Stop Hating on Gold Miners

It’s no secret at this point that gold miners are going through a rough patch.

After gold’s recent routing, firms that dig the precious metal out of the ground have fallen by the wayside, and they continue to drift lower as labor issues and political problems have raised production costs to reduce margins. Some smaller miners have even crossed the critical “marginal cost of production” line, deeming many projects unprofitable.

Given the various headwinds, it’s easy to see why the inverse Direxion Daily Gold Miners Bear 3X Shares (NYSE:DUST) — which basically shorts the sector, with some leverage — has been one of the best performing investments of 2013.

Yet, given just how hated the gold miners are, you have wonder if the risk/reward spectrum is starting to move into investor’s favor.

After all, sometimes the best time to buy stocks is when nobody wants them.

The Trio of Woes Still Persist

As we reported before, miners are really starting to feel the pinch with regards to costs across several fronts. Many gold mining firms have experienced surging energy costs over the last few years — to the tune of 500% for diesel fuel and 20% for electricity. Meanwhile, wages for mine labor, higher royalty rates and growing resource nationalization have also put the crimp on vital margins.

With spot gold prices now sitting in the $1,400 per ounce range, profitability at several of these firms have been absolutely destroyed. A prime example is industry stalwart Newmont Mining (NYSE:NEM). At the end of April, the mega-miner reported that earnings per share were 31% lower than they were in the year-ago period. As such, shares of the gold miner now sit at four-year lows as investors have run for the hills.

… But There Is Hope

Now that an industry leader is beginning to struggle (and as long as it’s clear that other miners are struggling similarly), why would anyone want to place their bets on the wounded sector?

It all comes down to cost controls and production stoppages.

Given that margins continue to be depressed, it seems like many in the gold mining industry are taking their cues from America’s natural gas producers. As hydraulic fracturing took hold across the nation, prices for the fuel plummeted last year and reached historic lows. When natural gas crossed below the $2 per MMBtu threshold, many producers were met with unprofitable wells. So what did they do? They stopped producing natural gas, idled wells and moved on to producing natural gas liquids and shale oil. Those efforts worked, and in time, prices for natural gas have risen.

Now, it looks like many of the gold miners are doing the same thing.

Already, some gold miners have announced plans to review their operations in light of these narrowed margins. Both Australian-based Newcrest Mining (OTC:NCMGY) and Silver Lake Resources (OTC:SVLKF) have put forth strategies to rein in production at several of their operations, while South Africa’s Gold Fields (NYSE:GFI) has announced plans to cut capex spending on exploration. Analysts expect that other miners — both large and small — will follow these firms’ lead and cut production at high cost mines over the next few months.

It stands to reason that falling global gold production will eventually drive up prices for the metal in the face of a rising demand picture. While many institutional investors have stopped buying gold, central bank buying hasn’t budged an inch. As nations like China, India and Russia have sought to diversify away from dollar- and euro-denominated assets, central bank gold buying has reached 50-year highs, according to the World Gold Council. It’s silly to think that China isn’t or won’t be “loading up the truck” if gold prices fall any more.

Then there is the sector’s “cheapness” to consider. The decline in metals and mining stocks has pushed their valuations down to attractive levels. After falling from a peak of 29.3 times estimated earnings back in September 2009, the MSCI World Materials Index currently can be had for a mere 14.1 multiple — just under 14.5 for the broader MSCI World Index. Meanwhile, gold is nowhere near as cheap as it was back in 2009.

Time to Buy?

As we’ve seen with the natural gas producers — and are starting to see with some of the coal miners — production cuts do help raise prices over time. And just like the natural gas producers and coal miners, the gold industry is going go through some pretty nasty growing pains over the next year or so. Remember that value investing is called time arbitrage for a reason.

Smaller junior miners could see themselves in pretty hot water as analysts at Canaccord Genuity estimate that more than 575 junior mining companies have less than $500,000 in cash and equivalents, according to their last reported balance sheets. That means if you want to play the potential value in the miners, you need to think big. We’re talking the Barricks (NYSE:ABX), Newmonts and Goldcorps (NYSE:GG) of the world as the potential shake-out starts.

Or better yet, since the NYSEArca Gold Bugs index — which tracks more than a dozen of the world’s largest gold companies — is down roughly 35% year-to-date, a bet on the popular Market Vectors Gold Miners ETF (NYSE:GDX) might be in order.

Just keep in mind that we’re in the first inning of a long ballgame, and it could take a while for this all to pan out. But if you have some free capital and are willing to take a longer-term view, the hated large-cap gold miners could be a bargain.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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