Finding gold in little miners

Mark Johnson

Dan Denbow

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NEW YORK (Fortune) -- A year ago investors fled small gold mining stocks as the desire for high-risk assets evaporated.

Now, even after investors have flooded back into the market, top-ranked gold fund manager Mark Johnson says the junior miners are undervalued, and he's betting on their recovery.

"The best value is at the smaller end of the scale," says Johnson, who is in his 16th year running USAA's Precious Metals and Minerals fund (USAGX).

Junior miners are those with less than 250,000 ounces of annual gold production, which equates to roughly $250 million in revenue at gold's current price.

Fund researcher Morningstar ranks USAA's Precious Metals fund No. 1 in each of its five- and ten-year categories. The $1.5 billion fund's 10-year annualized return of 22% handily beats the S&P 500's (SPX) drop of 0.15%. Its closest benchmark, the Philadelphia Stock Exchange Gold and Silver Index (XAU), has returned 9% a year since then.

We did argue recently against buying physical gold. Many experts think its rally is unsustainable based on simple supply and demand fundamentals. But Johnson and the fund's co-manager Dan Denbow expect undervalued junior mining stocks to rise without major movements in the metal's price.

Johnson and Denbow say they've outperformed the market by sticking to basics: finding miners with solid balance sheets, rising production, attractive valuation, and mines in politically stable regions. "We really try to pull out a balanced attack where we're not overly exposed to any one company or geographic region," explains Johnson.

Junior mining stocks make up 18% of his fund -- the highest percentage in years. That compares with 31.5% in intermediate miner holdings, which fall between $250 million and $1 billion in annual sales.

"The main difference between junior and senior miners will show up on the risk metrics," says Johnson, who regularly visits mines to gauge management's expertise and if workers are active. "They're going to be riskier, because typically they are one-project companies. But they usually have a better growth profile and cheaper valuations."

Co-fund manger Denbow points out that last fall, smaller miners were more reliant on capital from banks, and thus were sold off more than larger miners during the credit freeze. "They're still making up for some of that when they were beaten up last year," he says.

Two of the fund's top junior mining holdings are two Vancouver, Canada-based companies: Great Basin Gold (GBG) and Aurizon Mines (AZK).

The fund added Great Basin two years ago. Johnson says he expects its seasoned management to more than double gold production to 200,000 ounces by the end of next year. The company's Hollister mine in Nevada is high-grade, he says, producing 1 ounce of gold per ton of material mined. A typical mine might yield 1/10 of an ounce per ton. "They've already poured real gold out of this thing," he says. "It's not just a figment of someone's imagination."

At the operating level, Johnson says Great Basin has hired seasoned managers from Newmont Mining, one of the world's largest producers with mines also in Nevada. "These are experienced Nevada miners with a long track record," he says.

According to Johnson, Aurizon is a fairly cheap stock on an enterprise value-to-per-recoverable-ounce basis. The ratio represents the company's value -- market capitalization plus debt minus cash -- to the estimated ounces of gold it can recover from its mines.

Aurizon runs one mine in Quebec called Casa Berardi, which he expects to ramp up production to 200,000 ounces per year after 2010 from about 150,000 ounces this year.

Not only are the junior miners undervalued, according to Johnson and Denbow, but miners do disproportionately well in a gold bull market.

"The rule of thumb is a 1% move in gold prices equals a 2% to 3% move in mining stocks," Johnson explains.

So when gold prices rise by $1 an ounce, miners' profits can jump by $2 or $3. Here's why: Large and small gold miners operative massive mines with fixed costs like labor and fuel. Bullion dealer Kitco says it costs the average mine roughly $425 to extract an ounce of gold. That represents a $635-per-ounce profit if gold trades at current levels around $1,060 per ounce. If gold rises 10% to $1,170, a miner's profit rises to $745, up 17%.

Johnson is quick to point out that leverage also cuts the other way. But he expects mining stocks to gain amid physical gold's rise.

It's difficult for retail investors to do research. No indices or exchange-traded funds directly follow junior miners. But Johnson says if a retail investor wants to do his own stock-picking, "He first needs to identify management to make sure that they're getting in bed, so to speak, with reputable, experienced people."

USAA's complex models value miners by balance sheets, cash flow statements, currency risk, management expertise, recoverable ounces predictions, and other metrics.

The fund's 1.31% management expense might seem steep. But as its returns suggest, Johnson and Denbow have a strong track record excavating the best miners.