There are very few sectors with bullish fundamentals underlying them that are trading at reasonable valuations. I am a contrarian at heart, so I am drawn to beaten-down spaces. At the moment, two sectors that are trading at enormous discounts are the energy stocks and retail-focused REITs. However, I understand that these sectors have poor short and potentially medium-term underlying fundamentals.
The only sector I can think of that has excellent underlying fundamentals that is trading at a half-decent valuation is the precious metals sector. Gold stocks are not beaten up given their fabulous run year over year, but they certainly have the wind at their backs.
At the moment, you could practically throw a stick at the sector and pick a stock that will make you money, especially if gold breaks into new all-time highs.
A free cash flow generator
At the moment, I am looking for gold miners that are net-debt free and focus their operations in North and South America. I prefer a focus on North America, but anywhere on the two continents make the case for potential purchases. One stock that I have begun to dip my toe into is Yamana Gold Inc. (TSX:YRI)(NYSE:AUY).
Commodity companies live or die on the amount of leverage they have, so a company with no net debt is a jewel. Unfortunately, Yamana still has net debt. However, the company is actively reducing that debt substantially with its free cash flow. During Q1, Yamana decreased net debt by $20 million bringing it to $861 million. As free cash flow increases with higher gold prices, debt will come down further.
Another great metric that is starting to appear in gold companies is free cash flow. In Q1 2020, Yamana reported that it generated $91.1 million in net free cash flow. Free cash flow is what demonstrates that a company is truly profitable. It is also what powers dividend growth and capital expenditures.
Yamana operates in North and South America, which is positive. It has a 50% ownership partnership with Agnico Eagle on the Malartic mine in Canada. The remaining producing mines are all located in South America. While I prefer companies with more North American operations, having mines in South America does fit the criteria.
Let’s get one thing straight. I don’t invest in commodity stocks for the dividends alone. Commodity stocks are a great way to make outsized capital gains when the fundamentals work in their favour. Nevertheless, dividends are a way to get your capital returned. Yamana increased its dividend by a startling 250% over the past year on the back of massively increasing free cash flows.
Collect the money while you can get it, but know commodity stock dividends will likely collapse if the price of the underlying commodity falls. Hopefully, though, you will have sold the stock long before the stock price drops.
The Foolish takeaway
There is a lot to like about Yamana. It is generating free cash flow, which is a huge plus. Even more positive is the fact that it is using its free cash flow to pay down debt. Personally, I wish it would use more free cash flow to pay down debt rather than increase dividends since debt is a killer. However, the income from the dividend is a nice bonus.
I am taking a small position in Yamana since it proved it can generate strong free cash flow. I like the fact that they are dedicated to paying down debt. There is a very good chance that this stock can double, especially if gold prices break into all-time highs. Yamana would make an excellent addition to a basket of gold stocks.
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Fool contributor Kris Knutson owns shares of YAMANA GOLD INC.