious metals sector, as a hedge against a weakening U.S. dollar and the inflating away of purchasing power due to irresponsible fiscal and monetary policies. As such, we have long maintained a bias toward hard assets in favor of paper ones.

Often we are asked the question, "Do you prefer to own the commodity or the related stocks?" It is a fair question indeed.  Many years ago, we decided that building expertise in the resources area would be an important part of our strategy because of the significant value that can be created by a company that can move a nascent resource into an asset that can produce free cash flow. Beyond the largest companies, natural resources – be it energy, precious metals or base metals – are a very inefficient group of stocks. Many of the companies that are finding and building resources are individuals who strike out on their own after years of working for a large organization.  Analysis of these smaller, earlier-stage projects requires technical knowledge, ie., "Can this work?",  with financial expertise, ie., "At what cost will this work?" It has been my ongoing task to understand what will work and what will not, and to find the highest quality projects at the most reasonable prices.

All that said, companies present certain challenges, particularly the larger ones.  The senior gold producers have historically not paid a great deal of attention to such traditional investment metrics as returns on assets and capital, often instead favoring growth for the sake of getting bigger. Growth in shares outstanding often exceeds the growth in production and reserves.  Therefore, reserves and production per share for many senior companies is a metric that seems to be in terminal decline. Mergers often do not create synergies or result in any significant cost savings.  The big get bigger, but they do not necessarily get better.

Acquisitions and other management follies aside, mining is an extremely challenging business in its own right. Worldwide grades, or the amount of precious metal per tonne of rock, are in decline, which increases costs per ounce of production – not to mention expropriations by rogue governments, permitting risks, and cost inflation.  In addition, many of the projects the majors need to develop in order to show production growth – or in some cases just to keep production flat! – have single-digit internal rates of return.

For example, a recent major piece of news for the precious metals sector was the publication of the feasibility study and related economics for the 50/50 joint venture of Barrick Gold/NovaGold Resources' Donlin Creek project. The project is one of the world's largest undeveloped gold deposits, coming in at 29.3 million ounces of gold.  A decision to build it out would make the Donlin Creek mine one of the world's largest producers of gold. However, the project economics seem quite poor.  The life-of-mine cash costs per ounce are estimated to be in the order of between $467 and $477 per ounce.  At 89.5% gold recovery, the total capital costs per recoverable ounce are over $200 per reserve ounce.  In total, this comes to approximately $675 per ounce in costs without even factoring in sunk costs such as exploration, community relations, and other baseline studies – 13 years of work had been done on this project up until this point.  The high costs make themselves very clear in an analysis of the returns on the project.  With gold at $900 an ounce, the after-tax internal rate of return (IRR) on the project is 7.7 percent.  With gold at $725, the economics seem even more bleak, with an after-tax IRR of only 2.3 percent.  I do not mean to pick on Donlin Creek or on Barrick, I merely attempt to illustrate just how tough a business mining can be.

While we believe the price of gold will rise over the long-term, we acknowledge that there are significant risks in terms of volatility of the gold price over the life of a mine. Therefore, we do not believe it is necessarily prudent for a company to run project-economics for a 15-year mine life at spot gold prices. Additionally, it has been our experience that even when gold prices do rise, costs seem to rise right along with the commodity, rendering the operating leverage argument pretty ineffective.

All of these aforementioned factors have contributed to low and declining average returns for the major gold producers:

Return on Assets: Senior Gold Producers

So the question remains, why invest in any of these resources companies?  Despite all of the aforementioned industry woes, the fact that world mine supply is in secular decline presents an extraordinary opportunity for those who can find gold and move projects along what we call the "value curve."  The growth of diversified mining companies is achieved predominately through acquisitions, which leaves much of the earlier exploration and development of a project to smaller, independent companies. 

The "value curve" is effectively a full-cycle look at how a mine goes from being a mere discovery, through the development, permitting, building and commissioning of an actual producing mine.  Effectively, it is an asset creation cycle. At the lowest point in the curve, you have the exploration and appraisal of an ore body.  The resource is confirmed, expanded, and estimates as to the tonnage and grade are published in an NI 43-101 compliant resource estimate. Generally, early to advanced exploration companies trade between 0.2 and 0.5 times net asset value (NAV) because many of the risks have not yet been removed.  As companies move assets up the value curve and the project is "derisked" – permits are acquired, financing is obtained, resources are further delineated and become reserves, technical and political risks are assessed, and economics are published – they attract higher multiples to net asset value.  Although we believe gold prices will be substantially higher in the future than they are today, we look for valuation growth, multiple expansion and the ability to generate free cash flow independent of the gold price.  In other words, we want the higher gold price to be the icing on the cake, but not the cake itself.   Therefore, my job is to find companies that can execute – that have the right combination of technical expertise, asset quality, and sound economics in order to move assets up the value curve.

This is not to say that there are not attractive opportunities in some of the senior and intermediate names as well.  There are several of the larger names with existing production that have either grown organically (i.e. through the drill bit), or used the credit market conditions of late last year and early this year to their advantage in making acquisitions of companies at attractive prices. Many of these acquisition targets had been unable to obtain financing to move their projects up the value curve.  However, we believe the most significant alpha generation in our resources portfolio will come from the smaller, independent companies that can create value via the discovery and development of the particular commodity in question.

Lila A. Manassa, CFA, Vice President, Senior Investment Analyst at Federated Investors Inc. Ms. Manassa is responsible for researching and monitoring global natural resources companies for the Federated Prudent Bear Fund and Federated Prudent Global Income Fund.

Views are as of June 3, 2009, and are subject to change based on market conditions and other factors.  These views should not be construed as a recommendation for any specific security.

Federated Equity Management Company of Pennsylvania

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