Ralph Aldis: Gold Mining Success Lies in Proper Capital Allocation

“The proper use of capital allocation is to maximize long-term value per share.”

That’s according to Ralph Aldis, USGI’s resident gold expert and, since 2001, portfolio manager of our two precious metals funds.

In a recent “Five Principles of Capital Allocation” and how they pertain to mining, given that mining companies typically have no revenues for years after their founding?

A: These five principles are the work of a Credit Suisse writer, Michael Mauboussin. They apply to some companies in the exploration and development phase but obviously more so to producers.

1. The first principle is "Zero-Based Capital Allocation." This means, for instance, that you don't give your exploration department $20 million this year solely because they received $20 million last year. Companies need a strategy to determine the proper amount of capital spending.
2. The second principle is "Fund Strategies, Not Projects." In other words, capital allocation is not about assessing and approving projects; it is about assessing and approving strategies and then determining the projects that support those strategies. It is a common mistake for explorers to continue to push a project forward—particularly if it is its only project—even though it lacks the potential for great returns. Rangold Resources (NASDAQ:GOLD) is a good example of the proper approach. When it evaluates a project, it's looking for grade sufficiently high that it can produce a good margin at a $1,000 pit shell or even an $800 pit shell. Restricting your return calculation to the pit shell is more conservative, as you are only including those ounces contained within the mine's engineering plan.
3. Number three is "No Capital Rationing." Typically, miners believe that capital is scarce but free. They believe that profits are free money, or if they're raising equity, they sometimes don't seem to care enough about dilution. Properly speaking, capital is plentiful but expensive. Profits need to be spent in a manner that results in future profitability. And equity financing is only plentiful if you have a good project.
4. Number four is "Zero Tolerance for Bad Growth." In other words, don't throw good money after bad. Barrick Gold Corporation (NYSE:ABX) fell into that trap with its Pascua-Lama project in Argentina. Long before its price tag reached $8.5 billion, the company should have thought hard about whether it would ever generate good returns. Mining companies should always seek to upgrade their portfolios.
5. Number five is "Know the Value of Assets and Be Ready to Take Action to Create Value." So many people in the mining industry don't know the value of their assets. We value companies based on their resource statements, and we get a very high correlation to where these stocks trade. But we constantly see companies decide to spend, for example, $1.8 billion on a project that the market values at only $800 million. It makes no sense to spend that much because similar projects could be acquired for less capital.

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Q: What's your favorite gold producer elsewhere in the world?

A: I like Mandalay Resources Corporation (TO:MND). Its management is very experienced in rescuing assets that have been mismanaged. Mandalay has turned around the Cerro Bayo silver-gold mine in Chile and the Costerfield gold-antimony mine in Australia. Last year, it bought the Björkdal gold mine in Sweden from Elgin Mining, and I think Mandalay will turn that around too.

Management owns a lot of stock. Mandalay pays a healthy dividend: 5.4 percent. The market has not yet completely woken up yet to this stock. We still think it's easily a 100 percent gain. It's one of our top five holdings.

Q: What's your favorite royalty company?

A: Osisko Gold Royalties (TO:OR) probably has the safest royalties. It has a lot of room to grow but not so much as to draw the attention of Franco-Nevada Corporation (NYSE:FNV), Royal Gold Inc (NASDAQ:RGLD) or Silver Wheaton Corp (NYSE:SLW). One of the advantages Osisko Gold Royalties has is that its assets are not dependent on other commodities. Franco-Nevada has oil exposure, and maybe oil prices don't go up very soon. Royal Gold has base metal exposure in some of its assets, and if prices of those were to drop tremendously, some of its assets could be shuttered. Osisko doesn't have those worries.

Disclosure: Gold, precious metals, and precious minerals funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The prices of gold, precious metals, and precious minerals are subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in these sectors.

There is no guarantee that the issuers of any securities will declare dividends in the future or that, if declared, will remain at current levels or increase over time.

Fund portfolios are actively managed, and holdings may change daily. Holdings are reported as of the most recent quarter-end. Holdings in the Gold and Precious Metals Fund and World Precious Minerals Fund as a percentage of net assets as of 12/31/2014: Barrick Gold Corp 0.00%, Elgin Mining 0.00%, Falco Resources Ltd (World Precious Minerals 0.01%), Franco-Nevada Corp (Gold and Precious Metals Fund 6.97%, World Precious Minerals Fund 1.32%), Klondex Mines Ltd (Gold and Precious Metals Fund 10.00%, World Precious Minerals Fund 9.78%), Mandalay Resources Corp (Gold and Precious Metals Fund 3.38%, World Precious Minerals Fund 2.28%), Market Vectors Junior Gold Miners ETF 0.00%, Newmont Mining Corp (NYSE:NEM). (Gold and Precious Metals Fund 1.05%, World Precious Minerals Fund 0.22%), Osisko Gold Corp 0.00%, Randgold Resources (LONDON:RRS) Ltd. (Gold and Precious Metals Fund 2.30%, World Precious Minerals Fund 1.43%), Royal Gold Inc. (Gold and Precious Metals Fund 5.99%, World Precious Minerals Fund 1.51%), Silver Wheaton Corp (Gold and Precious Metals Fund 1.36%, World Precious Minerals Fund 0.45%), Virginia Mines, Inc. (Gold and Precious Metals Fund 1.14%, World Precious Minerals Fund 10.35%) .

The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.

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Written By: Frank Holmes