Money and Metals

Morningstar has some gold mining stock recommendations out. "We at Morningstar believe in buying assets at a discount to their intrinsic value and waiting patiently for prices to recover. The metal has been justifiably touted, though, as an inflation hedge and portfolio diversifier. However, gold stocks, while highly correlated with gold, carry additional baggage that may offset some of their diversification and inflation-hedge benefits."

"Gold miners are plagued with rising costs, lack of control over the price of their product, and few product differentiation opportunities. It follows that most gold producers have no competitive advantage, or economic moat, and their returns on invested capital trail their cost of capital. With no moat, we would never buy these companies in our market-beating Tortoise and Hare model portfolios."

"There are a few gold producers of whom we are particularly wary because they expose the investor to additional risks for one of several reasons. First, these stocks tend to have higher-than-average operational risk. This is a characteristic of small, undiversified producers whose output relies on a small group of mines or even a single mine. Because this is the case, a small operational glitch could severely affect overall production and revenue."

"Second, extraction costs at these companies tend to be above average. High costs are very undesirable in a price-taker's market like gold because it means producers will be among the first to incur losses if commodity prices take a dive. Indeed, even with the price of gold at the current high levels, three of the four companies we have singled out below have posted red ink in the past year. Finally, our less-desirable companies tend to have operations in politically unstable countries, adding geopolitical risk."

"Cambior (AMEX:CBJ) Two of Cambior's three mines (one in Guyana and two in Canada) are high-cost operations. Costs at the third mine--Rosebel in Suriname--are not substantially below average. The company's extraction costs in 2005 were $305 an ounce, compared with the industry average of about $250. Cambior is also subject to a high level of operational risk due to its small number of mines. Because Rosebel produces about half of the company's gold, a stoppage here, even if temporary, will have a big adverse impact on overall production and revenue. Finally, Cambior's debt--at 12% of total capital--is relatively high for a gold producer. Paying down debt during flush times, like now, is considered a best practice in the mining industry. However, Cambior was only marginally profitable in 2005, and the company has not brought down its debt level. When gold prices fall and profits turn to losses, servicing this debt might become a burden the firm cannot bear, given its high operation costs."

"Bema Gold (AMEX:BGO) Bema operates two mines--one in Russia and one in South Africa. While the economics of the Russian mine are respectable with slightly below-average cash costs, the South African operation has been a drag on profits and cash flow since Bema started mining there in 2003. However, instead of improving profitability at its existing operations, the company is intent on raising production from about 290,000 ounces projected for 2005 to 1 million ounces. Given the lack of cash flow from operations, Bema has been forced to raise additional equity and debt capital to fund its exploration and expansion projects. As a result, Bema has one of the weakest balance sheets in the gold mining industry. Negative free cash flow, a weak balance sheet, and uncertain prospects make an investment in Bema little more than a speculative bet on the company's future, in our opinion."

"Hecla Mining (NYSE:HL) Given all the risks at Hecla--a relatively small production base in unattractive countries, future production not growing as much as expected, commodity prices not cooperating, as well as more financing and environmental charges--an investment in these shares remains highly speculative."

"DRDGold (NasdaqSC:DROOY) Mining gold in South Africa is a high-cost business that started more than a century ago. As more gold is mined, mines get deeper and costs generally rise. In addition, older technology and strong labor unions in South Africa also contribute significantly to the high costs prevalent in that country. Even by South African standards, DRDGold is saddled with relatively high cost and older mines. While recent efforts at operational improvements mean that DRDGold is less of a 'cigar-butt investment' than before, we do not think the company is out of the woods. Even with all the improvements, we still expect the company's cash costs to be more than $300 per ounce, compared with the industry average of around $250 per ounce. For DRDGold to consistently turn a profit, gold must trade at prices comfortably above the firm's operating costs and relevant currency-exchange rates must cooperate. As a commodity producer, DRDGold has little influence over either of these factors because it is a price-taker in both the gold and the foreign-exchange markets."

"Should gold prices fall precipitously in the next year or two, something that is not inconceivable, these companies will be among the first to suffer."