Sprott Radio Podcast

The Best Kept Secret

Thursday, 11 January 2024 | 38 | 23;55

Sprott Portfolio Manager John Hathaway shares his views on gold, gold equities and why it’s important to be a contrarian.

Podcast Transcript

Ed Coyne: Hello and welcome to Sprott Radio. I'm your host, Ed Coyne, Senior Managing Partner at Sprott Asset Management. I'm pleased to welcome back John Hathaway, Managing Partner and Senior Portfolio Manager at Sprott. John, thank you for joining Sprott Radio.

John Hathaway: My pleasure, Ed.

Ed Coyne: John, 2023 has been quite interesting. Yields have been fairly attractive. You can make a little bit of money in your cash right now. The Dow has been relatively strong, and the S&P is on a record run, yet gold is hanging in there. What's going on with gold these days?

John Hathaway: Well, in fact, gold is at a new high within a couple of percent, and it's the best-kept secret in the Western world. Gold has performed as well as the S&P for the last 25 years, including dividends and income. If you exclude dividends and income, gold has beaten the index by a factor of 2:1. It's a stealth asset. Nobody knows about it, nobody cares. It's under-owned and, in my opinion, on the cusp of a big breakout to new highs.

Ed Coyne: Why do you think people don't care? What's behind that?

John Hathaway: I think the big thing is that there's this illusion that the S&P is doing well, but if you take out seven or eight stocks, as you know, the average stock has just gone nowhere. The S&P hasn't gone anywhere for the last two years. Most people aren't paying attention. To answer your question, most investors are complacent and very comfortable with their mainstream portfolios.

Ed Coyne: John, we talk a lot about the physical market and gold on this podcast and in our literature, but gold equities have been largely ignored. Why do you think people aren't paying attention to gold equities?

John Hathaway: Basically, they haven't done well. Even though the gold price has performed quite well, as I suggested, gold stocks have not. This is a stat worth thinking about. The price of gold has gone up 25% over the last ten years. In terms of gold stocks, using the VanEck ETF as a proxy, GDX is down over 40%, a complete disconnect. There are lots of reasons for it, but the main reason, and an answer to your question, is that gold stocks have done poorly relative to the gold price.

Ed Coyne: As that gold price goes higher, you have to believe the margins on these gold equities get more attractive. Why aren't people focused on that? They focus on every other industry, but they're not focused on gold equities. Why is that?

John Hathaway: For one thing, the market cap of the entire gold money industry is about the size of Home Depot. It's tiny in the context of these financial markets. It's quite easy to allocate to gold metal because it has a big market cap, is liquid, and is easy to position. On the other hand, gold mining stocks are a relatively small space, and I think most people just can't be bothered. They feel that if they need to have gold exposure, which you and I agree they do, they think that's just fine, so why go the extra step to invest in mining stocks, which are more difficult to understand and position?

Ed Coyne: John, what is your response when someone says something along the lines of 20 years ago, 25 years ago, it was difficult to own gold in a portfolio, and today, with all the ETFs out there and our product that we have out there, it's much more easily allocated to? Do you think that has anything to do with it? The fact that there are other risk-on assets you can apply capital to other than gold equities, and it is easier to physically own gold today in a portfolio than it was, say, two or three decades ago? Do you buy into that at all, or do you think it's much deeper than that?

John Hathaway: There’s no question about the advent of GLD, the first ETF. I believe the year was 2004, and since then, it has grown substantially. I can't think of the combined market cap of all the gold ETFs off the top of my head, but I'm going to guess 70 or 80 billion, and it's easy. It doesn't take a lot of analysis.

These markets today are driven by a lot of financial advisors who like to plug and play. They don't necessarily get into the nitty-gritty of individual companies. Gold, as a category, is relatively easy to understand. The fact that it's easy to position through ETFs certainly has been, in large part, a reason why gold stocks have languished.

Ed Coyne: What points would you want a listener to walk away with on why they should be thinking about gold equities today? What are some of the opportunities out there?

John Hathaway: I'm glad you framed it that way. First of all, let's not leave gold itself for a second. I would say that the average person who doesn't pay a lot of attention would think that gold is high right now, trading at roughly 2,040 or so, but it's not high because if you inflate it for the past ten years, it might only be 1,500 or 1,600. On that metric alone, inflation-adjusted gold is not high compared to the macro changes that have occurred. That's point number one.

Point two is that gold is in a very strong technical position. I would not rest any argument on technical analysis only, but it has broken out from a three-year base, and technicians that I pay attention to and take a lot of technical research from are calling for maybe 2,500 or 2,600 gold based on this breakout. Let's leave the gold discussion there for a second and then talk about what's happening with the mining stocks.

Gold mining stocks valuations are at the lowest level in 20 years, for example, and I'm basing this on generic sell-side research. Large caps trade roughly four times EBITDA, which is enterprise value over cash generation. In a world where the typical stock trades at much higher valuations than that, you look at that one thing alone and say, "Gee, there's potential for mean reversion."

Think back to what I said earlier: the average annual gold prices are up maybe 25% over the last ten years, and gold stocks are down 40%. That tells me there might be substantial mean reversion potential. We've seen examples recently when gold has had a decent move, and I'm thinking about the rise off the pandemic low a couple of years ago. Gold rose 30%, and increases of 100% to 150% in gold mining stocks were the rule of the day.

Gold stocks do have a lot of octane and alpha. If one is positioned for higher gold prices, gold stocks give you the octane many would be looking for to generate alpha in your portfolio. You mentioned margins. Here we are in a world where the Fed has been doing everything in its power to slow inflation, and lo and behold, they've had some success. The inflation rate has come down, picking a number from high single digits to maybe 3%. The gold companies are benefiting from that.

There are still cost pressures, but energy is down, and that's a huge component of gold mining. That means margin expansion in an environment where we can make a good case for a higher gold price and cost pressures winding down. With the stocks as cheap as they are, I think you can make a case for the kinds of returns we saw coming out of the pandemic: 2x, 2.5x. That's the heart of the case for why gold mining stocks now.

Ed Coyne: You mentioned something also: the Fed. A few of our guests this year have talked a lot about the Fed, and it seems like everyone's throwing a raise in their hands that they got it right that a soft landing is happening. But now Wall Street's already expecting up to 75 basis point cut over the course of 2024. Does that concern you that the market's already baking in interest rate cuts, and what would that mean for gold and, of course, gold equities?

John Hathaway: First of all, let me say I am completely at odds with my view, and I do not think a soft landing is in the cards. It will probably be a hard landing, which is not consensus. That would suggest to me if my view is correct, and I'm not the only one, but I'm in a distinct minority. That means that stocks probably will not do all that well in '24.

Let’s go back to 2002 to 2006, when the Fed was on a campaign to cut interest rates, and gold stocks outperformed the S&P by about 300%. That was the lead-up to the Global Financial Crisis. Usually, when the Fed starts to backpedal the way they're doing, it seems always to get it wrong. I think the Fed was bullied into this current pivot by Janet Yellen and even Biden because of the election year politics that certainly should lead to inflation concerns. It may be temporarily subdued, but it's not completely out of the picture.

The big point to make here is that rate cuts, and I'm using the cycle starting in 2002, which was the aftermath of the dot-com crash, were not great news for stocks, but it was great for gold stocks. The gold price did well, and then gold stocks did better. I think we're set up for that sequence again. I have to confess that I am very alone in that view, and I could take another podcast to describe why I think the consensus view is wrong.

Usually, when the Fed cuts rates, they're reacting to a weakening economy. That isn't in the consensus yet. We haven't had recognition of that. All the economic data I look at, aside from the headlines that the government puts out, which are very highly massaged and tricked up, if you look at things like freight traffic and tax collections, which are numbers they can't make up, they're consistent with a weakening economy.

Ed Coyne: So often you hear when rates go down, the dollar softens, and gold goes up because foreign investments settle in US dollars. Do you think that will also be part of it or is conventional thinking falling by the wayside?

John Hathaway: First, the dollar weakens when rates start to go down. One of the big headwinds for gold and mining stocks has been all this blabber out of the Fed about higher rates for longer. Well, I think that's nonsense, and we're about to see a cycle of rate cuts. You touched on something else, which I think is very important: the geopolitical situation. I'm not talking about the hostilities in Ukraine and Israel, which are bad enough, but a case can be made for gold even in the absence of that.

The case is that foreign commodities producers, Russia, Saudi Arabia, and all the BRIC nations, probably two-thirds of the world's landmass, are finding ways to circumvent recycling trade surpluses into US treasuries. One of the things they're doing is trading in local currencies and settling balances in gold. What does that mean? It means that central banks are buying gold at a record pace, and their buying is not price-sensitive. It's policy. They don't care if they pay $2,000 or $2,500 an ounce. They want gold to facilitate trade.

The second thing is that the U.S. fiscal situation is dire, and you're starting to see more and more talk about that. For example, interest on debt now exceeds our defense budget. That's crazy. High deficits mean the supply of U.S. treasuries is rising. At the same time, foreign buyers are trying to find ways to avoid them. You've got a supply and demand mismatch on U.S. treasury issuance, and the net beneficiary of all of that, in my opinion, will be gold, and the resolution will be in a higher gold price. It's geopolitical.

It's bigger than whether the Fed will do one thing or another. It's beyond the Fed's control. In my opinion, I can easily see gold trading 50% higher than where it is today based on all these factors.

Ed Coyne: What would you tell an investor looking to rebalance their portfolio and consider allocating to gold and gold equities? What would you say that should look like for someone listening to this podcast and saying, "I'm going to allocate to this space." How much should be on the physical side? How much should be on the equity side? Just in general, what would you tell an investor?

John Hathaway: Here are a couple of numbers for you: global AUMs allocated to gold today is roughly 1%, maybe a little more, maybe a sliver more. At the peak of the gold cycle in the 1970s, the allocation to gold was over 8% of global AUMs. Speculating what it would take to get it to 2% is fun.

If it got to 2%, the number I just gave on what I think gold can do over the next few years is too low. Here, we have gold at record highs, and there's been no participation by Western investors. It's amazing. Gold-backed ETFs, even though they are a factor, have had outflows. We've seen very little interest from active managers in mining equities. I think the table is set for good performance by one, the gold price, and two, for those with a little bit more risk appetite for gold mining stocks.

It won't take much, considering that the market cap of all the gold stocks is maybe the size of Home Depot. Considering the valuations that are rock bottom levels, it won't take a lot in the way of flows to drive gold mining stocks substantially higher. They have a history of responding, as I said, to low points in the price of gold, even though the price of gold is at a record high. If gold had a big move, which I think the technicals and the fundamentals suggest, then gold mining stocks have particularly dynamic prospects for outperformance.

Ed Coyne: The world talks about large caps and small caps when talking about the S&P or Russell 2000. We talk about them as seniors and junior mining stocks in the mining world. What do you like? Do you like the larger, more established companies or the smaller, more junior-type companies? Why do you like them? If you don't mind spending a few minutes talking about that.

John Hathaway: Sure. The big-cap names are fine, and they will respond accordingly to a higher gold price. I think there's a lot of potential there. What we do in the Sprott gold fund, we tend to emphasize the mid-cap and smaller-cap names. The reason for that is that there's more of an opportunity for internal value creation through the process of building and discovering new mines.

In addition to a rising gold price and expanding margins, these smaller companies will have growth in annual production earnings and cash flow. If they get the gold price at their back, which I think they will, they will offer much greater relative performance. I don't mean to say avoid the big-cap names, but for somebody looking for outstanding performance, I would look at our strategy, which emphasizes mid to smaller-cap names.

Ed Coyne: We've also seen this in the past. What about the M&A cycle? We saw an M&A cycle a couple of years ago in the mining space where large caps were buying other large caps and merging. As these smaller-cap companies do quite well, do you anticipate, or have you seen this in the past, where larger-cap companies will go in and buy that company to build their portfolio?

John Hathaway: Yes. You're already seeing it. You see, there was a deal today at a 37% premium. These companies always talk and understand that to be relevant, they need to have some liquidity, which usually comes from having more outstanding shares. You're going to see mergers of equals for sure. You're going to see outright takeovers at premiums. I thought 37% was higher than typical, but you'll see that.

More importantly, I think you'll see rationalization and eliminating redundant costs. Again, that's a very good story for earnings.

Ed Coyne: Is there anything else that maybe I haven't asked that you'd want to leave the listeners with as we go into 2024? Whether it's things to look out for or things that you think are real opportunities for, what should they be thinking about?

John Hathaway: Use a contrarian mindset because that often serves one well. Too many investors are content to be part of the herd and cluster into the seven or eight big-cap stocks that everybody talks about. They are probably all great companies and deserve to be well-valued, but maybe they're overcrowded. Maybe there's a potential in the face of continuing good fundamentals for at-the-margin investors to peel away from the herd and look for other opportunities. I'd say use contrarian with a capital C as a mindset, and there's nothing more in the crosshairs of a contrarian analysis than gold mining stocks.

I guess that would be my little sermon to end our podcast. Be a contrarian. I've always been one. Be a value buyer. I've always been one. Doesn't always work. Maybe it wears you out in terms of patience. Believe me, I'm black and blue from being too patient, but I do think that the stars are aligning for a really good sequence for not only gold, which, as I said at the outset, has done pretty well without people knowing it, and for gold mining stocks, which are basically in the orphan status if you look at the pecking order in the stock market.

Ed Coyne: Well, John, this is a lot of great wisdom. I'm hoping the listeners walk away with some great nuggets here, pun intended, about how they should be thinking about investing in 2024. It’s always a treat to have you on, and I believe personally very highly of you. I know you're well respected in the industry, and once again, thank you for joining the podcast.

For those listeners who want to learn more about what we're doing at Sprott and John's work on the gold equity fund, I encourage you to visit us at sprott.com as always. S-P-R-O-T-T.com. Once again, I'm your host, Ed Coyne, and thank you for listening to Sprott Radio.

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Ed Coyne
Ed Coyne
Senior Managing Partner, Global Sales
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John Hathaway
John Hathaway, CFA
Managing Partner, Sprott Inc.; Senior Portfolio Manager, Sprott Asset Management USA
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