October 2011’s Penny Shares to Watch…

I’ve picked two important subjects for October’s Penny Shares to Watch:

Investing in GOLD: There’s been huge volatility in the precious metal in recent months after it reached record highs. Debt crises around the world are certainly having an impact. Below I explain what I think is holding back the junior mining sector.

The impact of TAKEOVERS: In my second article this month I look at takeovers… The key message there is don’t sell out of perfectly good companies just because the stock market is falling. Read on to find out why…

Before you invest in gold stocks, read this…

(This article first appeared in Penny Sleuth in September 2011. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)

With the price of gold heading for $2,000/oz, you might think gold mining shares would be racing up just as fast. In fact, shareholders in the sector have had mixed fortunes.

The gold mining sector of the Australian stock market, a reasonable proxy for the industry worldwide, has gone sideways this quarter. Indeed, it is at pretty much the same level as it was a year ago.

We have seen the gold price rise by 50% since then. This should have spelled a bonanza for gold miners. After all, the cost of producing gold should not change whatever its price. The extra revenue from the higher gold price should feed straight through to the line that matters most for investors: profit.

But somewhere along this line the link in this profit chain has evidently broken. Why?

This is what’s holding the gold sector back…

The first reason is currency. While the gold price is quoted in US dollars, mining costs are mainly denominated in local currencies and these have tended to appreciate against the weak US currency. The Australian dollar, for example, is up 10% against the US dollar over the last 12 months.

The second reason is cost inflation. Supply pressures in the industry have led to rising costs. According to GFMS Research, costs increased in 2010 for the ninth successive year. And analysts believe cost inflation is returning to the 15-25% levels that prevailed in the period from 2003-2008.

On top of this, the deterioration in grades and a rising strip ratio has also affected the cost of producing gold. Miners have been digging ever deeper to extract gold of increasingly poor quality. This is a prolonged trend that has led to a decline in average grades of up to 30% in the last decade.

All told, GFMS calculates that the average cash cost of producing an ounce of gold shot up last year from $478/oz to $557/oz. Taking all capital and project development costs into account, the total rose 20% to $857/oz.

Fortunately, the price of gold has been heading up at an even faster rate than the cost of production. That allows plenty of profit margin, even at these higher mining costs. But not all miners are able to sell gold at $1,850/oz. Only those that are actually producing today can do so.

This is why the best performers have been established producers miners such as KIRKLAND LAKE (KGI) and HIGHLAND GOLD (HGM). Gold miners at the exploration and development stage, on the other hand, can only cross their fingers that such high prices prevail when they finally pour their first gold.

Few mining executives or analysts are taking this on trust. Executives in the oil industry routinely use a conservative price as the basis for forward planning, and the mining industry is no different. I should be surprised if any gold mining executive is using a gold price above $1,200/oz as a working long-term assumption. And most analysts are basing their forecasts on prices well below today’s arguably spiky price.

The fact remains, however, that most of today’s new gold projects were initiated prior to 2009, when the gold price was much lower than it is now. If the price stays anywhere over of $1,500/oz, many of these projects should be very profitable. But there is another factor that may prove an obstacle to bumper margins for investors.

Why the climate is changing for gold juniors

The potential for huge profits from post-2009 gold projects has not been lost upon host governments. In the search for rich deposits, gold miners have had no choice but to venture into countries where political risk is higher than they would like, and one government after another has been retrospectively changing the rules to prevent foreigners from walking off with prized assets. On top of this, China has muscled in, offering to fund infrastructure projects in return for mining assets – and it has not been shy of elbowing others out of the way.

Analysts, though, remain bullish and my inbox is full of recommendations for gold juniors. ANGLO ASIAN MINING (AAZ) and NORSEMAN GOLD (NGL) are both producing miners trading on forecast price/earnings ratios of around four. SHANTA GOLD (SHG), STRATEX (STI) and ARIANA RESOURCES (AAU) are all close to the transition from exploration and development into production. And SOLOMON GOLD (SOLG) is another favoured for its proven management and potentially massive resources in the Solomon Islands.

Taking big profits from takeovers

(This article first appeared in Penny Sleuth in September 2011. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)

Investors don’t have much to smile about at present… so why were readers of Red Hot Penny Shares and my other, lower risk newsletter The Bulford Files smiling last week? Has anxiety turned into grinning insanity? Or have they just cracked open the gin?

They are happy because they just made some real gains. I can’t give the names of the companies away – that would be unfair on my loyal readers.

But I can say that one Red Hot Penny Shares recommendation was among the biggest winners in the market last week.

Why did these companies give their shareholders something to celebrate? They both announced takeover bids. The Red Hot tip agreed a very generous cash offer from a US company.

This is no mere coincidence. In the face of so much bearishness, there are critical messages here for you as an investor…

Worry about the company, not the market

The first message is this: don’t sell out of perfectly good companies just because the stock market is falling.

Worry about the company and not the market. And by investing in small companies you are ideally placed to do just that. The bigger the company, the harder it is to dodge the crosswinds of the global economy. Many small stocks will hit the skids. But the big banks, for instance, are simply helpless.

Small companies stand or fall by the strength of their products and ability of their management. And there are plenty of small stocks with great products that could yet deliver serious returns in the year ahead.

At this stage, investors need to distinguish between industry sectors that will suffer in a recession, and those that will prosper through thick and thin. Take healthcare. Every year the global population gets older and sicker and demands more medical treatment. A banking crisis won’t change that. I would not touch the financial or retailing sectors but I don’t have the same concerns about investing in medical care.

My tip, for one, is a business that I think looks certain to prosper in the coming years. It helps big corporations to manage their web presence, a job that is about to become much more complicated with the forthcoming expansion of internet addresses.

By focusing firmly on quality companies with bright future prospects, shareholders in these companies have been well rewarded. And I believe these takeovers could be a sign of things to come…

We could see a wave of takeovers in the year ahead

There are two types of takeover. Companies can ‘go private’ because they are tired of the demands placed on public companies and are disillusioned with the investment community. They also see a chance to make good money. Borrowing cheaply to buy into a business with high and reliable cash flow can handsomely reward their private backers. Today’s combination of low interest rates and cheap valuations are the ideal ingredients.

But most takeovers see large companies buy small companies. Maybe they want to get their hands on a new product. Maybe they want to eliminate a dangerous competitor. Maybe it is a means to get into a new region.

Distrustful of the economic outlook, big companies have been piling up cash for the last three years. They have the ammunition for takeovers and with stock market valuations so low they may never get a better chance to strike.

But the key message for investors is this: acquirers are rarely interested in sorting out a mess. Takeover rumours that swirl around troubled companies are normally false and put about by shareholders who want to get out. But good businesses do attract takeover bids. And many of our Red Hot readers are enjoying an excellent run of news recently – from biotechs to medical care groups to oil explorers.

But if you are interested in reading about what I think are the penny share stories that could defy a downturn, simply click on the link below and try Red Hot Penny Shares today!

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Good investing,
 

Tom Bulford Editor, Red Hot Penny Shares

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(This article first appeared in Penny Sleuth in September 2011. Penny Sleuth is an unregulated free e-letter written by Tom Bulford and published by MoneyWeek Limited)