Gold Equities are on the Move

June 15, 2020 | (17 mins 04 secs)

Ed Coyne, Senior Managing Director at Sprott Asset Management, and John Hathaway, Senior Portfolio Manager, share their views on gold bullion and gold equities. They discuss how the COVID-19 pandemic has changed the landscape and is supporting a rising gold market.


Ed Coyne: My name is Ed Coyne from Sprott Asset Management. Sprott is a unique firm in that we focus exclusively on precious metals and real assets. With over three decades worth of experience in the precious metals space, we are uniquely positioned to talk about both physical gold and silver, as well as the gold equity market. I asked John Hathaway, one of our senior portfolio managers on the gold equity fund to join me today to talk about some of the recent developments we've seen over the last couple weeks and particularly the last few months and quarters as the gold market continues to March forward through this pandemic.

Gold Market Update

Before we go into that, I would like to talk about what's been going on for the last four to five years in the physical gold market. When you look at what gold's done since 2016, gold has been averaging over 10% a year,1 and that's really on the heels of the Fed [Federal Reserve] tightening in the fourth quarter of 2015. The market effectively voted against this and gold started moving forward in the first half of 2016. Gold equities were no exception. When physical gold was up more than 20%, gold equities were up north of 100% in the first half of 2016.2

Then the market continued to march forward. The gold equities market started to cool a bit, but then you entered 2018. When once again, the Fed attempted to continue to tighten with a quote of being on autopilot. And we started to pick a trade war with China. As that started to happen, gold once again got its second leg up in its bid and gold equities once again started to shine. In fact, in 2019, gold was up over 18%, gold equities depending on their market cap, are up between 30 and 40%.3 And our fund was along with that

Impact of COVID-19

Enter this novel pandemic. The pandemic is something that no one expected to happen, nor was gold continuing to get its bid in the first four years prior to the pandemic in being up over 50% over that four-year period.3 What the pandemic did do was to provide a not-so-gentle reminder that markets can go down and go down violently. Once again, as we've seen in multiple market cycles, gold did its job. More importantly, the market now has started to recognize this and gold has continued to go up and is now in the $1,700 range. We are now seeing mining company margin expansion, as the gold equity space gets more and more interesting. Just in the last two months alone, in April gold equities were up in the 40% range,4again depending on their market cap and size and liquidity. And month to date in May, they're up another 15%. 

With that backdrop, I thought it would be interesting to hear from a very seasoned portfolio manager, John Hathaway. John has multiple decades as a portfolio manager in the gold equity space, both in large-cap, senior producers as well as small-cap, junior producers. With that, John, let's start with the gold equity space in general. Over the last couple of years, we've seen gold equities continue to get more and more of a bid and the market is starting to pay attention to it, even though the broader market has not really embraced it yet. In your mind, what's happening right now in the gold equity space?

John Hathaway: There are many things happening. I think first and foremost, the landscape has changed dramatically relating to the pandemic. It's kind of a two-part thing. The pandemic, frankly, was the pin that burst the balloon of credit. The effects will be long lasting and the rising gold price is a major pillar for what I see ahead for gold equities. In a rising gold market, gold equities outperform the metal by anywhere from three to five times.5 And that's just a blanket statement for all shapes and sizes of large-cap, mid-cap and small-cap names. Even though gold mining equities have performed well this year, typically up 15 to 20%,6 the interest level has been relatively muted. This is surprising, especially in light of the great performance of gold the metal, and secondly, the very uneven performance of mainstream equities.

Gold Equities are Deeply Undervalued

I think that's going to change, and I think the changes will be quite dynamic as they start to filter in. I've been, as you mentioned, investing in gold mining equities for the last 20 plus years. I have never seen the group in general, sell at such bargain prices, and I'm talking about any metric you want to use, whether it is enterprise-value-to-EBITDA [earnings before interest, taxes, depreciation, and amortization] or more recently free cash flow yields. It's not hard to find in the large-cap space, free cash flow yields of 5% or more. And in the mid- to smaller-cap space, not hard to find free cash flow yields in the area of 10% to even 20%. That by any standard of valuation is inexpensive and spells opportunity.

I would just make a couple of other observations about what's happening in terms of the economics. We know that the gold price is rising and in fact, given the macro backdrop, it should climb higher for the rest of this year and well into next year and the year beyond. That's just based on the printing of money by the Fed, the deficit spending by the U.S. government and all of the unknowns out there in terms of potential inflation, further credit defaults, and so forth. The outlook for the gold price is quite bullish.

Gold Production Costs are Declining

What is often not recognized is that the costs of producing gold are declining very rapidly. There's tremendous margin expansion taking place. There are two big factors to explain lower costs. One is energy. We all know that energy has been hard hit by this pandemic, and it most likely will come back, but relative to where it was last year and years before, energy, which is a very major input for producing gold, particularly in open-pit mines will be much less expensive for the gold mining companies.

The second thing is that foreign currencies, such as the Mexican peso, the Brazilian real, many of the currencies in Africa and Asia, have fallen dramatically relative to the U.S. dollar so that local production costs are paid in local currency, which is far less because of weakening foreign currency. Margin expansion is a big factor in explaining expanding margins.

When you think about what's going on in the general market for airlines, for leisure, retail, most of the traditional areas of economic activity, there's nothing but problems to think about. Low business volume, problems with credit and interruptions of business because of the pandemic. The gold mining industry, while there have been some interruptions to mine production, is mostly on track to deliver 85 to 90% of what we expected at the beginning of the year, but at much lower costs and higher gold prices. The gold mining sector is one of the bright spots in the economy where you have a very good story in terms of earnings, cash flow, growth, rising dividends. It is tough to find that positive story anywhere else when you comb through the S&P Index.

BANG vs. FANG Stocks

I would like to finish with one point. Gold stocks have outperformed FANG stocks for the last five years [Facebook, Amazon, Netflix and Google]. We have kind of come up with a new index called BANG, which is basically Barrick, Agnico Eagle, Newmont and Goldcorp. They are up 215% since the end of the year 2015 versus 189% for the FANG stocks.7 This year, the BANG stocks are up nearly 40% versus 20% for FANG stocks. We're entering a period where I think we can make a very strong case that the gold mining sector will outperform almost every other equity index you can think of and the gold price as well. With that, I turn it back to you, Ed.

Ed Coyne: And I think the FANG versus BANG performance is a great thing to think about, because until recently when you think about what the market's looking at, for the most part, there's not a lot of acronyms out there for what's going on the gold equity space. People largely ignore that. And we talked about a little bit about the mining stocks, like the S&P and the Russell 2000, there are certain distinctions or differentials between the larger-cap producers and the smaller-cap producers. And you're seeing that also in the performance patterns of the two.

At Sprott, for example, our senior mining ETF is doing extremely well year to date where the junior mining ETF is just starting to catch a bit. Could you just talk a little bit about some of the distinguishing factors between a senior miner or a large-cap miner versus a junior miner or a small-cap miner? What are some of the differences? And where do you think those performance patterns are going to come from over the next couple quarters versus the next couple of years? And why do you think that? If you could touch on that, that would be helpful also.

John Hathaway: There is definitely a bifurcation between the performance of the larger-cap stocks and the smaller-cap stocks. A large part of it is due to the influence of passive investment vehicles. Passive investment vehicles and I will use GDX, as an example, are mainly created to accommodate large flows in and out for macro traders. And for that reason, they are very heavily weighted to large-cap stocks, Newmont, Barrick, Franco-Nevada, Agnico Eagle, to name a small handful. And that small handful might account for 40%-50% of the weighting in an ETF such as GDX. And because the flows so far have not come from generalist investors, but they've come from macro traders, they are only really looking at money flow. They're looking for liquidity, which is what these large-cap stocks provide. There are very few investors until now that have been willing to look past the fundamentals of the large-cap stocks, because most of the money flows have been coming from a trading mentality. Now that I think an investment thesis for gold mining, in general, can be stated and articulated and where one can think of a three to five year very bullish outlook, it's worthwhile for generalists to dig down into the details of the sort of overlooked forgotten about, ultra-cheap, mid to smaller cap stocks. And I believe that is something which will play out over the next year. Some of the metrics are incredible when you think about it. It is, as I said earlier, not hard to find in the mid and smaller-cap sector, free cash flow yields that are well over 10%, in some cases over 20%.

And to me, that's too cheap. And there's a discrepancy in valuation between these stocks simply because they've been bypassed by the flows that the gold equity market has seen for the last five years which mainly focused on liquidity. But I think once investors are willing to think in terms of staying for a while, staying for a one or two- or three-years stint, they will discover great opportunity in the smaller cap names. And I think as that takes place, the valuation gap, which is as wide as I've seen it in 20 plus years, will close. And so, you'll have a double tailwind. You'll have a tailwind from the macro picture that we talked about, that Ed and I have talked about for the gold price itself. And then secondarily, there will be a tailwind from the closing of this very wide and unprecedented valuation gap between the large and small-cap stocks.

Ed Coyne: That's excellent. Thank you. And I think that's worth pointing out because just in a microcosm we saw when the market started recognizing the gold equity space, really in April alone, you saw a major difference between the performance of large caps versus small caps. And in May, you're seeing the opposite. You're seeing the juniors start to do better. I do think people need to recognize that the large caps and the small caps perform differently over a full market cycle. And it sounds to me, from what you're saying, that the larger caps probably in the shorter term will do quite well, but the smaller caps from an opportunity standpoint is really where the valuations are and really where the opportunities are long-term.

1 The annualized return for spot gold as measured by GOLDS Comdty Index (Bloomberg) was 11.28% from 12/31/2015 to April 30, 2020.
2 Spot gold as measured by GOLDS Comdty Index (Bloomberg) was up 24.57% for the period from 12/31/2015 to 6/30/2016. At the same time, the HUI Index was up 122.60%. The NYSE Arca Gold BUGS Index (HUI) is a modified equal dollar weighted index of companies involved in gold mining.
3 Spot gold as measured by GOLDS Comdty Index (Bloomberg) was up 49.87% for the period from 12/31/2015 to 1/31/2020.
4 Gold equities as measured by Sprott Gold Miners ETF (SGDM) were up 44.06% for the month of April 2020.
5 Based on the relative performance of spot gold vs. gold mining equities since the 1970s.
6 Gold equities as measured by Sprott Gold Miners ETF (SGDM) were up 13.84% YTD as of 4/30/2020.
7 Source: Elliott Wave International.

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