Sometime during the 2nd half of 2015 I began following a Twitter account called @EconomicAlpha. I began to notice over the months that Luis (@EconomicAlpha) had a disciplined approach to investing in mining stocks that utilized a lot of fundamental analysis. He also shared his analysis freely (which he still does), which I admired – his biggest investment success thus far, Kirkland Lake Gold (NYSE:KL, TSX: KL) earned him a great deal of praise from followers, many of whom tagged along and benefited from the astronomical rise in KL shares over the last 2 ½ years (from US$2 in January 2016 to over US$23 recently).
KL (October 2015 – July 2018)
After following one another for more than two years, and closely following his success in Kirkland Lake Gold, I figured it was time to have an actual phone call with Luis in order to get some deeper insights into his investment process and how he became an investor in the mining sector.
The conversation was refreshing and his disciplined, humble attitude really made an impression upon me. Luis has clearly developed an effective process that he utilizes to identify attractive investment opportunities while weeding out the numerous investments that do not meet his criteria. I hope that my dear readers enjoy this conversation as much as I did…
Goldfinger: Great to speak with you Luis, I’ve followed you on Twitter for a couple of years now and i’m a fan of your tweets and the due diligence that you post. Obviously we’re in a challenging time in the precious metals sector, however, there are still ways to make money out there as you have demonstrated recently with Wesdome. Tell us about how you got interested in the mining sector and how you became an investor.
Economic Alpha: I started investing right out of high school and college in my early twenties. I have a corporate job and my investing in the mining sector is in addition to that. It wasn’t until about 2008 that I started investing in the gold mining sector. I was always interested in gold and protecting wealth against inflation and currency debasement. I buy coins and i’ve always been interested in money and how it works.
Investing in gold mining companies became a natural extension of my interest and curiosity in gold and precious metals. I didn’t really get into mining stocks until right after the financial crisis, so that was fortunate. I have an underwriting and risk management background and I use those skill-sets and they serve me quite well as an investor in the mining sector.
Goldfinger: A lot of mining investors took a similar route through investing in gold coins first, and then subsequently learned about investing in mining stocks later. You would be classified as a retail investor, although you’re definitely more sophisticated than the typical retail investor. Do you think the mining and junior mining sectors are good sectors for retail investors to get involved in?
Economic Alpha: It depends. It’s a stock pickers market right now in mining and junior mining. You can pull up a five year chart of GDXJ or GDX and see if you just held them you haven’t really made any money. However, if you traded it well there has been enough volatility to do pretty well if you had good timing. But my point is that there hasn’t been a reliable trend that investors could ride over a longer time frame (years).
If we were in a bull market that was well understood and clear then retail investors could do very well, just like the FANG stocks have been performing well recently. When the precious metals mining sector is doing well it usually results in the majority of stocks doing well, sometimes even regardless of their individual stories and how they’re doing operationally. A rising tide generally lifts all boats in the mining sector.
If you’re a retail investor who is either involved in the sector right now or would like to get involved in the sector you should ask yourself “What am I doing to create an edge for myself and how much due diligence are you willing to put in?”
If you just buy a stock that is involved in gold mining or exploration it won’t necessarily go up just because gold goes up. There are plenty of examples of miners that have had operational issues that have crushed the share price even in a bullish gold price environment. So you really need to do your due diligence and make yourself aware of the risks and opportunities in each stock.
Goldfinger: One of the trends we’ve seen in the last couple of years has been gold mining shares regularly decoupling from gold itself; we’ve seen periods of outperformance and underperformance. I think many new investors to the sector have been unpleasantly surprised about how their miners have performed during periods in which the gold price rose.
Economic Alpha: I think that’s the most frustrating thing. Historically mining shares have delivered shareholders a roughly 3-1 leverage to gold price gains. That’s simply not the case anymore it seems, as a broad basket the gold mining sector has not delivered much upside leverage compared to the gold price in the last couple of years. That’s why I said it’s a stock picker’s market; you have stocks like Kirkland Lake rise by more than 1000% since the 2015 bottom and you have a stock like Detour Gold which is actually DOWN from where it was in December 2015.
Goldfinger: That’s a great point! Tell us about your research and due diligence process. For example, how did you identify Kirkland Lake as an investment opportunity and what gave you such a high degree of conviction in that investment?
Economic Alpha: I would attribute some of that (KL investment) to a bit of luck – a good process and some luck along the way. What drew me into Kirkland Lake was the high grade nature of the Macassa Mine, I liked the fact that it was a high grade gold mine that had been in production for years and they had about 8-10 years worth of reserves remaining at the time. I also liked the fact that Macassa was a free cash flow producing gold mine, for me cash is king. For me it’s not just cash flow, it’s free cash flow that is important. Free cash flow is a huge driver of a stock and when you can create cash flow outside of your capex expenditure you now have internally generated financial resources to apply to generate excess returns above your cost of capital. You can take those excess cash flows and use it to conduct exploration programs on your properties (assuming they are prospective), you can buyback stock, you can pay a dividend, you basically have more flexibility and the threat of stock dilution is mitigated. Miners can be serial stock diluters, and that’s part of the business. Kirkland Lake had that financial flexibility so they started exploring Macassa beyond what they had done historically in the past.
KL also completed an acquisition of a company called Newmarket Gold in an all-stock deal. This occurred shortly after I went long KL and initially caused KL shares to drop because it was a stock deal. At the time KL bought Newmarket the market thought they overpaid for it which made me look into Newmarket much more deeply. I knew that Eric Sprott had ownership interests in both companies, which really captured my attention and made me want to dig deeper. I started to look at exploration results at Newmarket’s Fosterville Mine in Australia and I noticed a trend; the deeper they drilled the better the grades and widths got. I’m not a geologist but I just kept reading the press releases and my understanding with underground deposits if grades start to get better at depth the odds are greater that you’ve found something more substantial.
My research led me to buy more KL shares after it had dropped, so I dollar cost averaged. So I had bought at US$7, US$6, and US$5 in varying amounts. The next thing I noticed was insider buying coming from Eric Sprott after the KL/Newmarket deal got approved. Then KL started to aggressively do their own exploration at Fosterville, which prior owners did not have the financial capacity to do, and they were hitting grades of multiple ounces per tonne with impressive widths. Everything about the story just kept getting better.
Goldfinger: For less experienced investors can you define free cash flow for us?
Economic Alpha: It’s operating cash flow minus capital expenditure (the sustaining capital which the mine needs to be maintained in a steady state). Everything really comes down to watching where the cash is going, if the cash balance is going up then they’re generating cash (as long as they’re not raising cash by other means such as stock issuance or debt).
Goldfinger: Can you tell us about a couple of investments that didn’t go as planned?
Economic Alpha: While the thought process has led to some nice winners, there have been my share of losers along the way. Klondex had a great story and fit the process well but they ultimately couldn’t operationally execute. PVG, similar characteristics, but they failed to execute during the ramp up phase of Brucejack. The lesson learned with these, was sensing the operational issues and cutting losses while managing the exit.
Goldfinger: Let’s talk about insider buying. With Kirkland Lake you saw Eric Sprott buying more shares and adding to an already large position in the company, this gave you added confidence. How do you use insider buying in your investment process and what should an investor look for in terms of insider buying that makes it stand out to you?
Economic Alpha: The size of the purchase definitely matters. In the recent case of Wesdome (TSX:WDO) there were insider purchases in which some of the insiders didn’t have a position prior to buying. There was also buying by what felt like the entire board and some of the management team so that really stood out to me.
If an insider is just buying a few thousand shares I won’t pay too much attention to it, but if it’s a significant purchase, or it is consistent, then it will grab my attention. It’s also important to distinguish between a producer and an explorer, i’m not smart enough to say that I know whether or not an explorer has an economic resource on their hands. In the case of Garibaldi and Novo, the fact that Eric Sprott has been such a large buyer of both stocks helps a lot and is certainly something to ponder but it’s also important to remember that these big investors don’t have a 100% win rate and their timeframes and financial capacity are much different from an average investor. It’s nice to be able to piggyback off of Eric Sprott’s ideas as he is a legend in this sector, and I have done that, but that’s not the only part of the process for me. For me, consistent insider buying in cash flowing producers has generally served me very well.
Goldfinger: It’s also important to note that these big investors like Beaty, Giustra, and Sprott are going to have plenty of losers throughout their careers but when they hit winners they tend to hit home runs that make up for dozens of losers. In the case of both Garibaldi and Novo, Eric Sprott is still very much in the green despite both stocks being well off their highs. These big investors are able to get deals on big blocks of stock that regular investors simply cannot.
Economic Alpha: An investor must also take into account the life cycle of an exploration/development/production company. Typically when they make that first discovery the stock explodes, speculation comes in and drives the stock higher as we saw with Novo and some of these other names in the last year. The market has a tendency to overreact to the upside initially, then you get more news and typically it’s not as great as the hype and speculation wanted it to be which causes selling and the stock corrects.
Then the market starts to form a base and waits for more news as to the viability of the resource. Then we get an initial resource estimate, PEA, pre-feasibility study etc. All of these events have the potential to generate an upward revaluation in the share price if they turn out to be better than market expectations. That brings us to the development stage if the company has an economic resource which brings with it a whole new set of challenges including permitting, financing, and mine construction.
I prefer to invest in junior/intermediate/mid-tier producers because they are still small enough for large gains but there are fewer variables and projects have been largely de-risked. Explorers are obviously much more cheaply valued but that is for a good reason due to the questions around whether they have an economic deposit as well as all the hurdles they need to jump over to bring a project forward to the production stage.
Goldfinger: So you don’t invest in junior explorers or you invest a much smaller percentage of your portfolio in juniors?
Economic Alpha: I invest in cash flowing juniors but I invest a much smaller percentage of my portfolio in the smaller companies as opposed to the intermediates/mid-tiers.
Goldfinger: That brings us to my next question. Bankroll management. How do you determine how much to allocate to each investment? Do you have any rules that you follow in terms of position sizing?
Economic Alpha: There are two parts to my portfolio: First there is the core portfolio which consists of names that I have done extensive due diligence on and I am willing to buy these names during corrections (averaging down but also averaging up) unless the thesis changes. If the thesis doesn’t change then I am holding these stocks and potentially even adding to them over time. The second part of my portfolio is the trading portfolio which consists of all kinds of miners, including explorers and more speculative names that I have a shorter term view on; i’ll trade news flow, technical setups, and other ideas that come to me to generate an income.
Goldfinger: Thanks for that insight. Regarding Kirkland Lake how large did that position become at its greatest point in your portfolio?
Economic Alpha: At one point that position represented more than ½ of my core portfolio. Being in risk management as my career I had to address that extreme overweighting so I trimmed the position over time. The more prudent decision for me was to sell into strength and reduce the position to a level that I was comfortable with.
Position sizing and portfolio allocation to me is both an art and a science, and to be honest this is an area that i’m still working on to get right. With Kirkland Lake I allowed the position to get so large because my confidence level was very high and the story kept getting better, and because the rise happened over a very short period of time.
For me, my high conviction names vetted through the process get a higher concentration in my portfolio; I’ve dedicated a portion of my investment portfolio to mining stocks outside of traditional investments and high conviction names get a heavier weighting with my framework. The fact that KL became more than ½ of my core miner portfolio was an extreme situation and at that point I also had large unrealized gains in the position.
Goldfinger: Please give us a couple of your favorite stocks right now, one producer and one explorer/developer?
Economic Alpha: I have a lot of tweets on the names that i’m looking at. For better or worse, I tweet a lot of my ideas. It helps me keep track of the thesis and gives me the opportunity to document my success/failures and make changes along the way. I can hold myself accountable, too. I did a recent tweetstorm on Wesdome Gold, I looked at their individual assets and applied a value to it. When I tweeted in May the stock was at C$1.98 per share and I felt like the market was only valuing Eagle River and you were getting Kiena for free.
Kiena has the potential to hold more than 1,000,000 ounces of high grade gold so that’s a lot of upside the market was giving away for free. Coincidentally, shortly after I started tweeting about Wesdome the insiders started buying in large quantities which drove the stock from C$1.98 to C$2.40. Since then we’ve seen Wesdome rise all the way to C$3.50 and this is during a time in which the gold price has performed poorly. Wesdome would be another example of being a “stock picker’s market” – there are mining stocks that can actually rise during weak periods for the sector and these are the stocks that I like to look for as an investor. There is still a long way to prove out, but if Kiena turns out to live up to its potential, we can still see substantial upside in Wesdome shares from current levels.
As far as a junior miner I like Superior Gold (TSX-V:SGI). It’s cheap. But it’s cheap for a reason because they only have enough reserves to mine for another three years. What attracted me to SGI is their ability to generate free cash flow and then use that free cash flow to explore and add to their reserves. So you have a cash flow positive junior that has the potential to apply that excess cash flow to towards exploration upside.
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