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Anticipate Before You Participate: Patterns in Trading
September 2, 2014

The primary unit of time measurement for high-frequency traders might be the microsecond, but for normal retail traders, it’s vital to know the best months, days and even half-hours of the day to make market transactions.

Consider Black Friday, the most active shopping day of the year. Let’s say a 60” 1080p plasma HDTV normally goes for around $900 but, on Black Friday, is discounted to $500. That’s a 44 percent savings. If you had a desire to own this TV and were somehow guaranteed a way to bypass the rabid mobs, you’d be a fool to spend $900 on it the day before.

Likewise, you’d be at a disadvantage to buy or sell a security without first conducting some level of research to determine the optimal time, statistically speaking, to make a transaction. At the very least, you should know when not to make a transaction. 

Just the facts, ma'amFortunately, much of this research has already been conducted. My friend Jeffrey Hirsch, following in the footsteps of his late father Yale Hirsch, has for years edited the invaluable Stock Trader’s Almanac, which is updated annually. The book is notable for finding reliable patterns in market trends and behavior, on both the micro and macro scale. It also gave birth to such well-known investing adages as “Sell in May and Go Away” and the “January Barometer.”

Thirty-five years ago when I was just getting started in the investment business, I asked Yale how he managed to arrive at his findings. He told me that his background in music composition enabled him to “hear” melodies, if you will, in four-year presidential cycles, seasonal cycles, weekly cycles and more. This interdisciplinary approach of combining music and finance should inspire all investors to leverage their own unique skills, talents and backgrounds to seek patterns in the market that others might overlook. 

If you don’t already own a copy of the Stock Trader’s Almanac, I urge you to make a special trip to the bookstore. You can also visit the book’s website and sign up for a free seven-day trial. The site provides a wealth of helpful and fascinating information for investors to peruse.  

The Best Times to Trade
Previously I discussed market patterns in four-year presidential cycles and seasonal cycles. But now let’s look at months and work our way down to half-hours of the trading day.

Months
“Sell in May and Go Away” is more than a clever expression. The Stock Trader’s Almanac has over six decades’ worth of data to support the reliability of this strategy. Based on the S&P 500 Index’s monthly closing prices, November, December and January are the best months for trading volume. Conversely, the worst-performing months of the year fall between May and October. Even though the Dow Jones Industrial Average has been up four of the past five Septembers, the ninth month has still been the worst-performing since 1950 for all of the major indexes and exchanges, including the Dow, S&P 500 Index, NASDAQ and Russell 1000 Index.

Average-Month-to-Month-Percentage-Changes-in-S&P-500-Index
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What this shows is that, in August, September and October, it’s time to “nibble” on stocks, as prices are dropping. In March, April and May, it’s time to trim.

As I said, the Dow has been improving slightly in September over the last few years. Its 20-year return has risen to -0.51 percent from its 50-year return of -0.77 percent return.

Theoretically, investing from November 1 through April 30 and then switching to fixed-income products for the rest of the year seems to be a safe and effective strategy. If you backtest this to 1950 with an initial $10,000 investment, you would have gained an estimated 6,740 percent. Investing the same $10,000 from May through October would have cost you $1,024. What a difference six months makes.

I must stress, however, that this chart, and those that follow, shows only probability. Like a basketball bouncing down a rocky mountainside, nothing is certain, and actual behavior varies. Macro events such as presidential elections, midterm elections and changes in fiscal and monetary policy have a dramatic effect on the outcome of the market.

For further data, check out the Almanac’s best and worst S&P 500 entry and exit dates, separated into the five best months (November through April, excluding February) and seven worst months (May through October, including February).

Weeks
Below you can see the best and worst weeks of the Dow, ranging from 2008 to 2012.

Best and Worst Weeks for the Dow Jones Industrial Average
2008 through 2014
Best 20 Weeks Worst 20 Weeks
Week Ending % Change Week Ending % Change
10/31/2008 11.29% 10/10/2008 -18.15%
11/30/2011 7.25% 9/23/2011 -6.41%
11/28/2008 9.73% 08/05/2011 -5.75%
07/17/2009 7.33% 05/07/2010 -5.71%
03/13/2009 9.01% 01/24/2014 -3.52%
10/14/2011 4.88% 11/25/2011 -4.78%
04/18/2008 4.25% 02/08/2008 -4.40%
09/16/2011 4.70% 07/29/2011 -4.24%
07/09/2010 5.28% 10/03/2008 -4.84%
03/27/2009 6.84% 05/23/2008 -3.91%
06/30/2011 4.02% 01/18/2008 -4.02%
08/26/2011 4.32% 06/27/2008 -4.19%
12/20/2013 2.96% 02/20/2009 -6.17%
09/13/2013 3.04% 10/24/2008 -5.35%
01/31/2008 3.63% 06/20/2008 -3.78%
06/08/2012 3.59% 01/04/2008 -3.50%
09/03/2010 4.33% 08/19/2011 -4.01%
12/23/2011 3.60% 05/18/2012 -3.52%
10/28/2011 3.58% 11/21/2008 -5.31%
11/23/2012 3.35% 11/14/2008 -4.99%
Source: Stock Traders Almanac 2014, U.S. Global Investors

What’s interesting here is that, even though September is historically the worst month in which to trade, it had three of the best weeks and only one of the worst weeks. Conversely, December, one of the best months in which to trade, had only two of the best weeks. No week in December fell in the “worst” category, however.

Days
Which day is the best to buy? Which day is the best to sell? That depends on whether we’re talking about days of the week, days of the month, days preceding or following holidays—there are innumerable contexts and implications to consider, all of which have already been carefully studied and scrutinized by Yale and Jeffrey Hirsch.

According to Hirsch, the best day to trade was once the last trading day of the month, followed by the first four trading days of the next month. Front-runners who noticed this trend, however, took advantage of it, leading to a shift in 1982. Since then, the strongest days tend to fall on the ninth, tenth and eleventh trading days of the month.

To the right, you can see what Hirsch’s research says are the days of the week when the greatest likelihood that performance will rise in the Dow will occur. Between 2008 and 2014, Mondays have been the weakest, climbing less than 50 percent of the time—the only trading day to fall more than it rises, in fact. 

As a special case study, let’s focus just on the three days before and after a holiday, specifically Labor Day. Historically, how does the market react to this particular day?

The following chart tracks the historical 33-year performance of four major indexes three trading days before and after Labor Day. As you can see, investors tend to be bullish on the Friday preceding the weekend (-1) and bearish starting Tuesday, the first trading day of the week (+1). The NASDAQ does slightly better than the other three both before and after the holiday, leading into the rest of September.

3-Days-Before-and-3-Days-After-Labor-Day
click to enlarge

There’s plenty more research on the best days on which to trade—and which to avoid—in The Stock Trader’s Almanac.

Hours and Half-Hours
Canada is the largest natural resource market in the world. The TSX Venture Exchange, with a market capitalization of over $37 billion, represents approximately 2,250 small-cap companies, many of them in the mining and metals space.

Intraday-MArket-Performance-of-the-TSX-Venture-Exchange
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What you see above is the intraday market performance of the TSX Venture. I chose to use it as an illustration because mining, metals and gas are some of our specialties here at U.S. Global Investors. Therefore, it’s imperative that our portfolio management team is cognizant of these exchange-specific intraday trends to buy and sell stock at the best possible price and execution.    

With the TSX Venture, it’s generally smarter to sell rather than buy in the morning. Over the last two and a half years, this is when prices tend to be high. There’s heavy volatility as the market is reacting to what might have happened since the previous trading day’s closing bell. Unless you really know what you’re doing in this particular market, if you buy in the morning, you can often expect to see your shares sink as the day unfolds.

The “safest” time to buy would be in the late afternoon. The market has cooled somewhat and traders are gauging where things might be headed. The challenge during this time, however, is that volume has dipped and, as a result, bid-ask spreads have widened.

A similar pattern emerges, a little like the shape of a waterslide, if you chart the intraday performance of the Market Vector Junior Gold Miners ETF, which gives investors exposure to small and intermediate gold and silver companies. Prices are highest in the morning, decrease throughout the afternoon and then get a final boost starting around 3:00. Making a trade at 9:30, then, will have a vastly different outcome than making one at 1:30.  

Intraday-Performance-of-the-Market-Vectors-Junior-Gold-Miners-ETF
click to enlarge

Now compare the TSX Venture and Market Vectors Junior Gold Miners ETF, both of which have their own DNAs of volatility, to the NASDAQ 100 ETF—or “the Qs”—which tracks the 100 largest and most active non-financial and international companies listed on the greater NASDAQ. In other words, blue chip stocks.

Intraday-Performance-of-the-Market-Vectors-Junior-Gold-Miners-ETF
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Over the same timeframe as the previous indexes, the pattern here has almost reversed. Relative lows in the morning. Modest improvement throughout the trading day. You could, in this market, reasonably buy in the morning and sell in the afternoon.

Again, these charts are imperfect and show only probability. Trading activity can fluctuate widely, especially prior to and after earnings and economic announcements. And there will always be the unforeseen event—a workers’ strike, a CEO’s termination or resignation, civil unrest—that shakes up the market.

You don’t have to be as obsessed and intuitive with statistics and patterns as Yale or his son Jeffrey Hirsch, but it pays to “Anticipate Before You Participate.” If there’s one thing I want to leave you with, it’s that research must be conducted on the market you’re planning to trade in before you enter.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.

The Russell 1000 Index is a U.S. equity index measuring the performance of the 1,000 largest companies in the Russell 3000 Index.  The Russell 3000 Index consists of the 3,000 largest U.S. companies as determined by total market capitalization. The Russell 2000 Index is a U.S. equity index measuring the performance of the 2,000 smallest companies in the Russell 3000. The Russell 3000 Index consists of the 3,000 largest U.S. companies as determined by total market capitalization. The Dow Jones Industrial Average is a price-weighted average of 30 blue chip stocks that are generally leaders in their industry. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The Nasdaq Composite Index is a capitalization-weighted index of all Nasdaq National Market and SmallCap stocks. The S&P/TSX Venture Composite Index is a broad market indicator for the Canadian venture capital market. The index is market capitalization weighted and, at its inception, included 531 companies. A quarterly revision process is used to remove companies that comprise less than 0.05% of the weight of the index, and add companies whose weight, when included, will be greater than 0.05% of the index. The Market Vectors Junior Gold Miners Index is a market-capitalization-weighted index. It covers the largest and most liquid companies that derive at least 50 percent from gold or silver mining or have properties to do so. The NASDAQ-100 Index includes 100 of the largest domestic and international non-financial securities listed on the Nasdaq Stock Market based on market capitalization.

Fund portfolios are actively managed, and holdings may change daily. Holdings are reported as of the most recent quarter-end. The following securities mentioned in the article were held by one or more of U.S. Global Investors Funds as of 6/30/2014: Market Vectors Junior Gold Miners ETF.

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Lucara Diamond Stock Sparkles, Reports Another Strong Quarter
August 28, 2014

Let’s talk diamonds for a change.

A 257-carat diamond unearthed from Lucara's Karowe Mine in Botswana Often it seems that gold gets all the fun when I write and speak about precious metals and minerals. But Vancouver-based Lucara Diamond, which we own in both our Gold and Precious Metals Fund (USERX) and World Precious Minerals Fund (UNWPX), has been turning heads here at U.S. Global Investors lately for a number of reasons, the most notable being that it continues to report stellar returns.

The company reports that, in its second quarter, it achieved tender proceeds, or profits, of $95 million from sales of 111,900 carats of diamonds, amounting to $849 per carat. Compared to last year’s second quarter, profits are up an impressive 93 percent.

For the six months ended June 30, it generated $129 million from sales of 219,370 carats, or $586 per carat.

As for its annual revenue forecast, Lucara has increased it 60 percent to between $240 and $250 million.

William Lamb, Lucara’s president and CEO, commented on the company’s continued prosperity:

Lucara has a strong first half of the year and this has continued into the third quarter with our second exceptional stone tender in July… To the end of June, the mine sold 54 diamonds larger than 50 carats, including 11 diamonds larger than 100 carats and 30 diamonds selling for more than $1 million. The sustainable recovery of special diamonds has enabled the addition of the third exceptional stones tender which will be held in the fourth quarter.

In a July 16 press release, the company also reported that, of 16 stones sold, four were sold for above $4 million each, one 109.4-carat diamond went for $6.19 million, and a 118.4-carat diamond was let go for $5.36 million.

For these reasons and more, Lucara has made investors very happy. The company has returned 440 percent since 2010 and 41 percent year-to-date (YTD) compared to the S&P/TSX Global Mining Index’s 14 percent. Last year alone, share prices gained 179 percent.

Lucara Diamond VS the SPTSX Global Mining Index
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A Strong Position in Southern Africa
Lucara Diamond Corp.'s Mining Properties Lucara’s success is mostly attributable to its 100 percent ownership of Karowe Mine, located in Botswana, one of the world’s most prolific diamond producing countries. The company is currently spending approximately $50 million this year to upgrade the mine’s plant to handle the immense size and quantity of diamonds exhumed from this deposit.

When Botswana gained its independence from Britain in 1966, it was one of the poorest nations in the world. Now, because of the lucrative diamond industry, which represents 33 percent of its GDP, Botswana ranks as one of the wealthiest in Africa. Diamonds, in fact, fund the country’s free health care and education.

Lucara also has a 75 percent interest in the Mothae Project, located in the tiny, South Africa-surrounded nation of Lesotho, whose two main natural resources are diamonds and water.

The southern part of the continent, as many people know, is the world’s main hotspot for diamond mining, which employs close to 40,000 Africans in one way or another. About 65 percent of all natural, as opposed to synthetic, diamonds are mined in the region, amounting to about $8.5 billion annually.

Over the years the diamond industry in Africa has received much critical media attention for its corruption and hazardous working conditions—dramatized most recently in the 2006 Leonardo DiCaprio-starring film Blood Diamond—but Lucara is explicitly committed to the health and safety of its workers. In the 12 months ended June 30, the company reported only one injury, at its Karowe Mine.

From Mine to Matrimony
Very much like gold, the diamonds that Lucara and other companies exhume are used for both fine jewelry and industrial applications.

The two main drivers of diamond demand are fine jewelry and industrial applications

However, there are several important differences.

For one, whereas gold has been worn and used as currency by countless cultures throughout history, diamonds have seen their popularity explode only in the last 100 years or so, specifically in the U.S. American men have been programmed to buy diamond-studded engagement rings and Valentines gifts mostly due to famed diamond jeweler De Beers’ classic “A Diamond Is Forever” ad campaign, conceived in 1947 by a young female copywriter named Frances Gerety.

So guys, next time you’re shopping for that diamond ring or necklace, you know who to thank—or blame. De Beers’ “A Diamond Is Forever” campaign, as timeless as the gemstones themselves, was actually recognized by Advertising Age in 1999 as the century’s greatest slogan.

And rightfully so. American brides receiving diamond engagement rings leaped from 10 percent in 1939 to more than 80 percent by the end of the 20th century. Gerety’s campaign has made more of an impact here in the U.S.—the world’s largest diamond market, responsible for half of the $72 billion in sales made annually—than probably she could ever have imagined.

Global Diamond Jewelry Retail Sales, by Percentage
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It’s hard for us to imagine not giving or receiving diamond-studded engagement rings and wedding bands, but for much of the rest of the world, the concept is foreign and a little puzzling. Japan is one of the few countries to have adopted our engagement ring ritual, and in the last few years China has followed suit as household incomes have increased.

Another key difference between gold and diamonds is that, unlike gold, diamonds haven’t quite taken off as a competitive asset class—until recently.

Last year a group of hedge fund traders launched the Investment Diamond Exchange, where investors can purchase diamonds with no intentions to turn them into jewelry—similar to gold coins and bars. And in September 2013, a new index was proposed, the GemShares Global Investment Grade Standard Diamond Basket Index—an unwieldy name, to be sure. Once launched, the index could be used to create an exchange-traded fund (ETF) backed only by physical diamonds.

As exciting as these developments are, the problem facing diamond investing is that, whereas gold bullion is priced reliably by the ounce, diamonds are graded on a wide combination of metrics, from size to cut to clarity to color. Because these metrics are largely subjective, it’s possible for the same diamond’s price appraisal to differ by 30 percent, depending on the expert who appraises it. That’s why there’s no “spot diamond” price as there is with gold, silver, platinum and other precious metals and minerals.

Here’s Hoping Lucara Diamond Is Forever
Because diamond sales in the U.S. continue to be brisk— imports in 2013 totaled $23 billion, up more than 16 percent compared to 2012—it pays to invest in mining companies such as Lucara that have a  proven ability to grow and manage their business prudently.

With the company’s announcement that it’s currently seeking merger and acquisition (M&A) opportunities—possibly with rival Gem Diamonds—Lucara Diamond’s future shines brightly indeed.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Past performance does not guarantee future results.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.

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.

The S&P/TSX Global Mining Index is a dynamic international benchmark tracking the world's leading mining companies. It is composed of publicly-traded international mining companies.

Fund portfolios are actively managed, and holdings may change daily. Holdings are reported as of the most recent quarter-end. Holdings in the funds mentioned as a percentage of net assets as of 6/30/2014: Lucara Diamond Corp. (0.30% in Gold and Precious Metals Fund, 1.67% in World Precious Minerals Fund), De Beers (0.00%), Gem Diamonds (0.00%).

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Gold Jewelry Demand in India Improves
August 26, 2014

Those who root for gold root for India. Despite a welcome June rally, it’s been a rocky second quarter for the world’s second-largest consumer of the metal, with demand down 18 percent compared to last year.

But consumer appetite seems to be on the upswing following a tepid July. Gold premiums rose to between $10 and $13 a troy ounce this month, compared to zero last month. Such premiums are good indicators that buyers are willing to spend more on gold jewelry and other forms of bullion.

That premiums have risen also suggests that Indians are making their gold purchases ahead of Diwali, or the Festival of Lights, a traditional time to participate in what I call the Love Trade. This year Diwali begins on October 23.

Other global celebrations and events that trigger the Love Trade include the Indian wedding season, the Chinese New Year, Ramadan and, of course, Christmas.

Gold: Annual Seasonal Cycle
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Challenges Affecting Demand

Government policy and temperamental weather are mostly to blame for gold’s less-than-satisfactory performance in India.

The recent election of Narendra Modi, who rules the pro-business Bharatiya Janata Party, had the global market hoping he would remove gold import duties. Unfortunately, the duty remained unchanged in the new government’s July budget. It’s my hope that the Modi administration will rethink this policy and ease the restrictions.

Ft-Pankaj Parakh, an Indian businessman showing off his 45th birthday present gift a $210,600 18 carat gold shirt

A slow start to the annual four-month monsoon season, beginning in June, also affected sales. Much of the country’s gold demand comes from rural households, especially farmers, whose summer crops depend on monsoon rains. Rural Indian households typically devote between 7 and 8 percent of their income on gold, but disappointing crop yields have no doubt cost them earnings.

A Golden Heritage

As it does in many other cultures, gold has a rich tradition in India, where people have been wearing gold jewelry for about 4,000 years. In ancient Hindu epics such as the Ramayana and the Mahabharata, gold is associated with godliness and kingliness, a sentiment millions of Indians still harbor to this day.

A 2012 World Gold Council survey, the results of which are shown below, stresses the high level of importance Indians place on the metal—as a financial asset, fashion accessory and cultural identifier.

Attitudes to GOld Jewelry in India
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The rupee gold price might have risen 320 percent in the last 10 years, but because gold plays such a vital role in the country’s heritage, appetite for the yellow metal remains robust.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

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Managing Expectations Part III
August 25, 2014

Part III of III: Picking Mining Stocks in a Bear Market

In the first part of this three-part series, I discussed the importance of cycles such as four-year presidential elections and the life of a gold mine, and how they play into our investment strategy here at U.S. Global Investors. Part II dealt with statistical diagnostic tools, in which I strived to simplify the definitions of standard deviation and mean reversion and explain how they’re applied.

The third part of this series on managing expectations is devoted to fundamental resource stock evaluation. I’ll discuss some of the statistical tools we use to pick quality stocks during a treacherous bear market, such as what we’ve seen in gold stocks the last three years.

Let it be known, however, that, though our approach might vary slightly depending on the condition of the market, we fervently seek to pick the best stocks at the best price and execution.

How I Learned to Respect the Bear

The traditional definition of a bear market is when broad stock market indices fall more than 20 percent from a previous high—which sounds like a catastrophe, but is in fact “normal” market behavior. According to self-professed “investing nut” Ryan Barnes, a contributor for Investopedia, “bear markets… are a natural way to regulate the occasional imbalances that sprout up between corporate earnings, consumer demand and combined legislative and regulatory changes in the marketplace.”

No need for alarm, folks. This is all part of the natural order of things.Think of bear markets, then, as the gradual transition from warm summers into frozen winters. Trees lose their leaves, snow and ice blanket the ground, many animals—the bear the most notable—hibernate for the season. All life seems to take a breather. But just as you can always count on spring to emerge and, with it, new life, you as an investor can count on the market to rebound with fresh vigor.

As you might have known, the tail end of “winter” is when you want to take part in the inevitable recovery. If the market never had a winter season, if it were perpetually trapped in an endless summer, investors would be hard-pressed to find an ideal entry point.

It’s easy to determine when winter becomes spring. But what about the end of a bear market? How do you know when it’s bottomed and the optimal buying time has been reached?

CLSA consultant Russell Napier, in his now-classic 2009 book Anatomy of the Bear, describes the determinants of the end of a bear market:

The bottom is preceded by a period in which the market declines on low volumes and rises on high volumes. The end of a bear market is characterized by a final slump of prices on low trading volumes. Confirmation that the bear trend is over will be rising volumes at the new higher levels after the first rebound in equity prices.

Look at the chart below. You’ll see that, in three decades, the Philadelphia Gold & Silver Index (XAU) has never had a losing streak for more than three years.

In 30 Years, the XAU Never Experienced a Losing Streak of More Than 3 Years
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Historical precedent suggests that gold stocks were due for a jump in 2014, and just as expected, the XAU has returned close to 20 percent year-to-date (YTD) after an abysmal 2013, the “final slump of prices on low trading volumes.”

The following line graph illustrates just how dramatically gold and silver stock performance has rebounded. As you might remember from our discussion last week, what we see here is an example of mean reversion, which occurs when the price of a security reverts back to its historic average.

2014 Sees Improved Gains in recious Metals Mining Stocks
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These data exemplify the notion that you should remain patient during downturns, avoid getting discouraged and allow the security—in this case, precious metal stocks—to revert back to its long-term mean. When it does, you’ll find that the wind is suddenly at your back instead of in your face.

Spencer Johnson, author of the 2009 book Peaks and Valleys: Making Good And Bad Times Work For You—At Work And In Life, writes, “You cannot always control external events, but you can control your personal peaks and valleys by what you believe and what you do.” Likewise, we might not have any control over how the market behaves, but we can control how we respond to it: with grace, intelligence and levelheadedness.

Value Drivers for Superior Performance

Just the facts, ma'amOne of the tools we use to navigate around volatility, regulate emotion and focus on facts and fundamentals is an invaluable model we call the portfolio manager’s cube. It helps us separate the weak from the strong, evaluate a company’s attractiveness and pick the best GARP-y stocks. “GARP” stands for “growth at a reasonable price,” which is an investment strategy that aims to identify companies with superior growth and value metrics.

The cube allows us to sift, sort and prioritize. It draws attention to the intersections among a resource company’s production, cash flow and reserves (rows) and relative value, momentum and event drivers (columns). Using this model, we compare stocks on a relative basis in production per share to find attractive opportunities and overpriced risks. We also identify events that could increase reserves and/or production per share over the next 12 months.

More than anything else, the cube affords us the framework for conducting relative valuation of a stock. Relative valuation is a method that compares a security’s value to that of others to determine its financial worth.

For example, we evaluate mining stocks in the same way you or I might compare cars on multiple metrics before making a purchase. On this topic, I urge you to check out one of my favorite websites, Dennis Boyko’s GoldMinerPulse, for a look at the type of fundamental analysis and relative evaluation that goes into comparing and contrasting mining stocks.

The following is an example of how we might use the cube. Suppose a young mining company has just discovered a gold deposit. This event might excite potential investors and compel them to enter when the stock is undervalued, expecting it to skyrocket. But it’s important to conduct a cross-sectional analysis of this discovery in terms of production, cash flow and reserves. How much gold does the company expect to produce in relation to others? The average concentration of gold in the earth’s crust is 0.005 parts per million, making a substantial yield very rare. About one in 2,000 companies is lucky enough to stumble across at least a one-million-ounce deposit.

Other questions might include: Does the company have ample cash flow to finance the costly yet necessary infrastructure, equipment, geological analyses and manpower to extract the metal, not to mention pay dividends? Has it kept up with its cash reserves to remain solvent during development of the mine and subsequent excavation? Many years, after all, typically go by before ounce one is plucked from the ground.

Besides using models such as the portfolio manager’s cube to determine a mining company’s or asset’s relative value, we also rely on “boots on the ground” experience. Members of our investment team and I routinely visit domestic and global projects to gain tacit knowledge and ensure that operations are running smoothly and management is knowledgeable and has a firm handle on things.

To see photos of what these visits look like, check out our most recent slideshow, On a Quest for Copper.

The Five Ms

A mine’s lifecycle is the perfect segue into what I call the five Ms to picking the best mines. Most of what follows can be found in the 2008 book I co-wrote with London-based financial writer John Katz, The Goldwatcher: Demystifying Gold Investment.

One of the five Ms is Mine Lifecycle, which I cover at length in Part I of this series along with other cycles such as weather patterns, gold seasonality trends and four-year presidential cycles.

The Life Cycle of a Mine
click to enlarge

The other four Ms are Market Cap, Management, Money and Minerals, detailed below.

Market Cap

Market cap is simply the number of shares outstanding multiplied by the stock price. The gold sector is broken down into three sectors by market cap: seniors (market caps >$10 billion), intermediates (between $2 and $10 billion) and juniors ($2 billion).

If a gold company has 10 million shares outstanding at $1 per share, the company is valued at $10 million. The question any investor should ask is, “Is this company really worth $10 million?” If the market pays $25 per ounce of gold in the ground, the company should be valued at $25 million (one million ounces in reserves X $25 an ounce). If the company’s market cap is only $10 million, it may look undervalued. Accordingly, if the company’s market cap is $50 million, it may appear to be overvalued.

For larger gold companies, an investor can measure a company’s market cap against its production level, reserve assets, geographic location and/or other metrics to establish relative valuation. For junior mining companies—an area of focus for our World Precious Minerals Fund (UNWPX)—we look for balance sheets with ample cash for exploration and development of prospective reserves, but we resist paying more than two times cash per share.

Management

Essentially, management of mining companies must have both explicit and tacit knowledge to be successful. Explicit knowledge is academic. How many PhDs or masters in geology/engineering does company management have?

Tacit knowledge is more personal in nature and much more difficult to obtain. It is acquired over time through first-hand observation, experience and practice. How many years have they worked in the industry? Has management ever successfully completed a project with similar geopolitical/environmental constraints?

Success in the mining sector, especially the juniors, relies on the ability to raise capital and communicate with investors. Often the heads of junior companies are geologists or engineers who have no relationships in the brokerage business. This lack of relationships impedes their ability to generate market support. Historically, companies with the highest number of retail shareholders have the highest price-to-book ratios and carry higher valuations than peers.

Some of the most successful company builders in the gold-mining industry are what I call the “financial engineers”—people who have the relationships and understand the capital markets and who know how to hire the best geological and engineering teams. We tend to have more confidence investing in them.

Money

Mining is an expensive business. Often, companies burn through substantial amounts of capital before generating their first $1 in cash flow. A gold exploration company has to deliver reserves per share to have a chance at another round of financing. It has to convince the capital markets that it is an attractive investment on a per-share basis.

We call this the “burn rate”—how long will the company’s current cash levels last before it has to return for additional financing. If a junior exploration company has $15 million in cash reserves and is spending $3 million a month, it has five months to deliver enough reserves per share to convince capital markets it is worth the risk.

This calculation can be done quickly. Exploration reserves are generally valued at one-third the reserve values of a producing mine—if producing reserves are valued at $150 an ounce, exploration reserves would be $50 per ounce.

The gold-equities market is generally efficient at judging reserves per share, so if the exploration company doesn’t come up with the results necessary to get an evaluation—find gold for less than $50 an ounce—investors quickly lose confidence. There is an old rule when it comes to exploration companies: don’t pay more than two times cash per share if there are no proven assets in the ground.

Minerals

Compared to the rest of the mining sector, gold companies have the highest industry valuations based on price to earnings, price to cash flow, price to enterprise value and price to reserves per share.

Companies operating mines that produce gold as well as industrial metals tend to have lower valuation multiples.  For example, the current price-to-earnings ratio for Freeport-McMoRan, is 8x-times forward earnings. Investors can use the low relative valuations of copper/gold producers to increase their margin of safety in anticipation of an upward move in gold prices.

I must stress once again that these relative valuation techniques apply whether we’re in a bull or bear market. In Peaks and Valleys, Spencer writes, “Have you ever noticed that your life is filled with ups and downs? It is never all ups or downs.”

Similarly, the market is never all ups and downs. As active money managers, we have learned to adapt to an ever-changing climate—from “summer” to “winter”—to select what we believe are the best, most reasonably-priced mining stocks for our investors.

Next week, look out for my discussion on how our investment team uses statistical tools to make trades around core positions.

Happy investing!

Further resources on active management of resource stocks:

For more on my unique approach to active management, listen to my interview with Frank Curzio of S&A Investor Radio.

Also be sure to watch the latest edition of Kitco News, in which Daniela Cambone and I chat about what’s in store for gold in the coming weeks.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Past performance does not guarantee future results.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.

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.

The Philadelphia Gold and Silver Index (XAU) is a capitalization-weighted index that includes the leading companies involved in the mining of gold and silver.

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Diversification and Discipline Are Key to Investing in Gold
August 19, 2014

Like training for a marathon, investing in gold isn’t for the apathetic or indifferent. It requires strong-willed discipline.

Gold investors need discipline to keep up with the metal's variable stridesComing into 2014, gold was in a depressed state. The metal had lost over 28 percent the previous year, its greatest slide since 1980. Investors who dropped out of the race in January no doubt regretted the decision in March after watching the metal unexpectedly soar to above $1,300 an ounce.

And the news didn’t stop there. By midyear, gold was one of the top-performing commodities; last month, India, the world’s second-largest consumer of gold, increased its bullion imports by 65 percent; gold mining stocks are currently outpacing the commodity itself.

When prices plunge as dramatically as they did in 2013 and early 2014, it’s easy—instinctive, almost—for our so-called reptilian brains to hijack our better judgment. Our primordial fight-or-flight response kicks in, and too often we choose to fly, only to regret our decision later.

But we’re stronger than that. Jacqueline Gareau, the 1980 Boston Marathon winner, said of long-distance running: “The body does not want you to do this. As you run, it tells you to stop, but the mind must be strong. You always go too far for your body. You must handle the pain with strategy. It is not age. It is not diet. It is the will to succeed.”

Earlier in the year I spoke with Business Television’s Taylor Theon about this very idea that to invest in gold requires not only discipline but also diversification. As I’ve often stressed, we at U.S. Global Investors recommend that 10 percent of your portfolio should be allocated to gold—5 percent to bullion, 5 percent to mining stocks, and rebalance every year. This should always be the case, whether gold is soaring at a good clip or whether its wings appear to have been clipped.

As I advised Theon’s viewers:

Be diversified. Just appreciate the seasonality and volatility of all these different asset classes. The DNA of gold over any rolling 12 months is plus or minus 15 percent; gold stocks, plus or minus 35 percent. So any time gold stocks fall 35 percent, it’s become an opportunity to buy. When they fall 60 and 70 percent, it’s a screaming buy. And they will rally, and they will rise.

And rise they did, just as the theory of mean reversion predicted. Mean reversion, which I discuss at length in Part II of my three-part series on managing expectations, states that security prices will revert to their historic average eventually, whether we’re in a bull or bear market.

Below you can watch the entire interview, during which Theon and I also discuss India and the importance of the Purchasing Managers Index (PMI).

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

The J.P. Morgan Global Purchasing Manager’s Index is an indicator of the economic health of the global manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

The Consumer Price Index (CPI) is one of the most widely recognized price measures for tracking the price of a market basket of goods and services purchased by individuals. The weights of components are based on consumer spending patterns.

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Net Asset Value
as of 08/29/2014

Global Resources Fund PSPFX $10.06 0.09 Gold and Precious Metals Fund USERX $7.57 0.06 World Precious Minerals Fund UNWPX $6.99 0.04 China Region Fund USCOX $8.29 -0.01 Emerging Europe Fund EUROX $7.99 -0.01 All American Equity Fund GBTFX $34.04 0.16 Holmes Macro Trends Fund MEGAX $24.69 0.15 Near-Term Tax Free Fund NEARX $2.26 No Change U.S. Government Securities Ultra-Short Bond Fund UGSDX $2.00 No Change