The Value of Gold Equities

Podcast Transcript

Ed Coyne: Welcome to Season 2, Episode #1 of Sprott Gold Talk Radio. I'm your host, Ed Coyne, Senior Managing Director at Sprott Asset Management. I'm pleased to be joined today by our very own Doug Groh, Senior Portfolio Manager of Sprott Gold Equity Fund, as well as other investment vehicles within Sprott. For today's topic, we will be talking about the value of mining equities. Doug, first and foremost, thanks for joining us today on Sprott Gold Talk Radio.

Doug Groh: Thanks, Ed. It's great to be here. Good to see you again.

Ed Coyne: I'm looking forward to going into some deep topics about the value of mining equities. Doug, before we dive into all things related to mining equities and the value of their current balance sheets, please tell us a little bit about yourself and also give us a little bit of an insight into what you're doing at Sprott on a day-to-day basis and how you work with the rest of the investment team.

Doug Groh: Sure. Thanks, Ed. It's been about two years since I joined Sprott in 2020, January of that year, and it's been a great experience focusing on the precious metal equities and the investment effort here, similar to what I was doing at Tocqueville Asset Management for over 17 years. In the 1990s, I was involved in investment banking with J.P. Morgan, Merrill Lynch and ING, and at that time, I was focused on banking and equity research and investing in the base materials sector. A little bit different from precious metals, but in the same vein where we were looking at the value creation potential from the various dynamics that managers can realize value from, whether it's the assets or perhaps their strategy or perhaps opportunities in the market using their balance sheet to create value. In the 1980s, I was first hired as a precious metals analyst after graduate school from the University of Texas, focusing on mineral economics. Before that, I was involved in the oil field as a geologist. But in the 1980s, I also was a precious metals investor, focusing on several portfolios that invested in precious metals explorers and developers and miners, similar to what I'm doing now. More than half of my career has been spent in precious metals investing.

Ed Coyne: We've been thrilled to have you and the whole team, along with John Hathaway, be part of Sprott now. It's hard to believe it's been two years. I remember when we were just getting to know each other a few years back — certainly a phenomenal addition to the firm at large.

Let's dive into it here. 2021 was an interesting year for the Fed and their ongoing accommodative policies, which continue to provide investors with double-digit returns in the S&P 500. Yet even with these record debt levels and stubborn inflation that we've seen in the market, precious metals, as well as precious metals equities, continue to be in more of a holding pattern. I have a two-part question for you to start this off.

First, can you comment on why you think physical gold and silver have not done better? We get that question all the time. And then the second part of the question is: given that there is change in the air again – just in January alone, there's more posturing by the Fed – can you give us an outlook on what you think may or may not happen and why for 2022, for both the physical side of the market as well as for mining equities?

Doug Groh: That's a great way to start. I think looking back at this past year, some precious metals investors might have been disappointed that gold basically went sideways. But if you look at gold for the long term, it has done very well over the last number of years. Last year gold averaged about $1,800 an ounce, about one and a half percent better than the average in the prior year, in 2020. Gold did pretty well. From the beginning of the year to the end of the year, price point to price point, gold was down about three and a half percent, but on average, gold was up over the prior year. I think it's important to put the view on gold in perspective, whether it's a short-term view or a longer-term view. That becomes very important because I think it will lead investors to recognize that there are opportunities in certain markets at certain times. I think the price is very determined by technical activities, the interest rate environment, and the U.S. dollar's relative strength or weakness. Those are things that happen day-to-day that affect the gold price.

Over a long period of time, gold has shown itself to be a real important store of value and that's what we've witnessed over the past couple of years. I think that it's important for investors to recognize gold exposure provides that diversification for a long time, not just the day-to-day trading opportunity. I think with what's in front of us for 2022 with regard to gold, we'll continue to see the technical environment affect the gold price. It will probably continue to be relatively volatile. I can see a trading range of around $1,750 to $1,850 in the next several months. I think that there will be an attempt sometime during the year to break out above $2,000 an ounce. I think that's maybe somewhat short-term thinking. The long-term thinking should be that gold serves a purpose as a diversifier in a portfolio. The long-term value of gold is held by its very nature of being scarce and being an alternative to other asset classes in the marketplace. I think with regard to the precious metals equities outlook, last year was a pretty good year for them.

Granted, gold mining equities were down, but the companies did very well. They built up their balance sheets. Their cash flows continued to show real high quality. The margins are doing quite well. There's been a restraint in terms of asset allocation. We saw several mergers and acquisitions last year, which is a common theme in our space, which will continue to be the case. I think this year probably even more so. This year I would expect more M&A activity for the reason that the balance sheets are in such great shape. Companies have a little more flexibility and ability to go out into the world now that things are becoming somewhat normalized with whatever normal is given COVID. I think people understand how they can operate now and get out and do due diligence on assets. We did see several deals last year, so there is a method to go out and do an analysis on making an acquisition. We'll see that, I'm sure. I also expect to see relatively good margins continue into the end of the year. The gold price here at $1,800 an ounce offers many producers an exceptional price in terms of their cost profile, which can be $1,250 to $1,300 an ounce. Really quite good margins.

Over the last couple of years, we've seen the sector reduce its debt significantly. Quite a few companies are cash positive or negative net debt, as it were, on their balance sheet. In real good shape in that regard. The question becomes "where's the audience for investing in gold equities?" and I think that what's now unraveling in the marketplace with the recognition that the Federal Reserve and other central banks will be raising interest rates to try to counter inflation, which has probably gotten away from them, it's very likely that we're going to see some significant disruptions in the broader markets where investors are perhaps not positioned for higher rates, where equity values do decline because rates are higher, where investors maybe don't have alternatives that they were looking at a year ago, looking at the high growth names. In that type of situation, gold should do quite well. It again offers a good alternative to some of the mainstream investments investors are used to. I think it's important for the broader market to recognize, for investors to see that gold might have been flat this past year, but it is very much serving the purpose of holding onto value, and it's a safe haven asset available for those times when things are quite disruptive in the marketplace.

Ed Coyne: You mentioned something that I think is worth repeating, the "Fed". It seems that the Fed is playing a bit of chicken with the economy, first stressing that inflation is transitory, then making a lot of comments about dropping the word transitory, now talking about tapering and eventually raising rates. There will certainly be disruption in the market because gold loves nothing more than disruption, gold loves nothing more than uncertainty. It feels like the market this year will be riddled with a lot of uncertainty. It will be interesting to see what the Fed does. I'm reminded of 2015 and even 2016 when the Fed attempted to tighten for the first time in a long time. In the first half of that year, gold was up over 20% and the equities were up over 100%. By no means am I forecasting future returns, but it's just interesting to see that rising rates don't automatically have a negative impact on gold. The reason behind that is probably more important than anything else. How closely do you look at Fed action, what they're doing with rates, what they're doing with debt purchasing?

How closely do you look at that and try to forecast what may or may not happen to gold, or do you even bother forecasting and just simply look for the best companies out there? Walk us through that a little bit and how do you think about that?

Doug Groh: Certainly, the gold price has a lot of impact on the profitability of the gold miners, so we certainly have to watch what's going on with the gold price. It is an indicator. It does send a message to the marketplace. Obviously, the gold price moves daily, and we're not necessarily traders on just a move in the gold price or a move for a week or two weeks or three weeks. We are long-term investors. Perhaps to answer your question; how do we think about our investment process with regard to exposure to the mining equities, if you step back and look at what a mining company can do, they're able to create value in several different ways. For us, we want to understand how they do create value. The first and foremost obvious place for them to create value is in their assets, the geology that they own or operate, the machines and the mill, and the facilities from which they're producing gold. This is where the value comes from. As part of that, their strategy and how they realize value, their financial position, whether it's their balance sheet or their cash flow or their ability to raise capital, are all important considerations in realizing value creation.

But each company that we've invested in, each one is a little bit unique, but it has something in terms of that profile that I just described, whether it's the geology or the strategy or perhaps their financial position where value is created. We try to identify what the market is valuing, what is the market giving them credit for, and what is the market perhaps missing in terms of the opportunity for value creation? Perhaps the market is discounting the company's geology, discounting the strategy, or not giving enough credit for the balance sheet. We try to understand how things could be different for that company and what might change to create more value for that company in the marketplace. That's key for us – to find that differential between reality and potential. When we find that differential, it's a matter of digging deeper to the point where we have a conviction that the perception of that value can change in the marketplace and create a different value reality. I think we've seen that happen, and it can be a very powerful force in terms of value creation.

Ed Coyne: Last year, we had a couple of guests on our show, one of them being our own Paul Wong, who highlighted that mining companies today are operating differently than they have in the past. I know you touched on it a little bit with the quality of the balance sheets, with less debt, more cash rich, some paying dividends. From an asset management standpoint, are you looking at these companies differently from a research standpoint than maybe you did ten or fifteen years ago? Are you taking different things under consideration that maybe you hadn't in the past because the companies are operating slightly differently than maybe they did pre, say 2011, the previous peak in the market? Has anything changed in the way you evaluate these companies?

Doug Groh: Yes, I would say that's certainly true. Several things have changed. The markets changed, for one thing, so we have to think differently. Compared to ten years ago, one of the changes is that companies were positioning themselves for growth, which got them into trouble. They positioned themselves for very aggressive growth and leveraged up their balance sheet. As a result, when the gold price corrected, they were not able to address the obligations on their balance sheets or realize the growth potential they had envisioned. There was a bit of a misalignment with the time. Gold prices were high, but their plans were long-term plans they could not execute. In this environment, in the 2020s, management teams are more focused on a quality balance sheet, as I mentioned earlier, and things that they can achieve and be successful with. Instead of building big plans or big facilities or what have you, there's a little more incremental growth that will add value over the long term, a more staged approach to spending, and add to the company's profile. There's a much more cautious approach in terms of valuing the resources and the reserves that a company extracts over time. There's a greater conservatism among management teams, and I think more responsibility as a result. That's one aspect.

Another aspect is geopolitical risks have risen significantly over the last ten or fifteen years. It's always been the case that there's geopolitical risk, but it's become more pronounced, I would say over the last ten years. As countries want to recognize the value from their resources, they're imposing more royalties or taxes or in some ways nationalization in some form or fashion. We have seen some of those episodes in the last year become a little bit more pronounced. As investors, we're becoming more concerned about where the assets are located. Years ago, when we would start analyzing a company, we would ask about the geology, because that's where the initial value comes from and that still is very important to us. But now we also need to understand right away, can you extract value from this investment thesis? In other words, can you take value out of the country or out of the deposit or realize value from the strategy that the company is trying to deploy? We are more inclined to go to safer jurisdictions, whether that's North America being Canada and U.S. and Mexico. Right now, that's the biggest exposure we have in the portfolio. We have less exposure to Africa than we did years ago and in other parts of the world. That's become more of a concern for us.

Then there's another element, too. Just in the last three or four years, the investment community has become more concerned with Environmental, Social and Governance compliance. That, too, has become a little bit more of an articulated message for us. It's always been important for us to see a company operate with a great business model. A great business model means that they are following the law, they are doing what they say they do and they're committed to shareholder returns. While we've always been concerned with that, now it's becoming a little bit more structured within the ESG analysis and framework, where there are some specific questions and concerns with regard to the environment or the social commitment the company has or governance and the proper structure of a board and representation that is on a Board. Those two have always been important to us, but they're a little bit more pronounced. Again, I come back to that idea that we're looking for good business models and a good business model is addressing these issues as appropriate for that company and their activities. We want to see that management teams are complying with requirements with regard to the environment and the social obligations as well as governance. That's a little bit different.

Ed Coyne: I'm glad you addressed ESG, because I agree that's something that we've seen in a lot of our clients, particularly on the institutional side, on the endowment side and now even in the larger family offices that we deal with. They all have a bit of an ESG overlay where appropriate. I know you and I have talked many times offline about how in many ways because of the nature of the way you have made stock selections in the past of the higher quality businesses, before ESG had a brand or a name, we were already applying some of those things. I like your word "structured". It's become a much more structured approach. I can't seem to get through an investment conference or conversation without ESG coming up.

I want to shift gears a little bit and talk about the investment itself within the space. Arguably, you would say that the physical market is sort of a risk-off trade. It's a natural hedge trade, but the [gold] equities in general would be, in my mind, more of a risk-on trade because you are still dealing with equities, you're dealing with management, you're dealing with balance sheets.

One of the things we've noticed in the last decade or so is that it's become a much more crowded universe with cryptos, with SPACs, with different investments out there. There's much more of a universe of ways to take a risk-on trade. Help a listener think about how mining stocks can potentially be value-add in this current market as you're looking for ways to potentially replace some other equity that they own and continue to have a bit of a risk-on trade or an opportunistic allocation in their portfolio. How should an investor incorporate mining stocks into that sleeve of their diversified portfolio? How should they think about that?

Doug Groh: Yes, that's a great question and a good point. I think that when I started out in the precious metal space some 30 years ago, you could either buy a gold coin or a gold fund or a gold stock.

Ed Coyne: Right.

Doug Groh: Now there's so many different options. You can buy ETFs, you can buy gold stocks, you can buy funds, you can buy a blend, you could buy options, you could trade in the futures market, whatever. And there's more accessibility to the different markets. There's a lot of different ways that you can get exposure to gold and the dynamics that gold presents. I think with regard to the mining space, to your question, the opportunity here, I think, is several fold. The mining companies are extracting a natural resource and creating value in the process. If you think about that, those companies that are making discoveries are creating significant value when they make a discovery. There's that opportunity for investors in a mining company or exploration company to participate in that eureka, as it were, when gold is discovered, which is very exciting, and that can see a multiple valuation increase when that discovery is made.

Another dynamic is certainly the profits that these companies make when the gold price moves, profits can expand or contract. Some investors are intrigued by the leverage to the precious metal price and so for some investors, they want to play that price leverage. The gold mining sector provides that opportunity to participate in price leverage, price-profit leverage, which I think is sort of unique because it can be a very dramatic move. Investors can realize a lot of value in a short period of time. And likewise, to be fair, values can contract very significantly in a short period of time. There's a risk and a reward, and one has to pay attention to that.

I think another element is in the [mining] sector. There's a lot of mergers and acquisition activity. Just by the nature and the structure of the industry, where the industry depletes its resource, it has to replace that resource with a new geology or acquired geology or some other alternative means of producing gold. We see a lot of M&A activity to address that dynamic, where a lot of small companies are not able to produce gold on a scale that the larger ones are. The larger ones are maybe a little bit more capable in terms of their financing or flexibility to realize the gold in a deposit. We see the larger companies acquire the smaller ones, or maybe there are two mid-size that come together to become more relevant in the marketplace. Or perhaps there's a property sale that makes sense for one company that wants to sell its property and use its capital for something else. There's a number of different card games, as it were, that are being played here where investors can bet their money on the outcome. It's a dynamic space in that regard. There's a lot of different opportunities here in the mining space.

To go back to your earlier question, you can buy gold ETFs or gold coins or what have you. What you're participating in those investments is the price move. There's nothing wrong with participating in the price move. With the mining equities, you're participating in the price move, but there are other elements of value creation or other valuation metrics that are at play where you can realize value. I think that's the interesting dynamic. There are other avenues for value creation.

Ed Coyne: The value creation, I agree is key and some people have always simply said gold equities are a levered trade to the price of gold. But to your point, there's so much more to that with management and certainly now with the strength of the balance sheets. Before we end today's podcast, are there any final thoughts you would like to leave our listeners with before we go on to wrapping this up?

Doug Groh: This year is going to be an interesting year with regard to what the Fed does and how responsive they can actually be to inflation and the economy. It's very likely we're going to see some upsets and I think that's where gold presents itself as a dynamic winner when the market gets disrupted. It's also important to recognize that gold should be part of a portfolio for the long term. While price action can be disturbing on a daily basis, investors have to keep in mind their precious metal exposure is exposure for the long-term as a diversifier to other risks in the marketplace. I guess I'd leave you with the idea that as much as the daily gold price or precious metals price can be exciting, sometimes positively exciting and sometimes very disappointing, investors should recognize it's the long term that becomes more important, really, to the investment process.

Ed Coyne: I think that's always a wise thing to say and for investors to think about, this is a marathon, not a sprint for sure. The goal is to stay invested in the market. I think gold certainly helps you do that. Doug, thank you for joining us today on Sprott Gold Talk Radio. To our listeners out there who would like to learn more about the value of mining equities, we're constantly doing white papers and interviews and so forth. We encourage you to visit us at sprott.com for more information on all things mining, all things gold, all things silver. Welcome to season two. We're excited to have this still going and I'm your host, Ed Coyne. Thank you for listening to Sprott Gold Talk Radio.