Gold: A Safe Haven without Parallel?
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May 16, 2023 | (62 mins 34 secs)
The current “Everything Everywhere All at Once” environment and credit crisis are unprecedented. Gold has proven to be an effective safe haven asset during this challenging period, which began with the early 2022 Russia-Ukraine invasion and was followed by rising interest rates, stubborn inflation and the 2023 banking crisis. We believe near-term support for gold will remain at ~$2,000 per ounce, while markets are poised to test new highs.
- There is likely no safer investment asset than physical gold
- The U.S. dollar and other paper currencies are at the epicenter of sovereign credit risk
- Gold is severely under owned in Western capital markets
- Gold supply constraints are likely to continue as miners face challenges in replacing reserves
- Gold miners’ balance sheets are healthy and strong, and their stocks are inexpensive
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Sprott Asset Management
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Sprott Asset Management
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Sarah Martin, RIA Database: Cover Slide
Ed Coyne: Slides 2-7, Introduction
Edward Coyne: Thank you for joining us today for our webcast on "Gold: A Safe Haven without Parallel." We're excited to have John Hathaway and Douglas Groh from Sprott join us today for this webcast.
For those that aren't familiar with John Hathaway, John is a Senior Portfolio Manager at Sprott Asset Management USA Inc and Managing Partner at Sprott Inc. John is a Portfolio Manager of the Sprott Hathaway Special Situation Strategy and Co-portfolio Manager of the Sprott Gold Equity Fund. John earned a B.A. from Harvard College and an MBA from the University of Virginia. He is a CFA Charter Holder.
Douglas Groh is a Senior Portfolio Manager at Sprott Asset Management and Sprott Inc. Douglas is a Co-portfolio Manager of the Sprott Gold Equity Fund and other investment vehicles in the broad Gold Equity Strategy. Douglas earned his B.S. in Geology and Geophysics from the University of Wisconsin at Madison and an M.A. from the University of Texas at Austin, where he focused on Mineral Economics.
For today's webcast, I've asked John to join us to talk about the macro view on gold, and then Douglas will highlight the gold mining equities opportunity. At that point, we'll open the webcast to address questions. If we don’t get to your question, we’ll respond via email or phone call after the webcast.
For those listeners on today's webcast unfamiliar with Sprott, Sprott is a global leader in precious metals and energy transition investments. Sprott is a publicly traded company listed on the New York Stock Exchange and the Toronto Stock Exchange under the ticker symbol (SII). With over $25 billion in assets under management, Sprott offers multiple ways to invest in precious metals and energy transition investments. At Sprott, we offer three suites of opportunities. We offer an exchange-listed suite with over $19 billion in assets, whether you're looking to allocate to physical gold, silver, platinum, palladium, or other energy transition materials. We offer a full suite of trusts on the physical side and ETFs on the equity side. In addition, we have a full suite of Managed Equities where we give you a similar approach in a more active manner. Lastly, we have a suite of private strategies where we make bespoke credit investments for mining and resource companies.
I want to set the table for today's webcast by reviewing how gold has performed over the last few decades. Many of our investors are surprised to learn that in the previous two-plus decades, gold has continued to do its job. Gold has outperformed the S&P 500, bonds and cash.
If you look at compounded returns, gold has been up over 8% on an annualized basis. During the same period, the S&P 500 Index has been up slightly over 6.5%, bonds have been up about 4%, and cash has been flat.
That continues in the current decade. If you look at gold and silver on a short-term basis, from January 2022 through 2023, gold continues to do quite well. On a relative basis, gold has actually held up quite nicely and outperformed both bonds and equities.
I want to talk about why gold is doing so well on an absolute and a relative basis and why there are opportunities in gold equities today. You can sum it up quickly with a quote I've been using for the last couple of years. It holds more truth today than ever before. It simply states, "It's dangerous to accept that government spending no matter how much or for what is the only solution, and even more dangerous to believe that the shape of the recovery is only a function of the size of that stimulus package." Or even more simply, "Central banks do not manage risk, they disguise it."
We’ve seen that this year and in the last couple of years as things unfolded in the market.
John Hathaway: The Macro View on Gold, Slides 8-14
Edward Coyne: With the table being set, I'd like to turn it over to John Hathaway to discuss the macro view on gold. John?
John Hathaway: Thanks, Edward. Let's move to this first slide. Remember that gold previously peaked about 10 years ago, in 2011 and 2012, at around the prices we’re seeing currently. There's a lot of nervousness today and we may see another peak. However, investment sentiment is still quite low. You rarely have a peak in any market when sentiment is poor. As you can see in the next chart, the assets in GLD, the exchange traded fund backed by physical gold, are lower than at the previous peak in 2011 and 2012.
We may be going through a period of backing and filling or just treading water for a month or two over the summer. I expect gold to settle at around these levels. We may trade down to $1,900, and maybe we won't go to new highs of $2,075, but this backing and filling would be very constructive.
The two charts I showed at the beginning of my talk support that view. Because even though gold is knocking on the door of its all-time highs, people aren't that excited about it. There's a lot of interest, but many investors have not moved into it. They are hesitant because they see gold at near the high end of its range for the last decade. It’s understandable that people will hesitate to move in. But I expect that investors will become comfortable with gold trading at around $2,000 an ounce as we see more backing and filling.
The next slide shows what Ed mentioned in his introduction: that gold has outperformed everything in the universe over the last 20 years. It's a well-kept secret. But the point I want to make here is that gold stocks have disconnected from the metal. There are a lot of reasons for that. I don't think we have enough time to go into all of them, but there has been a disconnect between mining stocks and the metal itself.
The main takeaway is that there is an enormous potential for mean reversion, and that's if gold only stays around the $2,000 an ounce level. If gold goes higher, then the risk/reward characteristics of gold mining stocks are likely to be very compelling.
Let's go to the next slide. This may be beating a dead horse, but bonds have been very disappointing. Investors think of them as a safe asset, as a risk diversifier, but as you can see — and I guess it's not necessarily news to anybody listening — bonds have been extremely disappointing. Was last year an aberration? Maybe. But I suspect that bonds are becoming increasingly risky for macro-economic reasons.
The Consumer Price Index (CPI) has been revised around 25 times in the last 40 years, going back to 1980. In all but one of those instances, the revisions have resulted in a lower inflation rate. That leads to fading trust in the CPI as a measure of inflation. Of course, lots of government statistics are massaged and tweaked for political purposes. I don't think there's any mystery that the CPI is highly political. Gold and TIPs have separated. TIPs, or inflation protected Treasuries, pay investors if inflation rises. The correlation between gold and TIPs should be fairly tight since they protect against inflation, but that relationship has broken down. That’s because there's a lot of distrust in the CPI as a true measure of inflation. And anecdotally, I'm sure you all have stories of your own that would corroborate that view.
Somebody recently said, "Buying inflation insurance through the U.S. government is like passengers on the Titanic buying shipwreck insurance from the captain”. This underscores the point that bonds are not the safe asset and the risk diversifier that people thought. So, caveat emptor on bonds. The Fed is on this crusade to crush inflation, but the reality is that the Fed will likely end up crushing the economy. Then, the Fed is likely to revert to the same policies that caused inflation in the first place, even if they succeed in bringing inflation down, which is happening now to some degree, it will be at a huge cost and risk to the economy.
My last slide ties all these ideas together. First, investors still don't believe that gold belongs at around $2,000 an ounce. This lack of interest is an encouraging sign that there's a lot more upside for gold once it finds its footing based on macroeconomic factors. We can expect volatility. Gold is notoriously volatile in the short run, but as we've seen over the long run, it's proven to be a risk diversifier. This is not the end of the story just because we're hanging around $2,000 an ounce.
There are lots of reasons to think that gold can go higher. The credibility of the U.S. dollar is crumbling. There's much talk about the debt ceiling, and of course, we're in the stages of a high-wire act, a dramatic finish before June 1 when U.S. Treasury Secretary Janet Yellen says that the Treasury can no longer meet its obligations. That’s not exactly confidence inspiring. Still, most people believe there'll be a last-minute effort to save the day and kick the can down the road. It’s a short-term phenomenon, but there's a lot of drama and it's very distracting.
But more importantly, the fiscal picture for the U.S. is ominous. Tax receipts are down substantially. Through April, year-to-date, they're down 3%. Corporate tax receipts are down substantially more than that, and fiscal spending is up 13%. You have a widening gap between income for the U.S. government and outflow for the various things that the government pays for. The Treasury Borrowing Advisory Committee recently increased its deficit projections for 2023 to 2025 by 30% to 50%. That's 30% to 50% on a base of something like $1.5 trillion. The idea of the debt limit is a joke because they raise it every couple of years when needed. But that requires increasing Treasury issuance — that is, more bonds, and that’s another reason why bonds are not safe.
In addition, de-dollarization is spreading. What do I mean by that? Establishment folks in investment and political circles disagree with this, but there's an increasing flow of trade away from the U.S. dollar. Oil is a good example. Increasingly, countries like Pakistan are paying for oil in Chinese currency. Saudi Arabia now accepts Chinese currency instead of dollars. The same is true with Russia. De-dollarization may not occur in the very short term, but it's an important trend. Increased use of other currencies, the Chinese currency being the major example, means there's less of a trade surplus denominated in U.S. dollars to buy Treasury bonds. As a result, supply increases, especially in a scenario of falling tax receipts and increasing deficits. Add de-dollarization to that, and there's a smaller and smaller pool of trade surpluses globally to buy Treasury bonds. In a free market, that would lead to much higher interest rates.
Ultimately, policymakers will have little choice other than to suppress interest rates through Federal Reserve policies and yield curve control. It's a playbook for banana republic finance.
Lastly, trust in Fed policymaking is being shredded before our eyes. The Fed has raised interest rates at the fastest pace in 40 years. That will cause a deeper, longer recession than the investment consensus is forecasting. We're just beginning to see it. The data increasingly makes it clear that we're headed into a serious recession. It's not reflected in earnings estimates or security valuations yet. But as a result, mainstream equities have substantial downside risks. You can see it in the collapse of bank lending, which will lead to slower economic activity. In my view, the Fed is about to do a face plant based on its policies. They will have no choice but to revert to balance sheet expansion and interest rate reductions, probably by the end of the year. Then we'll be back on the treadmill of higher inflation before they can declare victory.
To sum up, once the consolidation phase in metal prices is over and investors become comfortable with gold priced around these levels, there's enormous potential for mining stocks to catch up. You don’t need a higher gold price for gold mining stocks to have a big mean reversion trade. But suppose the macro issues I've discussed, such as de-dollarization and intractable fiscal issues, continue to plague policymakers with no solutions in sight. In that case, there's substantial upside for the gold prices from here.
Think about what that could mean for the gold stocks. Investors are skeptical that gold belongs at $2,000. Sell-side analysts are unwilling to use models with a $2,000 gold price beyond this year. But if that changes, then a big mean reversion trade is in place because mining stocks and gold bullion are joined at the hip. Whatever the reasons for the disconnect, there are a lot of reasonable rationales to suggest a substantial catch-up for gold mining stocks.
Hopefully, I have set the table for Doug Groh, who will talk about how cheap mining stocks are and how much better managed they are.
Edward Coyne: Thank you, John. And John, it might be worth reflecting on the threat of recession right before we go to Douglas. What would a recession do to gold prices?
John Hathaway: Once a recession becomes inescapable and obvious, the Fed will start expanding the balance sheet and dropping interest rates. That is very favorable for gold. Getting from here to there could be a little rocky, but the result would be policies that would be beneficial for higher gold prices.
Douglas Groh: The Gold Mining Equities Opportunity, Slides 15-20
Edward Coyne: Thank you, John. Let's talk to Douglas about "Gold Mining Equities and the Current Opportunity We're Seeing." Douglas, thanks for joining us.
Douglas Groh: Thanks, Edward and thanks, John. I'd like to discuss the investment thesis and investment opportunities in the precious metal mining sector today, but before I get into it, I do want to point out and emphasize that, as much as John mentioned that gold and gold equities are joined at the hip, they're two different investment vehicles. Gold is appropriate for portfolios looking to offset some of the issues John illustrated concerning monetary and fiscal policy. However, gold mining equities are different. They offer optionality and leverage to the gold price. They are affected by the gold price, but they have value elements and value creation opportunities that are a little bit different from just the dynamics that drive the gold price. While the gold price does partly drive gold mining equity valuations, some inherent aspects of the gold industry drive value and the performance of the sector.
I will address the industry structure and the business model of the gold mining companies to understand the opportunities that gold mining equities currently present. I'll discuss the sector's valuation and the gold price supporting that investment thesis. I'll do that by examining the business model, the investment opportunities, and in particular, the valuations on the next several slides.
My first slide speaks to the rarity value of gold, which supports the gold price and gold mining equities. On the right, you can see a depiction of the global gold production, which is beginning to plateau. We could spend some time discussing whether we are witnessing peak gold production, but perhaps the better point to make is illustrated on the left-hand side of the slide. It shows how gold discoveries have declined even as exploration budgets have increased. Production will certainly decline if new sources of gold are not found, and that idea supports the gold price but also presents investment opportunities.
Now, I'd like to discuss the precious metal mining industry’s structure and company business models. We can break the sector into categories. Some companies are good at exploring for gold. There are companies that are good at developing deposits. And finally, there are companies that are producers of gold. In some cases, the producers do all three things — exploring, developing and producing gold.
But generally speaking, the explorers are good at doing just that, going out and identifying regions in the world or having access to countries where they can do exploration and create value through that discovery process. The developer's role is a little bit different. They're more focused on identifying the economic value, permitting a project, designing a mine, and then putting it into production, perhaps becoming an operator and building a company. That skill set is slightly different, as it involves more engineering and financial expertise than what is required for the explorers.
And then, you have the producers. These are companies operating mines. They're generating cash flow by exploring and developing new supplies of gold. Their model is to stay in business for the long term, and as such, they have to add to their resources as they deplete them over time.
This dynamic presents a lot of different opportunities. Value creation can occur through exploration but also through de-risking a project. As a project is de-risked and brought closer to production, the market generally assigns a better value to that company. In addition, producers who are leveraged to the gold price have opportunities to create value either through their capital structure or in the marketplace.
The next slide shows how gold prices aren’t the only factor in gold mining equity valuations. You can see how gold mining equities have been undervalued compared to the past. After gold prices peaked in 2011, gold equities have underperformed as capital has sought other markets. Now, gold prices are once again on the rise, but investors have not yet embraced gold mining stocks. This could be for several reasons, whether it's the market structure, alternative investment opportunities, or the perception of the risk/reward that mining equities present. Part of it might be the past cycle where mining companies disappointed investors with the returns they generated in early 2010 and 2012.
Since then, investors have moved on to other opportunities and have not yet embraced this opportunity here. This lack of enthusiasm persists despite the supporting dynamics of the gold price and the cash flows these gold mining companies can generate. Closing that gap towards the historical trend — or revaluing the sector—is certainly one way to realize investment returns in the space.
However, as I’ve mentioned, there are other opportunities to realize value. I want to address that now with regard to operating leverage. I think many of you are familiar with this, but just to illustrate. It costs about $1,350 per ounce to produce an ounce of gold, so $1,350 is the cost of production. That provides about a $650 profit at current prices.
If gold prices go from $2000 to $2,100 an ounce, that's a 5% move. However, the profit increase from $650 to $750 is more like 15%. Gold mining companies don't always directly participate in the gold price move, but they do generate a profit based on it. The market will revalue those gold stocks based on that leverage of one to three times or even more. As a result, a 1% move in the gold price can mean a 2% or 3% or even larger move in gold equity valuations. That's where the real opportunity is, and so far, investors have ignored it and not participated.
In addition to the gold price leverage operators can realize, the impact on the cash flows can be significant. That affects the asset value of a company. Gold deposits become more valuable because of the price when the price is rising. This is because rising prices not only make the gold deposit more valuable, but they can make the deposit larger. Ores that were marginal in the past become more valuable, and the gold deposit that was not considered economical can become economical at higher gold prices. That becomes an important concept that investors underappreciate in general. It's something that we look for at Sprott. We look for that element that the market is not valuing as a basis and thesis for our investment in the sector.
In addition to operating leverage, there is also asset leverage. Companies can potentially benefit from financial leverage in their capital structure, and this is often expressed in a company's valuation relative to the operating leverage. I’ll talk more about financial leverage in a moment.
Another investment opportunity presents itself in the gold mining sector around the potential to grow and expand operations. Companies perform exploration to find new deposits, but they don’t always have the resources to build out those deposits. In this case, another company will often acquire those assets to grow. Organic growth is certainly the best way to grow, but companies can't always find a deposit. We often see acquisitions as a way to enhance a company's operations or expand its operations or replace depleted resources. It’s also a way for management to maximize its capital position and reduce operating costs.
In simple terms, a large producer of a million ounces a year can be more efficient than a company that produces just 500,000 ounces a year, because the larger producer can spread its cost across a greater production volume. As a result, larger producers are incentivized to have a growing profile. That dynamic encourages the industry to explore for gold and consider and pursue an acquisition strategy to acquire more gold resources. It becomes important in driving valuation and opportunity in the sector. The sector is very active in terms of mergers and acquisitions. Both the industry’s structure and the capital markets facilitate that.
The geology of gold also plays a role. Gold deposits are not large compared to other metal deposits. As a result, it takes more gold deposits to achieve economies of scale and realize favorable unit operating costs. Gold's enduring value derives from the fact that it is hard to find and rare. Gold’s scarcity certainly supports its price, but it is not fully reflected in mining company valuations, even though those companies own the gold resources and generate value from developing those resources for the capital markets. The markets are missing an opportunity in that there are gold resources out there under development with growth potential, but the market is assigning no value to that right now.
With that perspective on gold's value and the industry's business model, let's talk about the valuations. Relative to the S&P 500 Index, gold miners are undervalued. Enterprise Value to EBITDA is 9.3 versus 12.5. Dividend yield is 2.3% against the market at 1.7%. Net debt at 0.5 relative to EBITDA compares to 1.3 for the market and total debt is 15% relative to 25% for the S&P. The sector is undervalued.
The market still perceives risk based on conditions when gold prices were lower. At current gold prices, the sector is generating very good cash flow versus operating costs. While gold mining companies were under pressure last year during the inflationary period all markets experienced, cost pressures have eased significantly, and we're now seeing a better gold price, so margins are expanding. We dropped down to margins of about 25%. We're back up to margins of about 30 to 35%. Those margins should continue to expand, yet the equities are not fully reflecting the gold price and value creation they offer, even after strong performance since October 2022.
The sector is overly discounted, given its potential. The discount partly reflects competition among investment opportunities in the gold space. Years ago, when investors wanted gold exposure, they could either buy gold coins or they could buy gold mining stocks. Now, there's a plethora of opportunities, including coins, equities, ETFs, exchange traded notes, options or futures. Investors have more flexibility and opportunity to invest in different means to gain gold exposure.
Still, the gold mining equity segment is unique because it offers an opportunity to participate in not just the gold price but also from the value creation of a discovery, from the cash flows generated and from mergers and acquisition activity in the sector. All these companies are looking to grow organically through exploration and discovery. But if they can't do that, many will resort to M&A activity to expand.
One good example happened yesterday when Newmont Mining announced that it agreed to acquire Newcrest from Australia. That adds to Newmont's resource base and should increase its cash flow over time. That type of consolidation is very much a part of the industry's business model. Smaller companies hope to be acquired and larger companies look for quality assets to acquire to build up their profile. It’s a way to diversify away from a single jurisdiction or a limited amount of resources or one deposit. That becomes a very important element in the sector.
In conclusion, if there's anything you take away from my comments today, I hope it will be that you appreciate that gold scarcity and its rarity value, presents a value in various investment opportunities that have not been fully appreciated by the market, and the structure of the industry and the business model of the mining companies offer a unique perspective for investors to participate in a real constructive gold price that we've been outlining. At Sprott, we fully engage with the precious metals mining sector to identify those value opportunities, whether through discovery or growth potential or perhaps in M&A and the capital markets where valuation and values are expressed. We're very engaged with these companies to identify where they seek value and capture that for our investors.
With that, Ed, are there some questions or comments we can address?
Edward Coyne: Thank you, Doug. And yes, before the Q&A session, I want to reiterate that gold provides low correlation to other assets. I think that should be one of the takeaways as well. Some of you may be looking to allocate to this space for the first time. As John said earlier, there's been a lot of interest, but there hasn't been a lot of allocation. We've seen people asking questions about it, but we haven't seen the capital necessarily flow into this space the way one would expect, given long-term performance patterns.
However, if you look at the correlation of gold relative to other assets, to U.S. equities, international equities, fixed income or other commodities like oil, gold has traditionally had a low correlation over the last two plus decades relative to other assets.
On a shorter-term basis, during all the bumps in the night we've seen over the last couple decades — events like the Ukraine-Russia war, COVID, the Fed rate hikes and the Eurozone crisis — gold has created positive spreads to other assets like the S&P 500 and U.S. Treasuries. Gold continues to do its job from a performance pattern standpoint, from an opportunity standpoint, and from a value standpoint, and gold equities are looking more attractive now than they ever have. Thanks so much for joining us and have a great rest of your day.
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