Taking Apart the Gold Sector — Bank Accounts Are Flush

precious metal stocksThe best action for equity speculators (other than being short) continues to be in precious metals, particularly gold and silver. In the precious metals industry, the players are made up of large-cap producers, mid-tier producers, juniors and then the specs. These are companies that own property with mineral resources, but that aren’t currently producing.

Currently, the best action for investors within the industry is in mid-tier producers. This is where merger and acquisition activity is beginning to accelerate. Red Back Mining (TSX/RBI) just agreed to a friendly merger with Kinross Gold (NYSE/KGC), and it’s only a matter of time before large-cap producers like Barrick Gold (NYSE/ABX) and Newmont Mining (NYSE/NEM) start bulking up on mid-tiers. The reason that merger activity has been accelerating within the industry is that a lot of these companies have a lot of cash on their books with no place to put it. When you have a producing mine and a certain amount of money dedicated for exploration each year, any excess cash just sits in waiting. That’s why, when the spot price of gold is strong (as it is now), most established producers generate significant amounts of excess cash. Combined with higher stock prices, gold companies have all the currency they need to do very big deals.

Kinross Gold announced a $7.1-billion deal to acquire Red Back Mining in an all-stock deal, right when Red Back Mining was trading near its 52-week high for the year. Gold companies don’t have to worry about overpaying, because their stock prices are lofty and so are their bank accounts. The high spot price of gold makes shareholders very forgiving.

One thing that’s been detrimental to investors among large-cap precious metal producers is a lack of dividends paid by most of the players. By this I mean enough of a dividend yield, like three percent and up, for an investor to make a long-term commitment to a stock. Because the price of gold is so volatile, it’s difficult for investors to consider a big producer as a core holding, because cash flow changes dramatically with the spot price of the underlying commodity.

I have no doubt in my mind that we will see a lot more mergers and acquisitions in the gold sector over the coming quarters. There are only so many good names out there. If I had my druthers in this market, I’d own them all.