Dave: Debt and cash position are some of the first things I look at when evaluating a potential resource investment. These can be deal-breakers. You might have the best gold mine or oilfield on the planet, run by top-notch professionals, in a stable and profitable place — but if you run up against a wall of corporate debt that can’t be paid off, none of these advantages will be of any help to equity holders. The only people who benefit are the bankers who seize control of the assets when the company defaults on its loans. Debt holders almost always come first in line in terms of getting paid. You don’t want to be a stockholder at the end of the line when debt goes bad.
Many investors ignore this factor, to their extreme financial detriment. Especially in the current market, which has become desensitized to the high levels of debt that many companies are taking on. Investors think that having a debt-to-equity ratio of 1 or 2 is acceptable or even normal. But when buying into companies with those kinds of metrics, you’re taking on a lot of risk.
You just don’t want to set up a situation where you’ve done everything right in terms of analyzing and selecting an investment — only to have the rug pulled out from under when bad debt stings and paralyzes a firm.
Bob: How would you characterize the current state of the industry? Is now a good time for investors to be considering junior resource stocks?
Dave: The current market has the hallmarks of being one of the most profitable times for investors that we’ve seen in many years.
Commodities businesses are continually taken to task as being risky because they are cyclical. This is true. We start with low prices, which discourage supply. Mines or wells get shut down, little new development takes place. Reliably, that lack of activity eventually restricts production to the point that the world needs more basic materials than producers can supply.
At that point, prices rise — often quickly, like we saw with uranium in 2006 or oil in the early 2000s. Higher prices give the opportunity for great profit through finding and producing needed resources — and that money-making potential attracts a lot of smart, motivated people to the industry. These people use their ingenuity to make valuable discoveries and bring on needed supply.
The problem is, these people are very smart and very motivated — which means they’re usually very good at bringing on production. Eventually all of this well-won output forces prices down again. And we end up back where we started.
That cycle has played out blow-by-blow for centuries. It will happen this decade. It will still be happening in a hundred years. If you’re a keen observer, you’d note that buying resource companies during down times is a good way to position for profits when the inevitable turn to higher prices comes. You’d also notice that buying when times are good in the resource business is a great way to position yourself for insolvency when the inevitable downturn hits.
Right now we are decidedly into bad times in the mining sector. I’ll give you a demonstrative stat: the world’s biggest gold miner, Barrick Gold, today pays $1,276 to produce 1 ounce of gold. The gold price is $1,325. That razor-thin margin is a sign of very challenging times for the business.
Paradoxically, those numbers are a glaring signal that this is one of the smartest times to buy certain gold stocks. When gold was trading at $1,800 per ounce, it was high enough compared with the industry cost of production that it was possible for the price to fall without overly impacting supply. And that’s exactly what it did. But today, if the price fell any further, we would see a large portion of global gold supply become uneconomic and probably shut down. That would cure low prices very quickly.
There is thus much less risk today of prices going down. In fact, there’s a likelihood that steady gold demand could cause prices to go up. When the risk is to the upside, I buy. It’s a time-tested way to make money on the dependable swings in commodities markets.
This article was originally written by Bob Bogda and posted on StreetAuthority.
