To begin with I tried to determine what would constitute the ideal gold mining share. Once you have an ideal in mind that gives you a standard to measure against, and a basis from which you can make compromises if necessary. So far I have developed these criteria for the ideal gold share:
■ The deposit must be in a reasonably safe political territory. For example, nothing in Russia, Venezuela or any country with the word 'stan' in its name.
■ A strong resource position. Reserves are of course preferred but NI 43-101 compliant resources are sufficient in most cases. Often there will be a combination of the two. Always check the total number of ounces of gold against the market capitalisation of the company – the cheaper per ounce of gold the better.
■ No serious environmental problems on the horizon.
■ A strong balance sheet with cash, little or no debt and no future major capital liabilities.
■ Rising gold production with a long life.
■ Future production should be unhedged.
■ A very prospective deposit with the potential for further discoveries in all directions including depth.
■ Strong cash flow with PCF below the average of its peer group.
Although it can be difficult to tell the quality of management, a good chief executive with a meaningful stake in the company is clearly very desirable. Many investors would argue that this requirement should come first. However, in my view, the other criteria are more important. Any company possessing them would be highly likely to be taken over if its management was poor.
The cost per ounce of gold produced and the grade are critical factors. High-cost (low-grade) producers are obviously vulnerable to downswings in the gold price but they offer greater leverage on the upside. My key criterion of strong present and future cash flow tells me if the cost per ounce is comfortable for the company, but clearly with high-cost producers a keen eye has to be kept on the gold price.
As with growth stocks another requirement of mine is a relatively small market capitalisation based on the principle that elephants don't gallop while fleas can jump 200 times their own body height. Also, small-caps are less well researched and are more likely to be taken over. Between say $20m (£13m) and $250m (£163m) would be my preferred range, but up to $500m (£325m) would be fine if justified by the fundamentals.
I recommended BHP Billiton, a much larger outfit, to Investors Chronicle readers in February 2006, since which time, and despite the intervening bear market, it has paid handsome dividends and doubled in price. BHP still looks good but, as its massive market capitalisation grows, the company will find it increasingly difficult to continue to perform at the same rate.
Just as there are very few growth shares that measure up to my requirements, there are very few gold mining companies that meet my suggested criteria. However, knowing exactly what you are looking for is a great help when it comes to making inevitable compromises. For example, if a gold mining company met all of my criteria except that it had a small amount of debt, that would be acceptable. If the mine had a very short life or was in an unsafe political area, that would be a turn-off. The key point is to understand fully what constitutes the ideal and then to develop through experience a technique for knowing when and how much to compromise.
Who passes the tests?
A gold mining share that ticks all the boxes for me is Norseman Gold (NGL). It is in Western Australia and has been mining gold for 70 years. Cash in hand is A$23m (£14m) and future production is unhedged. Chief executive Barry Cahill is hard-working, experienced and capable, and has a substantial stake in the company. There are three mines with narrow vein nuggety deposits that feed a mill with a present capacity of 140,000 ounces of gold a year. Another mine, North Royal, is coming on stream later this year and there is potential for more mines as and when the capacity of the mill is upgraded.
This year's production has been disappointing, with the target recently reduced to 65,000 ounces. However, the company's guidance for the year commencing 1 July 2010 is unchanged at 110,000 ounces. In the following year an increase to 140,000 ounces is likely, at which level operating costs should be reduced to about A$600 per ounce. With gold at say $1,100 per ounce (A$1,200) (£726), this would give an operating profit of A$600 per ounce – A$84m a year compared with a market capitalisation of only A$128m. Further exploration, administration expenses and tax would reduce net profit to A$45m-A$50m. The prospective cash flow is so strong that I would be keen to invest in the company if it made widgets.
Exploration potential
Newly-appointed joint broker Seymour Pierce has just issued a circular with a price target of 116p against the present price of 45p. Together with my family I own about 8m shares in Norseman.
You will have noticed that I have not mentioned pure exploration companies that are much riskier. As I have explained, I usually limit my downside risk by investing in mining companies that have existing production from a highly prospective deposit. However, a company that is moving from exploration to development, and as far as one can tell looks very likely to become a substantial mine, can be very tempting.
One such Canadian development company in which I have invested is Spanish Mountain Gold (TSX.V:SPA). At a cut-off of 0.3 grammes per tonne, the company has NI 43-101 compliant resources of 3.94m ounces of gold. At the current price of 41¢ the market capitalisation is about C$50m (£33m) which means that its gold in the ground can be bought for only C$12.5 an ounce (C$17.5 fully diluted). The leverage arising from every dollar increase in the gold price is therefore very attractive. The grade is very low but the tonnage is massive so there should be economies of scale and preliminary work indicates that there should be 88-90 per cent recoveries. The company is well-funded with more cash to come in as warrants and options are exercised. Also, it is in British Columbia, which is a very friendly and safe mining jurisdiction and there are producing mines and infrastructure with grid power and road access nearby. Annual production could be in the region of 150,000 ounces with a life of over 15 years.
Ian Watson, who was previously chairman of Galahad Gold, joined the board in September 2009, followed by the appointment in February 2010 of Dale Corman of Western Copper. I have participated in several financings and bought shares in the market. Together with my family I now own 5.8 per cent of the company together with warrants on a further 5.3m shares. I should also declare that I have a £4m investment in Junior Mining Fund, which has substantial core holdings in both Norseman and Spanish Mountain.
As you can see, Norseman and Spanish Mountain have many attractive features. However, the key point is that they both possess one outstanding financial attribute that is way out of line with the average of their peer group. Norseman has a very attractive potential future price-to-cash flow and Spanish Mountain has a low cost per ounce of gold in the ground in relation to its market capitalisation. As these very out-of-line features are corrected by the market, their share prices should be driven upwards. Meanwhile, they provide comfort and protection on the downside.
