The year had been an absolute belter for gold stocks – now we’re seeing the correction. Yet with upside ahead and miners still cheap, this is a buying opportunity, says Dominic Frisby.
If there is a more volatile asset class than gold mining, I’d like to know what it is. It’s feast or famine. If you bought a sensible, large-cap gold mining company in late 2000 or early 2001, then by 2003 you would have sextupled your money. Yes, you read that right. Your investment went up more than sixfold. But you needed to time it right. New investors who joined the party in 2004 found themselves down 35% within 18 months. Then, between 2005 and early 2008, you could have tripled your money. But within the year you were down 70% – gold miners were back at 2002 levels. Then, from late 2008 to 2011, they more than quadrupled. But from 2011 to the start of this year they fell by 85% – back to 2002 levels again.
What came next? True to form, 2016 has been an absolute belter. From low to high, the NYSE index of gold stocks (the HUI) has gone from $100 to $280 – almost tripling. To the best of my knowledge, gold stocks have beaten every other asset class this year, while gold itself has been among the best-performing currencies (if you don’t mind my calling it that), up some 25%-30% against the US dollar, and much more in sterling terms – gold has been a great hedge against post-Brexit currency disorder. Phew! It’s been some ride. However, since early to mid-August, gold and gold stocks have enjoyed what we might call “a healthy correction”. Mining share prices have fallen by 15%-20%. The question I and just about everyone else who dabbles in the sector is asking is: “Is this the start of something more serious, or is it just a natural, necessary pullback in a bull market?”
Blowing off the froth
My instinct tells me it’s the latter – though I am not as bullish in the short term as some. For sure, we needed a pullback. By July, many tiny explorers were doubling and tripling in just a few weeks, without actually having done anything. The newsletter pump-and-dump operations from across the pond were aggressively tipping stocks. Hot money was pouring into the small companies, particularly from the poorly informed retail sector. Many companies with poor management, poor assets, poor track records, or all three, were taking advantage of the mini-frenzy to raise capital for projects that will never become mines. In short, it had all got too frothy. We needed a sell-off.
Now some – including sensible bulls whose opinions I respect – are already calling the low. I’m not so sure. I think we may have a rocky few weeks ahead. But I also believe that some judicious buying over the next few weeks could pay off handsomely. At $235, the HUI is still only at 2004 levels. At its peak in 2011 it hit $640. So it could more than double from here and we still wouldn’t be at all-time highs. And if it broke above $640, there’s only blue sky ahead. There really is a lot of upside potential and it’s very easy to look at these basic numbers and make the case that, even after the nine months they’ve had, gold miners are still cheap.
But a lot of companies have raised a lot of capital in the last few months. The Canadian capital markets are among the most important when it comes to mining, particularly in the small- and mid-cap sector. Placements often work like this: a company raises money by offering shares at a slight discount to the market price, often with warrants to buy the stock at a higher price attached. But buyers are not allowed to trade the stock for another four months. A lot of money was raised in the March-July period, which means a lot of stock is now coming to market, as sellers want to lock in their gains. Over the coming months the markets will have to find a way to absorb all that extra paper. A higher gold price will solve this problem. It will bring in new capital. But without it, the selling pressure may hold things back. If gold falls, these markets are vulnerable. So I think the next few weeks will see some sideways action, with a little downward bias – assuming, that is, gold doesn’t rocket north of $1,400 an ounce.
My plan is to take advantage of pullbacks to accumulate positions in quality companies. The longer-term house view chez Frisby is that the gold price is going to $1,475 over the next 16 months and that gold stocks are going higher. There is, of course, always the outlier possibility that either the government-debt chickens or the central-bank, monetary-intervention chickens come home to roost and gold goes bananas, much as it did in 1980. If so, bring it on. I’ll sell my gold and buy a palace. But – ever the hedger – I’m also not ruling out a move to $1,200. Who knows? Maybe we need to go back and test the January lows. This could just be a relief rally. I doubt it – but never say never. When trying to gauge where you are in the grand scheme of things, it’s a good idea to look at cycles. And in an industry as cyclical as mining, it’s particularly worthwhile.
The mining investment clock
The Australian mining investment company Lion Selection Group has given us the concept of the mining clock, which Investec has since developed:
Such models are always a bit arbitrary and no two cycles are the same, but they are still a useful template. When the mining sector hits recession, first the market sells off. When it becomes clear that stock and metal prices are not going to rebound, companies begin cutting costs. Some mines become uneconomic at these lower prices and are forced into care and maintenance. Companies go bust, assets get written off, credit agencies make their downgrades, staff get laid off, behaviour improves, belts get tightened. Chief executives swap the Savoy for a Premier Inn, and companies no longer invest in exploration – there is no point when discoveries are not being given any value. Instead, companies start “high grading” (only mining the very best ore) in order to stay profitable. We’ll say this phase is between noon and four on the mining clock. That’s when you want to be well and truly out of this market, if not short.
But eventually metal prices stabilise. The better-run companies can still operate their mines at a profit. There will be some cautious buying of distressed assets, often using company paper rather than cash, which is at a premium. You’ll see some merger activity, debts are paid off, and capital investment creeps back into the sector as stock prices start to rise – and you get a boom. New companies start to list, spending on exploration grows, metal prices rise, and all is rosy again. We’ll say this part of the cycle is between about four and nine on the mining clock – and you, the investor, want to be very long.
The final part of the cycle sees rising debt and leverage returning to the sector. We get big new listings and huge takeovers. Mining executives get rich again and start to believe their own bank balances. They’re back at the Savoy now, and they’re paying too much for uneconomic assets, which they think are economic, because metal prices “only go up”. Compelling coverage spreads – “there is not enough metal to meet Chinese demand”, etc. We’ll say this part of clock is between nine and 12 – and you want to be selling hard into the decadence.
The end of the boom
The commodities boom that ended in 2011 saw all of this in spades. The floating of Glencore is perhaps the most conspicuous example – or maybe its merger with Xstrata in 2013, or BHP Billiton paying $4.75bn to Chesapeake for the Fayetteville shale assets, then buying Petrohawk for $12bn in cash. The subsequent bust saw the write-downs. There are too many gold mining examples to list, but a representative one is Goldcorp spending $3.6bn on the Cerro Negro project in Argentina in 2010, which it then had to write-down in 2013, as well the $2bn hit it took on Penasquito in Mexico.
This year, however, the clock has moved forward. Metal prices have stabilised. Belts have been tightened, and operations streamlined. Some mines are profitable. There has been a lot of merger activity, while other companies have been formed to take advantage of the opportunities in distressed mining assets. Share prices have started to rise and we have had the boom. I’d say we are now at about 6:30 on the clock. We are starting to see new listings, and some of the money that has been raised is making its way into the ground. Exploration is beginning again.
However, you could equally argue that we are only at about five o’clock. The merger activity seen so far has, mostly, been friendly. Further on in the cycle, such instances become ever more rare as companies start fighting for premium assets, but we’re not there yet. The deals havemostly been for paper too – cash, in other words, is still being preserved. Such an attitude, again, is early cycle behaviour.
But no matter which side of six o’clock we are on, the point to grasp is that we are still in the “buy” zone, and we have a few more hours on the clock to enjoy yet. The mining clock reinforces my view that this August sell-off is of the healthy “correction-in-a-bull-market” kind. It’s also worth noting that it’s nothing unusual for this time of year. August is never a great time for gold stocks (if you’re selling, that is). So you should use this as a buying opportunity to make some acquisitions. My ideas are below. Then, hopefully, it will just be a simple matter of being long and being strong in a bull market. Ride the wheels of time – but keep an eye on the clock.
The investments to snap up now
The easiest way to play gold mining is to buy one of the exchange-traded funds (ETFs). The US-listed VanEck Vectors Gold Miners (NYSE: GDX) – which tracks the large-caps – is the most liquid in the world. Going down the size spectrum, for the mid-caps you have its sibling ETF, GDXJ, or, to invest in the larger explorers, you can buy Global X Gold Explorers (NYSE: GLDX), which gives you the most leverage. Both GDX and GDXJ are also listed in London in US dollars.
For those who prefer active funds, BlackRock’s Gold and General is the best known. It does well when gold is going up. But between 2012 and 2015, like everything gold-related, it was a disaster. At the speculative end of the active fund world is the SF Peterhouse Smaller Companies Gold fund, managed by Amanda Van Dyke. Its remit is to invest in companies with a market cap below $250m. There are some sub-$10m tiddlers in there, which, if they catch a bid, have multi-bagger potential. So this is a simple way to buy some exposure to this sector. But all the usual caveats apply: what goes up can go down.
Pan African Resources (LSE: PAF) has done well since I mentioned it here last year, rising from 6p-ish to a high of 24p. It’s currently at 19p. This £380m market-cap company produces about 200 ounces of gold and 8,000 ounces of platinum a year. It’s probably the pick of the London-listed producers. It yields around 2.7% – not as tempting as the near-10% on offer last year when the share price was far lower – but it’s a quality operation and worth a punt below 20p.
I also tipped Randgold Resources (LSE: RRS) last year. I can no longer recommend this company. Some unfortunate pictures emerged a few weeks back of the boss, Mark Bristow, on safari, rifle in hand, squatting proudly next to a dead elephant and another next to a dead buffalo. That sort of thing is not really my cup of tea, to put it mildly, while any ethically minded funds who are in the company might not want to be any more – including Norway’s sovereign wealth fund, which has put Randgold “under observation”. Ethics aside, it all points to extra selling pressure.
Now we come to the exciting, speculative plays that can turn your pennies into pounds and, from there, into glamorous sports cars (hopefully). Please note, I own shares in each of the following four stocks. Keith Neumeyer’s Canada-listed First Mining (TSX.V: FF) has been going great guns since I first mentioned it at last year’s MoneyWeek Conference. It was C$0.35c then, and it’s now $1, having been as high as $1.30. Neumeyer set it up as a vehicle to acquire gold assets at distressed prices. He now has between 15 million and 20 million ounces.
This is some achievement – I daresay an unprecedented one. There might be a couple more acquisitions – most likely you’ll see it tidy up what it has acquired to make itself as attractive as possible for one of the large-caps to take out. All those ounces it has accumulated in the $10 per ounce region it will probably sell for over $50 per ounce. Any large-cap that takes it out will be covering perhaps 15 years of future production. The market cap is now C$500m – I reckon it’ll go for over a billion. It’s a buy in the C$0.80 to $1 region.
South American explorer Regulus Resources (TSX.V: REG) has had a great year. Its main asset is the AntaKori project in Peru. The market cap is around C$90m, high for an explorer, but it has plenty of cash, institutional backing and lots of upside potential. It’s in a highly prolific region, Cajamarca – one of the first areas in which the Spanish invaders began mining many moons ago. The “elephant-sized” deposits of Yanacocha, Cerro Corona and Tantahuatay are all within a 35km radius. Many other major deposits are also nearby – Sipan, Pierina, Alto Chicama, Antamina – plus future mines such as La Granja, Conga, Galeno and Michiquillay. A 2012 study showed a compliant resource of 3.5 million ounces of gold and almost six billion tonnes of copper. It could be huge. Buy in the $1.30-$1.50 region.
Finally, let’s mention a couple of tiddlers. Kesselrun Resources (TSX.V: KES) has a market cap of just C$7m, with a couple of project acquisitions – one in the pipeline, I understand, another announced – and the recent backing of some old-school Vancouver players. Don’t chase it up – buy in the low 20c range, no higher. African Queen Mines (TSX.V: AQ) is now out of Africa completely and trying to get some alluvial projects working in British Columbia. It just had a big run from 2c to 14c – nobody seems to know why – and it’s now back at 5.5c. It might be worth a flutter at that level.