Why I'm Buying Mining Stocks

It's been a pretty good year for my portfolio for two particular reasons: The stock market rally has been practically unstoppable, and I've remained diversified throughout the past couple of years, which has certainly helped spread around my risk and reward.

One area, though, that has been a chronic underperformer for upwards of the past year has been mining stocks. It really doesn't matter where you look: gold, silver, platinum, palladium, copper, molybdenum, and coal -- all down across the board. You'd think that a growing U.S. economy and improving global outlook would help these mined metals and commodities from a demand perspective, but that just hasn't been the case. Gold and silver are both in bear market territory, while coal has had trouble gaining traction next to cheap natural gas prices.

But I have a surprise for you: I've been buying mining stocks recently and adding them to my watchlist with regularity, as I see unparalleled value in the sector. Here are a handful of the reasons that persuaded me to take the dive, as well as a few miners on my radar.


Where's the beef?
First, where's the beef, Mr. Market? According to Thomson Reuters, as of last week 451 of the S&P 500's components had reported earnings for the quarter, with 67% topping EPS expectations compared with the historical average of 63%. That sounds fine until you realize that only 47% topped revenue expectations, compared with 62% historically. This is a clear-cut signal that cost-cutting and not top-line growth is what's driving results. To me, that would indicate that this rally is unsustainable and that metals like gold and silver would provide a great hedge against potential downside in the indexes.

In this space, I continue to keep a watchful eye on Silver Wheaton , which is a royalty interest company that negotiates long-term deals with silver and gold miners. By giving these miners cash upfront, Silver Wheaton is locked into paying a low, often lifetime, cost for the mined metal while excluding itself from being responsible for any maintenance or upgrade costs. With some of the most delectable margins in the industry -- even after a 55% tumble in spot silver from its highs -- and at 11 times forward earnings, which is the lowest level I can ever recall, it's on my probable-buy list.

They can cut costs, too!
Secondly, keep in mind that miners understand how to cut costs as well! With gold prices hitting a record high last year, many miners had been scrambling to expand capital expenditure budgets to take advantage of these prices. When the bottom fell out of gold prices, many of these miners were caught with their pants down, proverbially speaking, and forced to take large asset writedowns because of the growing costs to build out a mine versus the shrinking margins associated with falling metals prices. However, there are plenty of miners to consider that will see lower capex spending in the immediate future.

One name I've been considering here is Yamana Gold which is already the gold sector's leader in lowest cash operating costs, at $383 per gold-equivalent ounce, or GEO, in its most recent quarter. Yamana has plans firmly in place to lower its GEO by up to $100 per ounce by as soon as mid-year. These plans entail curbing capital expenditures that aren't cost effective, continuing with the automation of certain mining operations, which will lower long-term costs, and slicing administrative expenses. Yamana is now valued at less than 10 times forward earnings and is looking more attractive by the day

Supply and demand still rules
Regardless of what you might think, another factor worth considering is that supply and demand is ultimately what drives these miners and spot metal prices. Silver is often used as an electrical conductor, while copper has an abundance of uses, ranging from a strengthener in construction to electrical conduction. One of the biggest consumers of copper is China, and the last time I checked, GDP growth, while below the 30-year average of 10%, was still a robust 7.7% in the first quarter.

One name here that I have aggressively purchased in my portfolio is Thompson Creek Metals . Thompson Creek had been known exclusively as a molybdenum miner in the past, but is set to open its Mt. Milligan mine in British Columbia by August. This mine contains some 2.1 billion pounds of copper and 6 million ounces of gold and will sport a mine life of 22 years while giving Thompson Creek the diversity it's lacked in the past. The gold, of which a 52.25% interest was sold to Royal Gold in exchange for cash, will act as a byproduct reducing cost that'll should make Thompson Creek one of the lowest-cost copper producers around.

Trends are hard to change
Finally, long-term trends are really difficult to change just because spot prices move against the grain for a short period of time. Let's look at coal, for example.


Source: Stephen Codrington, commons.wikimedia.org. 

Coal was responsible for 42% of all electrical generation in 2011, according to the U.S. Energy Information Administration. Even though cheap natural gas prices and an abundance of newer clean-energy sources such as wind, solar, and geothermal are persuading electric utilities to beef up their alternative-energy portfolios, coal isn't going to disappear overnight. On the contrary, coal is expected to play a major part in helping America achieve its independence from foreign sources of fuel.

The company I've had my eye on here for a while, and which is currently in my "One Person's Trash Is Another Person's Treasure" portfolio, is Arch Coal . Arch's production is made up almost entirely of thermal coal, but it does generate close to 9 million tons of steel-strengthening metallurgical coal each year. For Arch, the catalysts I'm seeing are rising natural gas prices, which have made the switch to natural gas for utilities not nearly as logical, as well as a forecasted bump in demand from emerging markets such as China and India, which are still relatively early in their industrialization phase. Arch has been working diligently to diversify its cash flow by forging long-term export contracts for its coal, and just this week it signed a deal with Meritage Midstream to develop a rail and oil storage terminal at its Powder River Basin property. 

On the lookout
With the broad-based S&P 500 closing at another record high on Friday, about the only real value I see in this market lies with metal and mining companies. I will remain on the lookout for great deals primarily because of the catalysts I've mentioned here and suggest you not ignore a much-maligned and widely disliked mining sector.

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The article Why I'm Buying Mining Stocks originally appeared on Fool.com.

Fool contributor  Sean Williams  owns shares of Thompson Creek Metals and owns a January 2015 $2 call, but he has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle  @TMFUltraLong . The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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