Overview of Trends
A common misconception is that gold always performs best during times of crisis — actually it’s a bit more complex.
Gold often reacts positively to emergencies, however there are examples of gold prices falling during a crisis.
At the beginning of the current pandemic, gold prices plummeted to seven-month lows whilst the ASX was also dropping precipitously.
It’s likely the economy will experience a sharp contraction in this second quarter of 2020 stemming from factors related to the pandemic, including social distancing measures put in place to contain it.
The third quarter economic activity is expected to increase as concerns about the pandemic diminish and state and local governments ease stay-at-home orders, bans on public gatherings and other measures restraining economic activity.
However, challenges in the economy and the labor market are expected. to persist for some time. Gold prices tend to increase most in the aftermath of a crisis.
Market corrections since gold became a free-floating asset suggest that gold bull markets follow in the aftermath of turbulent events rather than in parallel.
While money printing is a catalyst for the gold market, margin calls dampen the immediate impact.
History suggests that gains follow the downturn. This applies to the commodity (gold) as well as the producer (gold miners).
The advantage provided to the miner is that governments cannot impound products in the ground and investors can pick the more efficient and emerging companies.
As the second biggest worldwide gold producer, Australia (60% in WA) is in the box seat; and the biggest producer, China, largely consumes its own production.
Current events indicate that the gold market is likely to boom.
The ongoing COVID-19 pandemic has caused central banks to inject cash into their economies in a bid to calm markets, with the predictable result of devaluing their currencies, and sending investors scrambling to protect their money by buying gold.
Gold Has a Strong Track-Record as an Event Risk Hedge.
Selection of Gold Miners
Critical to the selection of an investment in gold miners is to determine their relative value.
As stated by Charlie Munger, the share market is a polling machine in the short term and a weighing machine in the long term.
As investors, we want to pick a company of “value”, but to time purchases for periods when they are unpopular is difficult.
The first thing is to determine what “value” means in gold mining.
Traditionally, parameters such as P/E ratio have been popular, but the “E” part (earning) is only available from annual or half yearly reports.
What can be substituted? Traditional investors shun “price takers” such as gold miners (and other commodity producers), and prefer “price makers”, but this can be a bit ritualistic.
Whilst a commodity producer has to take the market price, a significant advantage to the active investor is that they know the commodity price on a running basis and can predict the cycles. It’s work but it’s also profitable.
The commodity investor doesn’t have to wait for half-yearly financial reports that commodity producers are required to produce, which provide guidance on activities each quarter, as the price of the commodity is public at all times.
Valuing Gold Miners
A good parameter for valuing any company is its “enterprise value”: that is its market capitalisation, less cash, plus debt.
It’s a bit like the value of a property with a mortgage and a treasure chest inside.
To appreciate how worthwhile the investment is we then need to determine the period required for the company’s earnings to pay off its enterprise value.
Gold miners in their quarterly reports set out what is called their “all in sustaining costs” (AISC) and also guidance on expected production levels.
The difference between the price of gold (PoG) and the AISC then multiplied by expected production gives a first approximation to the annual earnings (I call this “margin”).
This first approximation then needs to be corrected for “hedging”; which is gold committed to a bank (or other financial institution) at a pre-agreed price either as an insurance policy against gold price variation or as collateral for a loan.
The result is a “margin” which approximates to the earnings of the company (it’s important to note that actual earnings will be less than the margin due to refining costs, “green fields” exploration and non-sustaining capital expenditure — we have to assume that this is spent wisely).
The “value” parameter (a running approximation to P/E) I use is:
“value” (years to repay EV) = enterprise value (EV)/margin
“Value” varies daily based upon the PoG and the share price, however AISC and production are updated quarterly or at other company announcements and allows you to gain an advantage over those who just work on numbers derived from financial reports.
Conclusions Drawn from “value”
“Value” is only a first level sieve, however it is revealing. In classifying gold miner “value” against production, it’s immediately apparent that a demarcation exists between “junior” and “mid-tier” miners at around 300 Koz/yr production.
Whilst to become “a million ounce producer” is a badge of honour for company management, it appears not to be echoed by investors.
Valuations roughly double in moving through the 300 Kozs/yr threshold; reserves and resources appear to have lower impact (they are, however, important).
Within each category there are, however, exceptions but these are often for a valid reason, which needs to be appreciated.
A good strategy is to look for companies that are near the “threshold” and have prospects of moving to the higher valuation or, alternatively (for a lower entry price), takeover targets that would achieve this aim for a suitor.
When evaluating takeover options, it’s important to be aware of proximity, resources and “available” plant capacity for both suitor and target.
Role of ETFs in Gold Miner Share Prices
ETFs have become popular worldwide, and gold miners are no exception.
The “go to” indexes are GDX (for larger miners) and GDXJ for junior/mid-tier miners; both are operated by Van Eck and have considerable influence on share prices.
The mandates of these ETFs are summarised below:
GDX ETF (Value: US$12.2b) uses NYSE Arca Gold Miners Index (GDMNTR)
b) Market capitalisation greater than $750 million
c) Average daily volume of at least 50,000 shares
d) Average daily value traded of at least $1 million
GDXJ (Value US$4.1b) uses MVIS® Global Junior Gold Miners Index (MVGDXJTR)
a) Minimum 50% revenue from gold and/or silver mining/royalties/ streaming
b) Market capitalisation of US$150m to US$5.2b. Weighted average US$2.3b
c) Average daily value traded at least $1 million and traded at least 250,000 shares/month over the last six months
The “sweet spot” is for a gold miner to be in GDX and GDXJ simultaneously and criteria (b) is the focus for investors who “front run” these indexes.
Rebalances of both these indexes take place quarterly with evaluation on the first Friday of March, June, September and December; the announcement on the second Friday; and implementation on the third Friday.
Recently, Gold Road (GOR) and Silver Lake (SLR) were promoted to GDX but retained in GDXJ; the share prices increased dramatically prior to and throughout the process, no doubt assisted by speculators.
Similarly, companies are “shorted” when they fall out or are bought prior to entering GDXJ.
An alarming feature is ETF NUGT, which is GDXJ on “steroids” and gears GDXJ investments by 300%.
In the recent COVID-19 crisis this caused a misalignment of GDXJ’s net asset value (NTA) and units on issue of 13.7%; thankfully GDXJ survived, but it demonstrates a potential weakness in an ETF structure during a crisis.
Source: David Brooke, Australian Shareholders Association
P.S. I research and interview economists, NZ investors and profitable companies to find tools & tactics that you can use to achieve financial freedom.
IMPORTANT: This article is of general nature only and readers should obtain advice specific to their circumstances from professional advisers.