New Investment – A Distressed Gem

by Enis December 6, 2013 11:12 am • Commentary

Here’s our next addition to our investment portfolio:  

I discussed the slide in the gold miners to new 5 year lows in yesterday’s Morning Word post:

Gold miners have broadly underperformed gold because many of them took on high-cost projects with leveraged financing, leaving them doubly exposed to a decline in gold prices.  In the case of the junior gold miners represented by GDXJ, the risk is even greater given their riskier balance sheets and more speculative projects.  As to be expected, GDXJ has been an even worse investment than GDX over the past few years, down around 85% from its peak.

However, there are companies with better balance sheets and cost structures, such as GG and NEM which I citied above.  While precious metals prices have declined, many of the companies own valuable assets that will still yield cash flow over the long run.  Moreover, as the less competitive projects are forced off of the market (junior miners go bankrupt, other companies shelve projects), supply will of course lessen, and the remaining miners will have a healthier market in which to compete.

Some bargains are being offered in the current selloff in the sector (as hard as that may be to believe at the moment).  GG is at the top of my list given the low cost of its outstanding mines and its obvious staying power.  GDX is still the best proxy for those wanting the simple macro exposure.  Most importantly, though, is whether gold is close to a near term bottom, or has more room to move lower.

Goldcorp has been on my watch list since the summer, when I first dug deeply into the company’s financial statements.  The main question I was curious to answer was, at what underlying price of gold will the various gold miners get into trouble from a break-even perspective?

Goldcorp’s marginal cost for operating its mines is in the $700-$900 area, much lower than the vast majority of gold miners in the world.  On top of that low cost, Goldcorp’s projects are very well diversified geographically, limiting geopolitical risk as well.  While Goldcorp looks more expensive vs. peers on a P/E basis, in distressed situations like this, I prefer to look at the balance sheet and asset/liability structure rather than the current earnings power.  In that regard, Goldcorp has limited near-term debt, a Price/Book ratio of 0.84, below the industry average, and much better long-term mining assets than the bulk of its peers.

Finally, from a timing perspective, on a technical basis, the stock has fallen down to near the $20 level, which acted as support on a couple occasions in 2006 and 2007 (not quite in 2008, but really a false break then):

[caption id="attachment_33331" align="alignnone" width="600"]GG weekly chart, Courtesy of Bloomberg GG weekly chart, Courtesy of Bloomberg[/caption]

We like the entry point for a longer-term investment.

TRADE: Bought GG for $21.19

We simply bought the stock for our investments.  However, we wanted to present an alternative using options that we also found worthwhile, though did not do ourselves.


ALTERNATE TRADE STRUCTURE: Sell the GG Apr 20 Put, Buy the Apr 22/28 Call Spread for Even Money

Break-Even on Apr Expiration:

Profits: Profits up to 6.00 between $22 and $28, max gain of 6.00 at $28 or above

Losses: 1 for 1 with the stock below $20

Trade Rationale:

The main benefit of this trade structure vs. just owning the stock is that the options structure does not start to lose money until $20, though it also gives up the upside above $28 in return for that initial protection.  Given how extended the stock has become on the downside, we don’t want to limit our potential upside over the next 6 months, so we are just buying the stock outright ourselves.