Summary
- Even after bottoming, junior gold miners offer incredible value at these levels.
- From a big picture perspective, unless the global economy makes a radical shift away from its trend, there is little chance that gold demand slows over the long-term.
- Many miners now trade at significant discounts to their NAV, meaning that if the entire company was liquidated the proceeds would be worth more than the company’s market capitalization.
In January 1848, James Wilson Marshall discovered gold while constructing a sawmill along the American River near Sacramento, California. The discovery was reported in the San Francisco newspapers by March but caused little stir amongst the local population. Then in May, a storekeeper from Sutter's Creek named Sam Brannan walked around San Francisco brandishing a bottle filled with gold dust offering first hand proof of the riches to be discovered in the American River. By August, the New York Herald had printed news of Brannan's discovery and the rush for gold accelerated into a full-blown stampede. A census of San Francisco in April 1847 reported the town consisted of 79 buildings including shanties and frame houses. By December 1849, the population had mushroomed to an estimated 100,000. The massive influx of fortune seekers assured California's inclusion as a state in the union, and it hasn't looked back since.
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In a funny-way, the California gold rush of the late-1840s is analogous to the gold mining sector of today. James Wilson Marshall was the first to proclaim the riches available in the American River, but it wasn't until Sam Brannan offered tangible evidence that the gold rush began in earnest. Today, hedge funds and private equity groups are quietly snapping up shares in gold miners, but it will take higher gold prices to attract the masses. Gold miners have been one of the worst-performing sectors for over two years, and once there is tangible evidence that they've turned the corner, the sky is the limit.
Philly Gold & Silver Index (XAU Index, white) - Gold (orange)
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First, we need to understand why gold miners have performed so poorly. To start, gold mining is a tough business. It's not easily scalable. It requires huge upfront and ongoing capital expenditures. When margins are high, it can be lucrative, but when margins are low it's an unsustainable business. These characteristics make mining extremely prone to boom-bust cycles. Since the turn of the century, the Philadelphia Gold & Silver Miner Index, has gone up 200% (2000-2008), down 70% (2008-2009), up 263% (2009-2011) and now down 56% (2011-present).
Despite the technological revolution that has increased efficiency of almost every sector in the economy, gold mining has gotten more difficult. Since 2004, the amount of time it takes to build a mine has doubled from 10 years to 20, as the social, political, environmental and technical hurdles get higher. These hurdles can be expensive to overcome. In 2005, Barrick Gold (TICKER:ABX), the world's largest gold miner, estimated its Pascua-Lama project in Chile would cost $600 million to develop. After countless regulatory and environment battles, Barrick took a $5.1 billion write-down in 2013 and has since mothballed the project. Plus, most potential projects these days are lower quality. In 2005, the average mine yielded 3.5 grams of gold per ton of ore. Today, the average mine yields less than 2.5 grams.
At the end of the day, investors would be fine with a difficult operating environment if it led to more profits. Unfortunately, with gold trading around $1,300 oz., that is just not possible. Determining how much it costs to mine an ounce of gold is complicated, but experts estimate that 90% of operating gold mines have all-in costs (including operating costs, capex and exploration) of between $1,250 and $1,350 per oz. Since the mining industry decided several years ago to forgo hedging production, at current prices many companies are burning cash to keep their mines open. Miners have already slashed capital and exploration spending, and are not green-lighting many new projects. The World Gold Council (WGC) has acknowledged these trends and recently predicted that 2014 will be the year of peak gold mine production. The effects of industry cutbacks will be felt later this year and into 2015, when production is expected to drop.
GFMS World Gold Mine Production
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When you add up all of these issues, it's no wonder that gold mining stocks have struggled mightily. The selling pressure in 2013 was absolutely relentless, hitting both junior and senior miners. Barrick Gold peaked above $56/share in September 2011 and was trading at $13/share, down 76%, by July 2013. Shares have rallied slightly since then but are still trading like distressed assets. In fact, many of these companies have gotten so cheap that they've started to attract distressed and deep-value investors.
When private equity (PE) money starts to show up in a sector, it's often a sign that asset prices are bottoming and a turnaround may be close. According Bloomberg, there is around $8 billion of PE money targeting the gold mining industry and only 14% has been deployed so far. Apollo Global, one of the largest PE firms in the world, has hired executives with mining experience and is actively looking for deals in the sector. TPG Partners, another prominent name, invested $500 million in X2 Resources, a gold mining specific fund.
The smart, patient money is starting to show up in this sector because it has become outrageously cheap. Many miners now trade at significant discounts to their net asset value (NAV), meaning that if the entire company was liquidated the proceeds would be worth more than the company's market capitalization. The Market Vectors Junior Gold Miner ETF (NYSEARCA:GDXJ), which tracks a basket of small-cap gold miners, currently shows a price-to-earnings (P/E) ratio of 13.2 and a price-to-book (P/B) value of 1.03. For comparison, the S&P 500 has a P/E of 17 and a P/B of 2.34. It is very telling that many gold miners have seen strong insider buying so far this year.
With many of these companies trading at-or-below their NAV, it creates an extremely compelling risk/reward opportunity; especially if the price of gold starts to rise. Since the Federal Reserve began implementing emergency monetary stimulus in 2009, gold prices have tracked real interest rates closely. The distinction between nominal interest rates and real interest rates is important in this case.
US 10-Year Real Rates (white, inverted) - Gold (orange)
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The Fed is expected to wind down QE3 in October and insists it will start raising nominal interest rates some time in 2015. However, over the longer term, policymakers need to erode some of the country's enormous debt burden via inflation. This will force the Fed to keep real interest rates around, or even below, zero for some time, which bodes well for gold prices, especially if inflation accelerates.
VIX Index
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On the other hand, if real interest rates rise sharply it will likely be caused by a deflationary shock to the economy (think 9/11 or Fukushima). Over the course of history, there have been few instances where an economy suffered a deflationary shock with interest rates at the zero-bound. Under normal circumstances, the Fed would lower rates to boost economic activity, but in this case there is little capacity to stimulate. However, deflation of this nature would almost certainly help gold by increasing volatility.
Gold and inflation have historically gone hand-in-hand, but the yellow metal reacts just as strongly to market volatility. Whether real interest rates go up or down, the low volatility environment that investors have grown accustomed to since 2012 is almost certainly ending in the coming years.
Since 2000, the VIX (a gauge of equity market volatility) has closed the month above 30 (arbitrary number) twenty times. Of those twenty instances, gold finished higher over the next 6 months 75% of the time; often substantially higher. There were only two instances where gold finished materially lower, October and November 2008. Considering that the Lehman Brothers bankruptcy occurred in August 2008, we're willing to overlook these two anomalies. In fact, 12 months after November 2008, gold was 44% higher.
This is a rather esoteric analysis of the gold market, but the fundamental picture is just as bullish. We already know that global mine production is expected to drop going forward unless prices move high enough to incentivize production. Admittedly, the demand half of the equation took a hit recently. The WGC released data showing that global gold demand fell 16% Y/Y in 2Q 2014.
The headlines were rather alarming. Demand in China, the world's largest consumer in 2013, fell 52% Y/Y. Vietnam's bullion demand shrank 42% in the second quarter, while consumption in Thailand plunged 61% as political instability hurt sentiment. However, these scary numbers ignore a few important facts. First, consumer demand for the yellow metal broke records in 2013 making Y/Y comparisons suspect. Demand for gold bars and coins hit an all-time high of 1,654 tons in 2013, an impressive 28% higher than 2012. Second, the 2Q 2014 global demand numbers were still above the 10-year quarterly average.
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From a big picture perspective, unless the global economy makes a radical shift away from its trend, there is little chance that gold demand slows over the long term. The value of total gold stock has always maintained a close relationship with global GDP, and the world is undoubtedly getting richer. Especially the middle-classes in India and China, where the affinity for gold is especially strong.
Thus far we've outlined why gold miners will be driven higher by compelling valuations and the likelihood of improved margins (higher gold prices) in the future. There are a few ways to implement this theme depending on your risk tolerance. We prefer outright exposure and have been buying the Market Vectors Junior Gold Miner ETF in our portfolio.
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GDXJ is a very liquid ETF with over $2.6 billion in assets comprised of 61 junior mining companies. Historically, junior miners have been extremely volatile given the boom-bust nature of the business, but owning a basket mitigates some of this risk. On balance, junior miners have higher operating costs than their senior peers, which is to be expected considering their lack of capital and economies of scale. However, because their businesses are concentrated around a small number of mines (often just one), higher profit margins have a bigger impact on the bottom line. In many instances, these mines offer lower quality ore deposits that require higher gold prices to be economical.
By its very nature, the gold-mining industry is constantly depleting its own assets. Every producer eventually needs to replace its deposits by discovering new mines or buying rivals. As we mentioned, the time and money involved in developing a new gold mine has exploded over the past ten years (chart, right). To counter this, senior miners are increasingly looking to bolster their production through acquisitions and mergers. This is the main reason we favor GDXJ over GDX.
If you're looking to reduce volatility in this theme with an offsetting position, it makes perfect sense to be long GDXJ and short GDX. In fact, this GDXJ/GDX offset has an extremely strong correlation with the gold price over the past two years. However, given the premiums involved with acquisitions, a pick-up in M&A would likely cause the spread to outperform gold. An increase in M&A may already be under way. In April, Yamana Gold (NYSE:AUY) and Agnico Eagle Mines (NYSE:AEM) each paid an 18% premium for a 50% stake in Quebec-based Osisko Mining. At $3.9 billion it was the largest acquisition in the gold mining space since 2008. This is just the beginning.
GDXJ/GDX (white) - Gold (orange)
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Skeptics will likely point out that GDXJ has already rallied 42% YTD. This is certainly true but shares are still down 76% from their 2010 highs. On top of that, you can see on the chart below that trading volume in GDXJ has picked up dramatically in 2014. Higher prices on elevated volume is a classic sign that the bottom is in place. Furthermore, a look at the chart going back to late 2012 shows development of the vaunted "golden cross" technical pattern where the 50-day moving-average (MA) breaks through the 100 and 200 day MA in quick succession. This technical support is the cherry on top of a great risk/reward situation. For now, we'll set our stop level at $35/share with a target of $65 - where the stock traded in March 2013. A high conviction bet with a 1-to-5 risk/reward ratio is something that doesn't come along very often.
GDXJ
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For those of you with an even greater risk appetite, we'll give you a single-name miner that could really explode higher if gold prices rise. Allied Nevada Gold Corporation (NYSEMKT:ANV) has gotten absolutely slammed in the gold bear market, down 92% from the highs. ANV is a US-based gold miner, which operates its wholly owned Hycroft gold mine in Nevada. ANV is unique in that it uses "heap leaching" to extract gold from other earth minerals. Heap leaching works well for large volumes of low-grade ore, but is also expensive and environmentally hazardous.
Allied Nevada Gold
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ANV has been hit particularly hard because of issues at Hycroft. The open-pit mine's crushing facility has suffered from considerable delays due to engineering issues. On top of that, ANV is facing a class-action lawsuit for understating the challenges associated with expansion. For now, the company is making ends meet. ANV finished the first quarter with $49 million of cash on its balance sheet and generated $23.8 million of operating cash flow. What's more, it was able to increase the size of its revolving credit facility from $40 million to $75 million, meaning there's no liquidity crisis in the immediate future.
Higher gold prices would alleviate most of ANV's problems. In the meantime, the stock is currently trading at 45% of book value. Repeat, 45% of book value. Meaning if this company were liquidated, its assets would be worth $7.50/share. Granted an investment in ANV comes with extreme risk and volatility, but you could treat it as a call option where the downside is fixed. At the very least, ANV might be an attractive takeover target for a senior miner with a strong balance sheet. There's a lot of risk involved, but the potential reward is enormous.