Commentary: How to pick a stock

When I hear about a stock, I have a quick checklist that I use to determine if I am going to spend time researching it. This simple checklist is not comprehensive, but it is a good way to filter out stocks that you don’t want to own. Once you memorize this list, you can listen to interviews from mining company CEOs, and know what to listen for.

1) Flagship Property – The company must have at least a potential flagship property for 2 million oz. gold, or 40 million oz. silver. This is the most important criterion for picking stocks. All of your mistakes are going to be from companies who do not find flagship properties.

2) Market Cap – The lower the better, but it should be under $1 billion. After you find a company with a flagship property (or potential flagship property), you want it to have upside potential. The sweet spot is going to be around US$150 million market capitalization, but these are not easy to find.

3) Share Structure – I prefer less than 100 million fully diluted. Avoid structures over 250 million shares, because the share price will not have explosive potential to rise.

4) People – I prefer management teams with good reputations who are investor friendly. This isn’t as important for low-cap companies. For these companies, you just want good drill results. Avoid companies that are constantly diluting the share structure. Check the news releases on their company web page.

5) Location – I prefer locations that are mining friendly, and in a district that has infrastructure. No infrastructure can mean years until production begins. Excessive political risks should be avoided, such as those present in Venezuela or Bolivia.

6) Growth prospects – Does the company own additional projects besides its flagship property? Are they planning to increase production or increase reserves? These factors can be very positive for a stock. 

7) Good buzz – Do other investors like it? Does it have good trading volume? Does the stock price rise consistently with the gold price? Has the stock price outperformed its peers and reflected investor interest?

8) Cost structure – Ideally, you want companies that have a low cost structure. However, most companies fall into the moderate cost-structure category. The companies you want to avoid are those with high costs.

An easy way to determine the cost structure is to divide the company’s cost per ounce by the price of gold or silver. If it
is near one-third, it is low-cost. Conversely, if it is near two-thirds, it is high-cost. Gold today is at US$1,500 and costs under US$500 are low. Conversely, costs over US$1,000 are high. 

9) Cash or Debt – If a company has cash in the bank and no debt, this reduces the likelihood of dilution, and it increases the possibility of exploration. 

10) Low valuation – Use the simple formula of “Market Cap / Reserve oz.” For gold mines, you want the reserves to be valued under US$50 per oz. For silver, aim for around US$1 per oz. You can project the current market cap against expected future reserves to arrive at these low valuations.

In addition to this valuation, I use a spreadsheet to forecast potential market cap growth. I forecast potential future reserves and then use a future gold or silver price, which I multiply by 20%. This is my theoretical future market cap. Lastly, I divide the current market cap by the theoretical future market cap and arrive at potential market cap growth. 

Using this theoretical market cap growth, I give the company a rating (see below). Currently, I only invest in companies that have a rating of 3 or higher, which is at least a potential 5 bagger. Thus, the theoretical growth must be at least 400% or higher. Many companies today have theoretical market cap growth rates above 1,000%. However, I do not give these companies five-star ratings unless all of the other nine factors are positive. 

Rating Defined Rating

1 Lowest Rating

1.5 Potential 2 Bagger

2 Potential 3 Bagger

2.5 Likely 3 Bagger

3 Potential 5 Bagger

3.5 Likely 5 Bagger

4 Potential 10 Bagger

4.5 Likely 7-8 Bagger

5 Likely 10 bagger

Let’s do a rating of Canadian Zinc to show you how this works:

• Current market cap, fully diluted: US$168 million
• Projected future reserves: 80 million oz.
• Projected silver price: US$100 per oz.
• 80,000,000 x US$100 x 0.20 = US$1.6 billion projected future market cap
• (US$1.6 billion – US$168 million) / US$168 million = 850%

The theoretical market cap growth is 850%, or close to a 9 bagger.

However, I gave them a rating of 3.5 because the company is permitted for 1,000 tons per day, and it will take several years to ramp-up production. Also, production will not begin until 2013 or 2014, and that adds risk.

You have to use your judgment on what you think a company can achieve. If it planned to produce 6 million oz. by 2015, I would rate the company higher. 

– The preceding is an edited excerpt from Don Durrett’s 238-page book entitled “How to Invest in Gold and Silver: A Complete Guide from an Investor’s Viewpoint,” which was published by ECKO House Publishing in November 2010, and is available at www.amazon.com.