Commentary: How to pick gold stocks in a falling gold price environment

BMO Capital Markets’ recent report entitled “Flight to Quality” is perfectly timed for investors who have had their emotions roiled by the latest downswing in the gold price.

The report is geared towards investors who, while not blind to the current headwind the gold market is facing, still believe that there is exceptional value on the equity side of the market.

BMO offers some sound advice on how best to navigate the difficult times.

The central theme to the report is that investors, now more than ever, need to be extra cognizant and careful as they select the highest-quality stocks. To aid in the process the report suggests three trading strategies.

The first is to reduce exposure to those higher-risk stocks that the market continues to punish. Such perceived risks being harshly discounted include technical, financial, permitting and sovereign risk, as well as volatility and consensus surprise factors.

The second strategy is to move into better-value stocks that don’t come with higher risk. This can be achieved through pair trades, where the investor goes long in the stock with better value while going short in the stock with higher risk. The key metric the report uses to identify value stocks is the price to net present value (P/NPV), with a lower ratio, relative to peers, indicating good value.

The last trading technique advised is to avoid potential value traps. A value trap is when an investor purchases what is perceived to be a good value based on metrics, such as a low P/NPV, only to have the stock languish due to other risks. To assess such risks, BMO compared perceived risk against project free cash flows from a given company for the 2013 to 2015 period.

Unfortunately for value investors, since the market has been rewarding companies that do a good job of mitigating risk, there are no names that BMO would classify as being in the low risk and great value (low P/NPV) category.

Within BMO’s research universe of 142 stocks, the best a value investor can do is target a company in the medium P/NPV value range with corresponding low risk. Names in this category include: Barrick Gold, Goldcorp, Newcrest Mining, Silver Wheaton, Yamana Gold and Randgold Resources.

One of the reasons that such companies may be in the medium P/NPV range is because they have more risk than companies in the high P/NPV range. Companies that are in this higher range (with the higher ratio being driven by a higher price, which can be seen as a reward for having less risk) include: Franco-Nevada, Newmont Mining, First Majestic Silver and Agnico Eagle Mines.

Gold companies with higher perceived risk and a low P/NPV ratio include: Gabriel Resources, International Tower Hill Mines, Midas Gold, Centamin Egypt, Minco Silver, Orezone Gold, Romarco Minerals, Sabina Gold & Silver and Victoria Gold. This would imply that the market has been punishing these stocks for carrying higher risk. 

It is important to emphasize that the mining stocks mentioned in the report are only from BMO’s research universe of 142 stocks. So when the report picks the three best-quality stocks, it is doing so relative to the stocks in that research universe, not the entire industry.

Moving on to potential “value traps” that investors should be wary of, the report highlights Gabriel Resources, International Tower Hill Mines and Midas Gold. While such stocks do have low P/NPV ratios, investors may not realize that value due to significant permitting risks.

“Gabriel Resources, International Tower Hill Mines and Midas Gold appear as high-risk and low P/NPV stocks with potential of remaining a ‘value trap,’ if the stocks fail to achieve de-risking milestones over the next year,” the report reads.

But worse than value traps are companies that have perceived risk while being relatively expensive at the same time. The report points out Asanko Gold, Allied Nevada Gold and Exeter Resource as such examples.

“There do not appear to be any compelling reasons to invest in the high-risk medium price to NPV stocks,” the report reads.
But what of companies transitioning into cash flow-positive producers? Predictably, the report points out that the move into free cash flow is a significant de-risk milestone. The trick, however, is trying to find companies that truly fall into this category.

“Amongst the developer stocks, only Aureus Mining, Rubicon Minerals and Tahoe Resources display positive free cash flow from 2013 to 2015, as the projects transition to production and from consuming cash to generating cash,” the report reads.

Whatever strategy an investor may go with, the report argues that doing proper risk and value analysis to select the correct stocks will yield better results than “simply pursuing a broad move in commodity prices.”