The Fundamentals of Mining Stocks: Separating Winners and Losers

mining stocksWith gold down and mining stocks failing to find funding, your inbox is probably as littered as mine with new and great gold opportunities (if you need a reminder about why you shouldn’t buy gold, just look here: Do Not Buy Gold!). Just the other day I received four emails about mining stocks worth a look.

While there are always respectable investments in any industry – even gold mining – there are a few things you should look out for, especially when it comes to mining stocks.

 

The Quality of Minerals

The dangerous thing about mining stocks is how willing they are to tout their findings. Not all findings are created equal, though – here’s a guide to understanding mineral quality.

  1. Inferred Mineral Resource – This is the most dangerous type of resource because it is unproven. It’s also the type of resource that mining stocks like to showcase to potential investors. An inferred mineral resource is one that comes from basic geological surveys, and which the company assumes to be true based on the lay of the land. The certainty surrounding inferred resources is as good as nothing. A company seeking funding will often have very high inferred resources, but little evidence to back up their claims. Inferred resources are uninvestable, unless you have some eyes on the ground that can verify the company’s findings or intentions. That’s the danger of inferred resources: they’re not worth much to people who can’t actually verify the numbers.
  2. Indicated Resources – Indicated resources are the second-worst and second-best. They come from estimates based on actual samples from the ground that the company intends to mine. There is some level of confidence in these estimates seeing as they come from samples, but samples are samples – who is to say that these samples weren’t derived from the very best part of a mining operation? Remember, a mining company wants to make their operations look as good as it can. Fudging the numbers on indicated resources is only slightly more difficult than fudging the numbers with inferred resources.
  3. Measured Resources – Measured resources are the most investable kind. Measured resources are found by using a geologist’s (ideally a third-party geologist’s) understanding of the mine and their own thoughtful analysis from their own samples. Measured resources can be measured with a very good degree of confidence as the sample selection is reasonable, and the assumptions are based on the actual samples obtained. When it comes to making an investment, measured resources are worth far, far more than inferred or indicated resources.

 

What’s a Mining Company Worth?

Mining stocks should be simple to value – they’re worth the present value of gold or silver (or other mineral) minus the mining cost necessary to bring it to the surface.

Unfortunately, junior miners are often in need of cash based solely on inferred resources, which are really just someone’s “best guess” of what happens to be in the ground at the time. Naturally, these numbers often come from the mining firm, and miners have plenty of incentive to inflate their numbers, just like a fisherman often tells the tale of a large catch in a nearby lake. Don’t bet on a stock promoters’ assumptions about what’s in the ground – they need to sell a stock, and nothing more.

Another important note is that small or junior mining companies typically have higher costs in starting and operating a mine compared to the big companies – the reason is simply scale.  Large companies can lower the cost per tonne mined simply due to lower overhead on equipment and already having a skilled labor force in place.  Smaller mine operators don’t have the same scale or experience, which can drive up costs significantly.

Having no other information about a mine than what it gives you is a dangerous position to be in.

 

Looking at the Big Mining Stocks

Let’s break it down and look at the biggest mining stocks when it comes to resources, costs, and profits.  Remember, you can value a company based on the present value of its mineral resources, so as commodity prices drop, so do the share prices of these companies.  What you typically want to look for is marketable product, sometimes called reserves or recoverable material.  Basically, the company looks at how much of each mineral it can recover from its mines, and presents it in tonnes.  Then, you can do the math based on the current commodity price (if you trust the math to begin with).  All of this information can be found in their company annual reports.

Rio Tinto (NYSE: RIO)

Rio Tinto miningRio Tinto is one of the largest and most diversified mining companies, operating in iron ore, energy, aluminum, copper, gold, and more.  Iron ore is its largest business, accounting for 44% of revenue.

As of last year, Rio Tinto estimates that it has 2,655 millions of tonnes of iron ore in its mines.  However, you have to ask yourself where you think the price of iron ore is heading?  Goldman Sachs thinks its going higher, while Morgan Stanley thinks its going lower.  So, even though you have good estimates on mineral reserves, how do you calculate value?

Anglo American

anglo american miningAnglo American is a mining company that specializes in other minerals, specifically gold and platinum.  However, it also has iron ore in its business.  It currently has about 955 millions of tonnes in reserves in its mines, which is worth about $133 billion at today’s prices.

Anglo American has made a lot of headlines recently due to labor strikes and unrest in it’s bread and butter gold and platinum mines in South Africa.  It has even had to shutter mines while resolving the issues.  Given that the costs of mining are rising dramatically, this can be a scary sign.

BHP Billiton (NYSE: BHP)

bhp billiton miningBHP Billiton is the largest mining company by value.  However, like the other companies on this list, it has been struggling with costs with it’s large operations and declining commodity prices.  BHP Billiton is the largest supplier of aluminum, and third largest supplier of iron ore.  It operates on 6 continents, and mines or extracts about every resource.

Vale (NYSE: VALE)

Vale mining companyVale is the South American company that also happens to currently be the world’s largest iron ore mining company.  Since iron ore has been about 90% of the companies profits over the last decade, the decline in commodity prices over the last year have significantly hurt the companies earnings.

 

The bottom line is that those who want to make the most of a mining stock investment should look only at measured resources. Consider the rest to be added-value if and when those resources are proved to be true by measurement.  Then, consider the companies costs and the price of commodities, and understand the company’s performance track record before diving in.

What are your thoughts on mining stocks right now?  Good or bad investment?

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  • http://www.thefreefinancialadvisor.com/average-joes-money-blog/ AverageJoe

    To the degree that they’re a reflection of the underlying asset price (I love your fishing analogy, btw….awesome), I like them for a small part of my portfolio. Because there’s often negative correlation between metals and other stocks, it’s a great diversifier for a portfolio.

  • http://www.myfijourney.com My Financial Independence Journey

    Personally, I’m curious about how many mining companies have a history of dividend growth. I think I’ve heard of BHP before in the dividend growth universe, but not the others. This probably warrants further investigation.

  • http://www.degreesanddebt.com Edgar@ Degrees and Det

    Very great info here! Thanks for taking the time to share it. I have had my eye on VALE for a while now.