Our Mining Stocks & An Introduction to Investing in Mining

May 2010 investment report for the South America Focus model portfolio at Covestor®

This is a monthly investment report for the South America Focus managed portfolio at Covestor. A description of this stock portfolio is also available at SimpleStockInvesting.com, as well as some other reports. You may read the latest at CVIM, if you open an account with them.

Recent performance

APRIL 24, 2010 — South American markets had a moderate performance this month (as of this writing, on April 24) with some early strength being offset by a small “flight to quality” that was triggered by Greek-debt developments and the Goldman Sachs lawsuit. Even though it was not severe, this flight to quality was probably the reason for Chilean and Brazilian markets underperforming US benchmarks once again. Exceptions were Peru, which more-or-less matched US markets, and gold miners, which did a bit better. These gave some strength to our portfolio, more so if we add dividends that are not yet reported on the CVIM profile page because they are still to be credited to the accounts. But it was not enough to overcome the relative weakness of our main markets this month.

Our mining stock

Gold miners gave the better note, driven by rising metal prices. We currently have 24% of our portfolio in mining stock, diversified among market caps, metals (not only precious ones) and different production stages. Our allocation at inception (on December 7, 2009) was 20%, I gradually increased it due to what I interpreted as an improving outlook, but I am not planning to enlarge this portion much, no matter how optimistic I am about the sector, so as to maintain a good level of diversification. After all, there are other opportunities for profit in South America and this is not a high-risk model.

These miners produce so-called “industrial” and “precious” metals, although all of the latter have industrial uses too. The largest company is Brazilian giant Vale (VALE), with a market capitalization of 168 billion, producer of a series of industrial metals with a focus in iron ore. The second largest is Silver Standard Resources (SSRI), mainly a silver and gold play with a market cap of 1.5 billion, that is transitioning from exploration company to producer. We also have stock from two smaller exploration companies: Exeter Resources (XRA), with a market cap of 585 million and a gold and copper project in Chile, and our latest purchase, micro-cap Solitario Exploration & Royalty (XPL), with exploration projects in Peru, Mexico and Brazil, in zinc, gold, silver, platinum and palladium.

Investing in mining

Mining is an interesting business to analyze, as it mixes several disciplines, starting with the economics used for estimating future ore prices. Industrial metals have recovered pretty much since the crisis, driven by Chinese and Indian demand. Besides, the crisis slowed down the production increase that would normally accompany such a secular trend in demand. If Chinese and Indian purchases dip, and they are not replaced by a recovery of the developed nations, then metal prices will suffer, but this scenario does not seem likely, at least not for the short-to-mid term.

The outlook for precious metals has another ingredient, because they are also used as store of value. I am bullish about them for the long term, as global monetary reserves will probably increase significantly. Moreover, there is a trend towards diversifying reserves with greater allocations in gold, silver and platinum, because emerging nations have only a small percentage of their reserves in these hard assets, and the appeal of currencies and bonds of developed nations has diminished with the deterioration of their finances. Nevertheless, for the rest of 2010, there are reasons to believe that this bullish forecast, correct or not, may remain on hold. The IMF is still selling gold, and the crisis has slowed down jewelry sales and increased the supply that comes from old jewelry stocks. Still, if the markets act in anticipation, gold price may rise. But if they wait, it might reduce. Therefore, I believe a gold price of $1300/oz to be about as likely as $1050/oz for the rest of 2010. This range seems to be more than enough for the advanced mining projects in our holdings, and if prices improve in 2011 and beyond, much better.

Small map of South America
Image courtesy of NASA

Let's continue with the disciplines involved in mining valuation. Secondly, there is a forecast of geological and mining-engineering factors in the company's properties, such as the amount of metal-bearing rock in them, the percentage of metal (i.e., “grade”) contained in this rock, the cost of mining this rock and extracting the metal, plus the chance of securing the water, power and permits that are needed. Here again the numbers are not completely certain until only after the metal is sold. What we have throughout the project are estimates, that go through a progressive “de-risking” as exploratory drilling and various other studies are advanced. Their results are summarized in regulated technical reports, that offer some certainty to investors like us.

There is a third element, a financial one, that most of all affects smaller companies (the so-called junior miners, or junior explorers, which are small and micro-cap exploration companies like Exeter and Solitario). Their projects may have great potential, but if they run out of money when their stock is cheap, they may be forced to issue a great amount of shares, diluting the value held by their current shareholders. One thing that I like about Solitario is that they have a business model where their projects are usually financed by larger partners, so they rarely issue new shares. This way, they significantly alleviate what is one of the main risks for junior-explorer investors.

Junior-explorer stocks are generally rather inefficient, which creates an opportunity for small investors doing their homework. Large companies with liquid shares, such as Vale, are constantly being studied by many experts, that analyze the factors mentioned above and buy shares when they find them to be too cheap, or sell them when they find them too expensive. Buying induces a price increase, and selling induces a reduction, so these effects compensate the hypothetical mispricing. Therefore, shares of Vale are reasonably priced more frequently than those that can't be as easily bought and sold in large quantities. Large investment pools would need to offer considerable premiums to buy stock from, for example, Solitario, in amounts that are meaningful to them. Thus, they seldom bother to analyze these small companies. If they do, they can't easily get out of the position and into it again. The consequence is that the price of less-liquid stock is left more in the hands of retail investors, and that is why stock such as XRA and XPL are frequently mispriced.

Moreover, I think it is a good time to invest in junior explorers, as long as we select companies carefully (for this reason, I would not invest in them through a passive fund like GDXJ). In normal times, it is a difficult business to invest in, but nowadays I think there is an opportunity, due to a general risk aversion that may have been caused by the large losses suffered during the recent crisis, when metal prices sunk and it became difficult for these companies to raise funds and sustain operations. Still, doing the homework and buying when the sector is out of favor doesn't eliminate the high risk of the junior-explorer class, so I am investing in them with caution, allocating no more than a limited portion of our portfolio (9.2% currently).

Once again I wrote a long report, but I hope it is useful as an introduction to this business that comprises approximately a fourth of our portfolio. I will return to mining on future reports. I wish you have a pleasant May, thank you for your interest in this model.


You can auto trade this portfolio with Covestor Investment Management. Click here to find out how.

«  April 2010 report  |  More-recent reports at Covestor Investment Mgmt  »