How dodgy salesmen are destroying gold mining stocks

So far, 2011 has been another good year for gold. Yet the same can’t be said for gold mining stocks. There are several reasons why, from the weak dollar to the popularity of exchange-traded funds. But one of the main problems is the mining companies’ tendency to fall for slick sales patter, reckons Dominic Frisby.

There's your old school, Essex used-car salesman who, with a barrage of banter, smiles and gold chains, somehow persuades you to buy that Ford Cortina you know you've always wanted.

There's your Middle Eastern market trader who, as you stroll through the souk, seduces you with flattery and puppy-dog eyes. Half an hour after meeting him you find yourself leaving his stall with a belly full of tea and an overpriced carpet, which you're not quite sure how you're going to get home.

There's your Nigerian spam-scammer who, with a combination of persistence and poor spelling, somehow convinces you that you are just the person to look after that $19 million he has just inherited. All he needs is your bank details.

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These are some of the greatest salesmen the world has ever produced. But there is one against whom they all pale in comparison.

The Vancouver stock promoter.

The slickest salesman in the world

The Vancouver promoter can be any size. I've seen short fat ones and I've seen tall slim ones. But they all wear expensive watches, cufflinks that would dazzle even Midas and suits that somehow manage to be both Saville Row and Italian.

The handshake is manly, the manners impeccable. And, boy, are they glad to meet you. The grey hair shines and then they smile. How is it possible to have such white teeth?

And then they tell you about this mine. Oh my gosh. This is it. This is the one. This is going to make us all rich.' There is nothing they won't say, nothing they won't promise, if there's commission in it for them. Mark Twain, who lost a fortune speculating in mining stocks, may as well have said a mine is a hole in the ground with a Vancouver promoter standing next to it'.

When gold miners lag gold, it's often a warning sign

I'm saying all this for a reason.

Even although gold is up something like 7% this year and made new highs just a month ago, gold mining companies are having a horrible time. From major producers to tiny explorers, the entire sector peaked last December and has been in a bear market ever since.

It's a divergence that is galling, frustrating and confusing investors everywhere. And it didn't necessarily begin last December. Charlie Morris, HSBC's head of absolute return, observes: "Since late November 2003, this gold bull market has broken the rules. If you had invested $100 into gold at that time it would have grown to $385 today. However, had you instead invested in a basket of gold mining shares, you would be disappointed to lag behind with just $216 (including dividends)".

The last time the divergence was as marked as this was in late 2007 / early 2008. We all know what happened next. It also happened in 1998 with the long term capital management meltdown, and in 2000 before the tech bust.

If another 2008 crash is around the corner, gold miners that don't yet have any production and rely on the capital markets for funding, will be even more hammered, just as they were in 2008.

But it doesn't have to be like this.

There are many reasons for lagging shares. One is the proliferation of gold exchange-traded funds (ETFs). It has become so easy for people to buy gold itself that they don't bother with the shares.

Another problem is so-called Dutch disease', when profits are choked by currency strength. Miners get paid for gold in US dollars, but they often incur their costs in other, stronger currencies. Since October 2008, gold has risen by 108% in US dollars, but 60% in Canadian dollars, for example, and just 23% in Australian dollars. The South African miners, in particular, have been hit hard by the strong rand.

How Vancouver promoters hurt gold mining shareholders

However, for me, one of the biggest offenders is companies diluting themselves (selling more shares to raise fresh funds). This happens right accross the mining spectrum from senior to junior. I've lost count of the number of small miners who declare they have easily mine-able, near-surface deposits with potential production at $500 or $600 an ounce.

Sounds great. But then they stray from that goal of a small amount of production. This is where the Vancouver promoter comes in. He doesn't care if the company gets diluted. In fact, the more shares that get issued, the better it all adds to his commission.

He flashes that smile. He persuades the miner that he can raise $2m or $5m or $10m for them. The miner's eyes glaze over as he imagines all the drilling he can do. And the promoter pockets a fast 10%, or whatever his fee is, plus a bunch of options.

On the advice of said promoter, the miner sets about further expanding the resource' and proving up more ounces' at the end of which he has to raise more money. And we're no nearer production. We've just increased the size (and value) of the ore body.

Gold miners: just get the stuff out of the ground!

But, for goodness sake, gold is at $1,500 an ounce. If you can produce even a small amount 500 ounces, 1,000 ounces a month at $500 an ounce cost, you'll make a mint. 1,000 ounces a month would mean $1m a month, $12m a year.

There are so many companies with market caps of $20-$50m. If they were making that kind of money, their market caps would double, triple, quadruple all without any dilution to shareholders. And most importantly they wouldn't be vulnerable to the ebb and flow of the capital markets. Surely it's not that difficult to see?

But that way the Vancouver promoter doesn't make his 10%. So he'll advise against it. And if management don't have a large stake in the company, they won't mind a bit of dilution. After all, drilling holes in the ground is easier than building a mine.

Not all miners make this mistake. Gold Resource Corp (US:GORO), a company I follow and indeed recommended to MoneyWeek readers at just over $2 has gone from $1 to $30 in five years and pays a monthly dividend. That is not a share that has lagged gold!

How has the company been successful? Because the boss Bill Reid had a huge stake himself, so he didn't dilute it. He began producing the near-surface gold as quickly as he could. Only then did he start expanding the resource further underground. It's really not a hard model to follow.

So I have two messages here. One is to gold share investors. Look for companies in which the management team has a significant stake. (In the case of Gold Resource Corp, over 30% was owned by the Reid family). Look for companies that are taking concrete steps towards building a mine. And ignore the ones that keep issuing paper, particularly when markets are weak. (I'll have a new gold report out soon, where I'll be identifying some of the most promising candidates.)

The other message is for the mining companies themselves. We are in the mother of all bull markets. It won't last forever. If there is any potential for near-term production, start producing. Forget all the other stuff. And, for goodness sake, ignore the bloke with the white teeth.

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