Fundamental Analysis

History gold mining tailings dumpInvestors are ultimately concerned with one thing – share price and this must obviously include the direction of share price. Of course this leads us to look for ways to predict price movement – to this aim we have two schools of thought which are fundamental and technical analysis.

Sophisticated and professional investors often use both methods – the huge institutions such as banks and insurance companies use both methods to compete with each other and in the market as a whole. The professional investors at the head of the trading rooms of these institutions are the elite – some of these individuals specialize in mining, some in currency trading, others in metal trading.

Let us take a look now – at a professional approach to this subject.

Top down fundamental analysis is the practice of analysing world markets, then down to commodities and finally down to the companies that mine them. This is the correct order of influence of these factors when attempting to establish the direction of share price for individual companies – sure individual stocks can go against the trend however this is more the exception than the rule.

So get the big picture right first, the rules are changing with global conditions and this is now a very specialized and complex picture. Then consider the trend and dynamics of the metals that your selected companies mine, intend to mine or look for – then consider the fundamentals of the stock you have selected. The next step is to select your entry point for your investment and this can be handled to some extent by fundamental analysis if it is done properly. However timing an investment is more the domain of technical analysis.

A sensible warning
The wonderful thing about the internet is that charts (technical) and general fundamental information are now available to all investors. The danger in this is that sometimes a little knowledge can be more of a trap than an advantage because it can lead to a false sense of security. False data treated as fact is down right dangerous and can lead to losses.

I have noted a tendency for non professionals to measure estimated resources, estimated earnings and estimated price trends… and even estimated total market crashes in order to arrive at an investment strategy. Minerals in the ground have zero actual tangible value until mined at a profit, estimated projections are just that. Intangible values change according to market sentiment and market conditions – more on this whole subject later….

Beware of the notion (idea) that raw data can provide the insight necessary to pick a worthy mining stock investment. For example imagine having a spreadsheet for racehorses with a multitude of parameters for each horse including: tail length, hemoglobin level, muscle mass, genetics, height, weight, eye color, refractory pigmentation (gobbledigoop term) – I could go on however I am sure you get the idea… – the point is – could all that sort of complex information tell you which horse will win the race? In short – the answer is NO. So it is with mining stocks too.

Correct evaluation of fundamentals is handled by educated investors every day however – remember this – data is no substitute for true understanding.

I will give you a couple of examples of stocks with apparently fantastic fundamentals – fantastic raw data too – so you see what I mean from another angle; I could tell you the name of a stock that has the rights to the worlds largest undeveloped zinc deposit – right in Iran – needless to say the stock has not risen in price. Another example is a small cap with billions of dollars in copper and gold in NSW here in Australia – why is it still a small cap??? Right next to rail, secure Government (low sovereign or country risk)… the question is can management develop and run a 10Mt per annum operation, will it make a profit considering grade, scale, local water restrictions, funding issues etc??

Get the point I am making? Professional investors are looking at profits and potential profits from digging up and processing huge volumes of earth. The huge amount of variables make fundamental analysis as much an art as technical analysis – especially when you consider top down analysis – which you must when you invest your money with the expectation of making good returns on the risk.

Web sites will spring up like mushrooms as the commodity boom continues – manned by non professionals on a part time basis – that will pretend to offer understanding on the complex subject of mining and investment. Caution that you get the right data which is required if your capital is to be preserved – patience, practice and professional opinion will all assist you to profit from your investment activities.

Beware of derivatives – they are for professionals – One of the leading investors on the planet is a gentleman called Warren Buffet who has gone on record calling derivatives “weapons of mass destruction” and he was referring to macro economics (big picture) however this can also apply to micro economics as well (your investment capital).

Break up of fundamental factors:

Top level influences

Global market conditions influence demand and the world is currently experiencing a historic event that has no precedent. When Japan went through their major economic growth phase in the 50’s to the 70’s they used massive quantities of commodities. However this was for a small population base compared to China and India today.

Growing economies use a disproportionate amount of resources, compared to mature economies, as they roll out infrastructure like electricity grids, railways lines, new cities, roads, power generation facilities, factories, plant and equipment – and modern housing. As these new economies create raised living standards – these populations all want consumer goods, new woks, toasters and computers and cars for instance.

Globalization has advanced to a stage never seen before – 2.5 billion people across India, China, Russia, Brazil and elsewhere are raising living standards and the building boom plus infrastructure roll out is fantastic. China plans to build 200 new cities to house a million people in each. Their near term railway expansion is equal to over half the railways ever built in history – everywhere combined.

India is reaching a stage – $500B GDP per annum – where it has tremendous impact on the consumption of commodities. We could go on and on about this however you should get the point by now. Housing growth of the modern economies like the US and Europe were the major economic drivers until recently – the basic economic rules have changed /are changing on a global scale. As I said this is now a specialized and complex subject.

Commodity fundamentals
Gold Oz is mainly interested in precious and base metals. Precious metals include gold, silver and platinum group metals – base metals include aluminium, copper, iron ore, lead, nickel, tin, zinc & uranium.

Demand is one thing to look at but the other essential part of the equation with metals is supply – mines are expensive and time consuming to build. The ore bodies can take up to ten years to be brought to market and to simplify this process let me elaborate a little. As initial wide spaced drilling leads to further testing and then step out drilling and then infill drilling to bring the resource to a level of certainty – to establish that the resource has continuous grades throughout the ore body.

This leads to feasibility studies and finally a decision to mine and then construction begins. But first capital has to be raised, engineering studies, studies to see how much metal can be extracted and by what method and at what cost – which leads to plant design and then there is power supply and roads and tailings dams – a huge time consuming and expensive task.

So when demand for a metal is found to be greater than supply and stocks begin to dwindle you have a problem. The problem is that the supply deficit is slow and difficult to fill – new supply is very hard to create. We have been caught off guard by total global demand and it may take another decade to solve the problem and shortages.

Other factors include – physical and political mine disruption, economic slow downs that lessen demand, new uses which can increase or decrease demand, short term problems such as strikes. Physical disruption can come in the form of flooding and wind damage, cave ins and mechanical plant failure plus accidents.

Precious metal fundamentals
When it comes to the precious metals there is also monetary demand as some Central banks look to increase their gold reserves as a hedge against currency weakness. Silver has been earmarked as a parallel currency in Mexico and this goes ahead we will lose considerable silver supply in future.

Gold producers have been closing forward contract sales of gold over the last few years and this has accelerated during 2007 as giant losses mounted. The biggest operators in the industry are closing these hedge books with loans, early physical supply of gold and out of revenue. Quite simply they believe that will go broke if they do not indicating strongly that they expect prices to rise not fall. This has tightened supply and cut off a major source of false supply that depressed the price of gold during the bear market years of the late 90’s. The era of selling gold that has not been extracted from the earth is over at this point in history.

Interestingly we have seen Central Bank and Government supplies of gold and silver coming to market for decades which filled supply deficits and this may soon come to an end which will dramatically change the supply / demand fundamental picture.

Investor apathy over the price of silver has contributed considerably to additional supply – however as other supplies dry up and the new technological uses gain momentum the price will rise and investors will be more inclined to hold their silver for a higher price. Precious metals tend to become more popular as price rises due to increasing investor demand which does not occur in base metals.

Cultural factors are important for gold and silver as these metals have traditional support in China and India so as incomes rise in these countries we will see vastly higher demand. China only recently decided to allow their citizens purchase gold after a long prohabition since 1949. As the retail system is improved this will ass significant demand for gold and silver as bullion and jewelry. India is growing fast and so is their middle class – demand will continue to increase as they increase their disposable income – Indians love gold and silver too.

Company fundamentals – general comment
Much is written and “dug over” about company fundamentals and the broad considerations are; management, financials and projects. Non professional investors are often confused to see their “good” stock go down in price or track sideways for long periods when all the fundamentals point to the “obvious” lack of true value reflected in the share price. That is to say share price does not reflect the perceived asset value or estimated asset value.

Large producers can be measured by fundamentals however the smaller non producers “drum to a different beat”. Let us start with large and mid-tier producers first as it is important to consider them differently to the explorers and developers.

Large company fundamentals
One can usually assume the larger companies are run by the leaders in their field and in general this is so. The mining industry is tough and long bear market from about 1980 to 2000 forced many of these larger and mid cap companies to scale down in order to survive. As conditions improved this lead to a flow of highly experienced managers finding their way back into the industry and down to smaller operations with quality prospects.