Part III of III: Picking Mining Stocks in a Bear Market

In the first part of this three-part series, I discussed the importance of cycles such as four-year presidential elections and the life of a gold mine, and how they play into our investment strategy here at U.S. Global Investors. Part II dealt with statistical diagnostic tools, in which I strived to simplify the definitions of standard deviation and mean reversion and explain how they’re applied.

The third part of this series on managing expectations is devoted to fundamental resource stock evaluation. I’ll discuss some of the statistical tools we use to pick quality stocks during a treacherous bear market, such as what we’ve seen in gold stocks the last three years

Let it be known, however, that, though our approach might vary slightly depending on the condition of the market, we fervently seek to pick the best stocks at the best price and execution.

How I Learned to Respect the Bear

The traditional definition of a bear market is when broad stock market indices fall more than 20 percent from a previous high—which sounds like a catastrophe, but is in fact “normal” market behavior. According to self-professed “investing nut” Ryan Barnes, a contributor for Investopedia, “bear markets… are a natural way to regulate the occasional imbalances that sprout up between corporate earnings, consumer demand and combined legislative and regulatory changes in the marketplace.”

"No need for alarm, folks. This is all part of the natural order of things."

Think of bear markets, then, as the gradual transition from warm summers into frozen winters. Trees lose their leaves, snow and ice blanket the ground, many animals-the bear the most notable-hibernate for the season. All life seems to take a breather. But just as you can always count on spring to emerge and, with it, new life, you as an investor can count on the market to rebound with fresh vigor.

As you might have known, the tail end of "winter" is when you want to take part in the inevitable recovery. If the market never had a winter season, if it were perpetually trapped in an endless summer, investors would be hard-pressed to find an ideal entry point.

It's easy to determine when winter becomes spring. But what about the end of a bear market? How do you know when it's bottomed and the optimal buying time has been reached?

CLSA consultant Russell Napier, in his now-classic 2009 book Anatomy of the Bear, describes the determinants of the end of a bear market:

"The bottom is preceded by a period in which the market declines on low volumes and rises on high volumes. The end of a bear market is characterized by a final slump of prices on low trading volumes. Confirmation that the bear trend is over will be rising volumes at the new higher levels after the first rebound in equity prices."

Look at the chart below. You'll see that, in three decades, the Philadelphia Gold & Silver Index (XAU) has never had a losing streak for more than three years.

In 30 Years, the XAU Never Experienced a Losing Streak of More Than 3 Years
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Historical precedent suggests that gold stocks were due for a jump in 2014, and just as expected, the XAU has returned close to 20 percent year-to-date (YTD) after an abysmal 2013.

2014 Sees Improved Gains in recious Metals Mining Stocks
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As you might remember from our discussion last week, what we see here is an example of mean reversion, which occurs when the price of a security reverts back to its historic average.

These data exemplify the notion that you should remain patient during downturns, avoid getting discouraged and allow the security-in this case, precious metal stocks-to revert back to its long-term mean. When it does, you'll find that the wind is suddenly at your back rather than in your face.

Spencer Johnson, author of the 2009 book Peaks and Valleys: Making Good And Bad Times Work For You-At Work And In Life, writes, "You cannot always control external events, but you can control your personal peaks and valleys by what you believe and what you do." Likewise, we might not have any control over how the market behaves, but we can control how we respond to it: with grace, intelligence and levelheadedness.

Value Drivers for Superior Performance

Just the facts, ma'am

One of the tools we use to navigate around volatility, regulate emotion and focus on facts and fundamentals is an invaluable model we call the portfolio manager's cube. It helps us separate the weak from the strong, evaluate a company's attractiveness and pick the best GARP-y stocks.

"GARP" stands for "growth at a reasonable price," which is an investment strategy that aims to identify companies with superior growth and value metrics.

The cube allows us to sift, sort and prioritize. It draws attention to the intersections among a resource company's production, cash flow and reserves (rows) and relative value, momentum and event drivers (columns). Using this model, we compare stocks on a relative basis in production per share to find attractive opportunities and overpriced risks. We also identify events that could increase reserves and/or production per share over the next 12 months.

More than anything else, the cube affords us the framework for conducting relative valuation of a stock. Relative valuation is a method that compares a security's value to that of others to determine its financial worth.

For example, we evaluate mining stocks in the same way you or I might compare cars on many metrics before making a purchase. On this topic, I urge you to check out one of my favorite websites, Dennis Boyko's GoldMinerPulse, for a look at the type of fundamental analysis and relative evaluation that goes into comparing and contrasting mining stocks.

The following is an example of how we might use the cube. Suppose a young mining company has just discovered a gold deposit. This event might excite potential investors and compel them to enter when the stock is undervalued, expecting it to skyrocket. But it's important to conduct a cross-sectional analysis of this discovery in terms of production, cash flow and reserves. How much gold does the company expect to produce in relation to others? The average concentration of gold in the earth's crust is 0.005 parts per million, making a substantial yield very rare. About one in 2,000 companies is lucky enough to stumble across at least a one-million-ounce deposit.

Other questions might include: Does the company have ample cash flow to finance the costly yet necessary infrastructure, equipment, geological analyses and manpower to extract the metal, not to mention pay dividends? Has it kept up with its cash reserves to remain solvent during development of the mine and subsequent excavation? Many years, after all, typically go by before ounce one is plucked from the ground.

Besides using models such as the portfolio manager's cube to determine a mining company's or asset's relative value, we also rely on "boots on the ground" experience. Members of our investment team and I routinely visit domestic and global projects to gain tacit knowledge and ensure that operations are running smoothly and management is knowledgeable and has a firm handle on things.

The Five Ms

A mine's lifecycle is the perfect segue into what I call the five Ms to picking the best mines. Most of what follows can be found in the book I co-wrote with John Katz, The Goldwatcher: Demystifying Gold Investment.

One of the five Ms is Mine Lifecycle, which I covered at length in Part I of this series along with other cycles such as weather patterns, gold seasonality trends and four-year presidential cycles.

The Life Cycle of a Mine
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The other four include Market Cap, Management, Money and Minerals, covered in detail below.

Market Cap

Market cap is simply the number of shares outstanding multiplied by the stock price. The gold sector is broken down into three sectors by market cap: seniors (market caps >$10 billion), intermediates (between $2 and $10 billion) and juniors ($2 billion).

If a gold company has 10 million shares outstanding at $1 per share, the company is valued at $10 million. The question any investor should ask is, "Is this company really worth $10 million?" If the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (one million ounces in reserves X $25 an ounce). If the company's market cap is only $10 million, it may look undervalued. Accordingly, if the company's market cap is $50 million, it may appear to be overvalued.

For larger gold companies, an investor can measure a company's market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation. For junior mining companies-an area of focus for our World Precious Minerals Fund (UNWPX)-we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.


Essentially, management of mining companies must have both explicit and tacit knowledge to be successful. Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?

Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?

Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors. Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.

Some of the most successful company builders in the gold-mining industry are what I call the "financial engineers"-people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.


Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow. A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis.

We call this the "burn rate"-how long will the company's current cash levels last before it has to return for additional financing. If a junior exploration company has $15 million in cash reserves and is spending $3 million a month, it has five months to deliver enough reserves per share to convince capital markets it is worth the risk.

This calculation can be done quickly. Exploration reserves are generally valued at one-third the reserve values of a producing mine-if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce.

The gold-equities market is generally efficient at judging reserves per share, so if the exploration company doesn't come up with the results necessary to get an evaluation-find gold for less than $50 an ounce-investors quickly lose confidence. There is an old rule when it comes to exploration companies: don't pay more than two times cash per share if there are no proven assets in the ground.


Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share. Companies operating mines that produce gold as well as industrial metals tend to have lower valuation multiples. Investors can use the low relative valuations of copper/gold producers to increase their margin of safety in anticipation of an upward move in gold prices.

I must stress once again that these relative valuation techniques apply whether we're in a bull or bear market. In Peaks and Valleys, Spencer writes, "Have you ever noticed that your life is filled with ups and downs? It is never all ups or downs."

Similarly, the market is never all ups and downs. As active money managers, we have learned to adapt to an ever-changing climate-from "summer" to "winter"-to select what we believe are the best, most reasonably-priced mining stocks for our investors.

Next week, look out for my discussion on how our investment team uses statistical tools to make trades around core positions.

Happy investing!

Further resources on active management of resource stocks:

For more on my unique approach to active management, listen to my interview with Frank Curzio of S&A Investor Radio.

Also be sure to watch the latest edition of Kitco News, in which Daniela Cambone and I chat about what's in store for gold in the coming weeks.


Index Summary

  • Major market indices finished higher this week.  The Dow Jones Industrial Average rose 2.03 percent. The S&P 500 Index gained 1.71 percent, while the Nasdaq Composite advanced 1.65 percent. The Russell 2000 small capitalization index rose 1.64 percent this week.
  • The Hang Seng Composite advanced 0.45 percent; Taiwan rose 1.88 percent and the KOSPI declined 0.32 percent.
  • The 10-year Treasury bond yield rose six basis points to 2.40 percent.



Domestic Equity Market

The S&P 500 Index rose to new highs this week. The market seems to be in a “Goldilocks” zone, as the global economy is not so hot that the Federal Reserve and other global central bankers feel compelled to raise interest rates, and the U.S. economy is not too cold to warrant significant concerns about earnings growth. Currently we are in that “just right” zone where the status quo remains and investors are comfortable with the situation.

S&P 500 Economic Sectors
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  • The industrial sector outperformed this week after underperforming for most of the year. Virtually every stock in the sector was positive, but airline stocks had a particularly good week as oil prices fell and underlying business demand remained robust.
  • The financial sector was also very strong with broad-based participation in the rally. Bank of America was the best performer in the sector as the company settled with the Department of Justice for $16.65 billion over mortgage-backed securities that relate back to the financial crisis. The market was relieved that the company could get past the issue.
  • Keurig Green Mountain was the best performer in the S&P 500 Index this week, rising 15.97 percent. The company rose sharply on Friday after announcing an agreement with Kraft Foods to offer Maxwell House, Yuban and McCafe to its home-brewing system.


  • The telecommunications services sector was the worst performer this week as both AT&T and Verizon fell on increasing pricing pressure in the industry.   
  • In an otherwise strong week, some commodity-related groups underperformed including gold, agricultural products, fertilizers and paper products.
  • Monster Beverage was the worst performer in the S&P 500 Index this week, falling by 7.63 percent. The company rose 30 percent last week on the announcement that Coca-Cola was buying a 17-percent stake. This week’s price action looks like normal profit taking after such a big jump.


  • Earnings season has run its course so the market will now shift attention to macro items which look likely to maintain the status quo as well as the market’s upward bias.
  • The U.S. economy is currently a bright spot in the developed world; a hopeful sign that could funnel money back into the U.S. equity market.
  • The path of least resistance for the market appears higher. This classis bull market phase of grinding higher with lower volatility remains intact for now.


  • Volatility has been remarkably low in this bull market as we experience an abnormally smooth ride. The calm won’t last forever though, while late-summer early-fall has traditionally been more volatile.   
  • The market could begin to worry about a policy mistake from the Fed, either raising interest rates too soon or not fast enough. Either scenario could negatively impact the market.
  • Geopolitical tensions remain high and while the market has been able to shrug off these events so far, an escalation could be the catalyst for a long-awaited correction. 
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The Economy and Bond Market

Treasury yields shifted higher this week as better U.S. economic data, along with more hawkish-than-expected Fed minutes from the last Federal Open Market Committee (FOMC) meeting, prompted investors to think that interest rate hikes may come sooner than many expected. The short end of the yield curve, which is most sensitive to changes in the Fed Funds rate cycle, saw most of the action with two-year treasury yields rising by 8 basis points.

U.S. Housing Startss Jump in July
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  • Housing data came in much better-than-expected. July housing starts rose more than 15 percent and hit the highest level so far this year, as can be seen in the chart above.
  • Other housing data was also positive. July building permits rose 8.1 percent, existing home sales rose 2.4 percent and we’ve seen an improvement in home builder confidence during August.
  • The Conference Board’s index of U.S. leading indicators rose 0.9 percent in July, and is at the highest level since 2007. This bodes well for continued economic expansion in the months ahead.


  • Global flash purchasing managers’ index (PMI) numbers were released this week, with Europe and China posting disappointing results. Generally speaking, Europe is at risk of falling back into recession and the China data was a negative surprise.
  • China housing prices declined 0.9 percent in July, making it the third-straight month of declines and raising warning flags about China’s growth prospects.
  • The Bloomberg Consumer Comfort Index hit a three-month low as consumers’ outlooks dimmed.


  • Geopolitical tensions remain elevated with war in Gaza, war in Ukraine and an increasingly unstable Middle East. Bonds could benefit from a flight to safety in this environment. 
  • European data has been weaker-than-expected and talk of additional European Central Bank (ECB) action increasing is not only taking European yields lower, it is also dragging U.S. yields with them.
  • With key global central banks back into easing-policy mode, and inflation trending lower in many parts of the world, the path of least resistance for bond yields should remain down.


  • The U.S. economy has positive momentum and appears poised to continue building on that as we move into the fall. Recent indications from some Fed officials point to the potential for higher interest rates sooner than many were expecting.
  • Economic data has been strong lately with more housing data being released next week. The potential exists for more market nervousness regarding the Fed’s eventual timeline for an interest rate increase.  
  • Several Fed speakers have become more vocal in recent weeks, indicating a potential shift in Fed thinking toward normalizing interest rates.

Gold Market

For the week, spot gold closed at $1,280.08, down $24.75 per ounce, or -1.90 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 3.08 percent. The U.S. Trade-Weighted Dollar Index rose 1.08 percent for the week.

Date Event Survey Actual Prior
Aug 19 U.S. CPI YoY 2.0% 2.0% 2.1%
Aug 19 U.S. Housing Starts 965K 945K 893K
Aug 20 HSBC China Manufacturing 51.5 50.3 51.7
Aug 21 U.S. Initial Jobless Claims 303K 312K 311K
Aug 26 U.S. New Home Sales 430K - 406K
Aug 28 Germany CPI YoY 0.8% - 0.8%
Aug 28 U.S. Initial Jobless Claims 300K - 298K
Aug 29 Eurozone Core Inflation YoY 0.8% - 0.8%


  • Orex Minerals announced this week that its investment partner, Fresnillo PLC, is optioning to proceed to the Second Investment Option stage on the Coneto Gold-Silver Project in Durango, Mexico. Evidently, Fresnillo likes what they are finding so far.
  • The Chicago Mercantile Exchange lowered its initial margin requirements this week for gold, silver, platinum and palladium after prices fell after the release of the Fed minutes.
  • Persisting geopolitical risks and low bond yields have continued to push investors toward gold exchange traded funds (ETFs), which have seen the largest inflows in nearly two years.


  • Deflationary pressures continue to plague the global economy. Both food and energy prices have been significantly depressed over the past few weeks. Even in the U.S. where strong signs of economic recovery exist, the producer price index (PPI) increased just 0.1 percent month-over-month in July and just 0.2 percent year-over-year. Persistent deflation seeks to reduce gold’s attractiveness as an inflation hedge.
  • The release of the Fed minutes this week resulted in a gold sell off on Thursday. The hawkish tone taken by the Fed fueled worries that a rate increase may come sooner than expected. 
  • Mexico’s federal environmental protection regulator filed charges against Grupo Mexico’s Buenavista del Cobre and Miner Mexico after a leakage caused by construction defects contaminated two rivers, leaving thousands without drinking water. The fine for the Bueneavista copper mine spill could reach $3 million, according to Mexico’s environmental secretary.


  • China has permitted three more banks to import gold. Standard Chartered, Shanghai Pudong Development Bank and China Merchants Bank were all given regulatory approval to import gold, according to Reuters. The news strengthens the opportunity for higher Chinese gold imports in the future.
  • Despite weak Indian gold imports in the first half of the year, demand in the second half is expected to be stronger due to the majority of the Indian holiday season falling during this time period. A significant amount of prizes used during these holiday festivals contain gold such as gold pots, coins and other decorations.
  • Shanghai is planning to implement a gold free-trade zone. On September 26, the Shanghai Stock Exchange is expected to start bullion trading in the city’s free-trade zone, confirming the idea that Shanghai is determined to become a regional gold-trading hub. Xu Luode, the exchange’s chairman, said that the gold contract will be priced and settled in yuan and trading should begin in the third quarter.


  • As the dollar continues to strengthen, the cost to insure against emerging market currencies is on the rise. According to data from Bloomberg, the costs of options contracts betting on a decline in the currencies of Brazil, Indonesia, South Africa, Turkey and India, have risen to their highest level in roughly five months. A stronger dollar has already started creating headwinds for gold, which typically moves inversely with the dollar. The subsequent decline in emerging market currencies would only serve to strengthen the dollar further on a relative basis.
  • After the release of the Fed minutes, sell stops were triggered against leveraged investors. However, this dumping of gold onto the market occurred in the late hours of the night, revealing that this sell tactic is still very much in use. This purposeful trading pattern to gap prices down in the middle of the night is one we have seen repeatedly since the Fed has started to reel in quantitative easing.
  • World demand for gold shrank 7.2 percent in the first half of the year, compared to the period a year earlier. In India, demand for gold fell 39 percent in the quarter ended June 2014, according to the World Gold Council. If there is no trend reversal in the demand for gold, the second half of 2014 could see significant headwinds.



Energy and Natural Resources Market

Increasing Requirements for Cars in China
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  • Canadian energy stocks rebounded on strengthening natural gas prices. Furthermore, Bellatrix Exploration gained 12 percent on the news that activist shareholders took a position in the company in an attempt to create shareholder value in the face of lagging performance.
  • Rail stocks made new highs this week on strong volume growth, particularly from crude oil and pricing. Union Pacific gained roughly 4 percent on the week.
  • Oil refining and marketing equities continue to advance on wider gulf coast margins.  Valero Energy and Marathon Petroleum both gained 3 and 1.5 percent, respectively.


  • Despite rising geopolitical concerns, the price of gold closed below $1,300 this week due to a strengthening U.S. dollar and the news that the Fed may raise rates sooner than expected.  Franco Nevada and Royal Gold lost an average of 4 percent on the week.
  • Base metal stocks lost momentum this week on news of weaker-than-expected global PMI numbers.  Lundin Mining declined 2.6 percent.
  • Small-capitalization resources stocks continue to lag large-cap stocks.  The S&P/TSX Venture Index trailed the S&P Global Natural Resource Index by 70 basis points.


  • BHP Billiton announced that it is planning on forming a new global metals and mining company. The company, aimed at creating a simpler portfolio, will base the company around its aluminum, coal, manganese, nickel and silver assets. CEO Andrew Mackenzie reported that the company is targeting gains of $3.5 billion per year by the end of 2017.
  • Apache announced the largest discovery in 20 years in the Canning Basin. Off the coast of Western Australia, the basin is reported to hold as many as 300 million barrels of oil. Apache officially holds a 40-percent stake in the area.
  • North American energy investment appears poised to take off. A variety of factors from lower natural gas prices to higher light sweet crude production are turning investors’ eyes to the productive capabilities of the region. IHS projects that total spending on oil and gas infrastructure alone will reach $890 billion over the next 12 years.


  • Weak manufacturing data out of China has caused concerns that global production may be slowing. Coming in at 50.3 compared to 51.7 previously, the HSBC China Manufacturing PMI could create headwinds for commodities moving forward.
  • The heatwave seen this week may be short lived, as analysts forecast cooler weather moving forward. Lower-than-normal temperatures would revive headwinds for natural gas prices, which had recently started to show signs of life.

Emerging Markets


  • Emerging market equity inflows were increased from the prior week, with Greece, China, and India leading the way. Greece outperformed this week as the government reported stronger current account numbers on Wednesday. The surge in inflows is a significant turnaround given recent global economic events.
  • Health care was the best performing sector in emerging markets this week, driven by Chinese pharmaceutical companies which outperformed in sympathy with the U.S. pharmaceutical and biotechnology rally and ahead of earnings announcements from local industry leaders next week. 
  • For a fourth-consecutive week, equity fund inflows to China ranked the largest within emerging markets both in absolute amount and relative to assets under management.  Inflows accelerated to $1.4 billion for the week ending Wednesday, August 20 from $0.53 billion for the previous week. 


  • Ukraine continues to be weakened by the geopolitical conflict with Russia. On Friday, the government reported that Russia, hiding under the disguise of aid, is actually invading Ukraine. The hryvnia saw its fifth-weekly depreciation, while Ukraine stocks declined on Friday.
  • Technology was the worst-performing sector in emerging markets this week, led by Taiwanese LED manufacturers as TV backlight orders, primarily from South Korea, started to trend down in August, raising investor concerns over possible TV supply chain destocking.  
  • Consumer goods was among the worst-performing sectors in Hong Kong this week, as Biostime International, the infant nutrition maker, declined more than 20 percent over five trading days after announcing disappointing results for the first half and receiving multiple broker downgrades.


  • Brazil announced this week that it is adopting measures to expand liquidity in order to boost economic growth. The central bank reduced bank reserve requirements by $4.4 billion and eliminated measures restricting bank lending, freeing up another $6.6 billion for loans. The monetary expansion will be combined with the $20.2 billion added in July.
  • Stronger economic data coming out of the U.S. should spur growth in emerging markets. Countries with significant exports to the United States should seek to benefit from the solid economic recovery taking place in the U.S.
  •  Despite the recent rally, Chinese property developers are still trading at below-average valuations going back eight years.  The much-lower-than-expected flash PMI released on Thursday, coupled with disappointing macroeconomic data for July published the previous week, should alert Chinese authorities against policy mistakes for the rest of the year, given the negative ripple effect on overall economic activity from ongoing anemia in the physical property market.

Chinese Property Developers Still Trading at Attractive Valuations
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  • Norway reported that its $880 billion sovereign wealth fund will be slowing a two-year effort to invest in emerging markets. This news comes after China reported much weaker than expected manufacturing data and the slightly more hawkish Fed minutes. Emerging markets ended their eight-day rally on the news from China and the U.S.
  •  Russian Deputy Prime Minister Arkady Dvorkovich, in an effort to appease Russian oil producers, chose the lesser of two oil output tax rates. The effect of this policy decision is a substantial decline in oil revenue for Russia. Oil taxes provide roughly 45 percent of the country’s budget revenue and the new policy will cause Russia to lose as much as $6.7 billion of that revenue next year.
  •  Since the Second-Child policy was approved in China earlier this year, eligible couples have been slow to embrace looser restrictions, based on provincial statistics.  The growth prospect of China’s mass consumer sector such as infant foods and diapers has significantly diminished due to structural migration to e-commerce and rising competition to name brands.

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