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Sprott Shifts From Gold Bullion To Gold Stocks, Explains Why
From Eric Sprott and David Baker
Gold Stocks: Ready, Set,…
Last week, the HUI Gold Index marked a new all-time high as it surpassed 600. Recent gold equity investors were undoubtedly happy with this move, but for longer-term holders, the recent strength is actually somewhat disappointing. If you review the chart below, you’ll notice that while the gold price has almost doubled since early 2008, the HUI Index has appreciated by a mere 22% over the same period (see Chart A). If the HUI was justified at 500 in early ’08, it should surely be justified at 1,000 today, given the appreciation of the gold price over that time. So why have the equities lagged?
Chart A
Source: Bloomberg
First and foremost: the sell-side’s abysmal gold price estimates. Table 1 shows the average gold price that analysts are using to value gold equities today. While the futures market is comfortably forecasting a continuation of today’s levels, the majority of sell-side analysts refuse to update their gold price estimates to reflect its recent strength. A rising gold price is normally a bad sign for the broader equity markets, and generally indicates a bearish trend. As bears ourselves, we’re completely fine with this, and invest accordingly. But the sell-side has difficulty pairing bearishness with new underwriting opportunities. It doesn’t mean you have to believe their price forecasts however.
The second reason is gold’s volatility. The amount of paper gold and silver contracts that trade on the futures and equities exchanges still dwarf the amount of actual physical trading that takes place. Paper markets continue to set price discovery – thereby allowing for dramatic volatility with little or no influence from actual physical fundamentals. In the LBMA market, for example, market participants traded an average 19.6 million ounces of gold PER DAY in July 2011.1,2 Keep in mind that the total gold mine production in 2010, globally, was approximately 86.5 million ounces. Global gold mine production is not expected to increase significantly year-over-year, so the LBMA is essentially trading a year’s worth of production in less than a week. And this is just ONE market. When you add the COMEX futures and gold ETFs, the paper trading volume becomes absurdly high. When price discovery is dictated by levered paper contracts with no physical backing, it’s extremely easy and relatively inexpensive to jostle the spot price around. The result for gold has been many days of extreme downside volatility, despite a strong and consistent overall upward trend. Investors don’t like volatility – and the constant whipsawing has probably kept many of them away from the gold equity sector as a result.
Thirdly – investors still remember how badly gold equities got crushed in 2008. There was a reason they sold off so aggressively however – they were the most profitable positions investors owned going into the ‘08 crisis. Gold equities had enjoyed a strong bull trend going back to 2001, with the HUI Index appreciating by 980% from its November 2000 low through to August 2008. Investor behaviour is fairly consistent – when panic hits, you sell your winning positions first.
Something has changed recently, however. A new divergence has arisen in the precious metals equity market – a subtle, but plainly evident shift in recent daily performance. On Wednesday, August 10th, for example, the Dow dropped 4% while gold stocks rallied 3%, for a delta of 7% on the day. That is significant outperformance, and not what we have come to expect on an equity market down day. Gold stocks, as represented by the HUI Index, also seem to be breaking away from their traditional correlation with the spot gold price. On August 29th, spot gold dropped 2.16%, while the stocks fell by only 0.81%. On September 7th, gold fell by 3.09%, while gold stocks rose by 0.33%. These small differences indicate a new trend forming. While gold’s daily volatility is expected to continue, we may be entering a new phase where the stocks react less harshly on gold down days, and outperform gold on days of strength.
The gold equities’ recent divergence has played itself out even more prominently against the financials, with the HUI Index outperforming financials by a stunning 49% since the beginning of July (see Chart B). As we wrote in "The Real Banking Crisis" two months ago, there appears to be a run on European banks, and financial stocks are reflecting that. IMF Managing Director, Christine Lagarde, recently confirmed as much in her Jackson Hole speech, where she warned about the banks’ need for urgent recapitalization: "They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis."3 Investors aren’t waiting around to see if they’ll pull it off, and as the chart below suggests, at least some of them have reinvested their former bank equity capital into the precious metals sector.
Chart B
Source: Bloomberg
As a side note, Chart C symbolizes the great wealth redistribution that has taken place since 2000. Those investors who have owned precious metals equities have prospered, while those who have invested exclusively in the broader equity market or financials have little to show for it. We clearly see this trend continuing, and even accelerating, in the coming years.
In many of the funds we manage at Sprott, we’ve transitioned out of gold bullion and into gold equities to better participate in the continuation of the trend indicated above. As long-time investors in this space, we can assure you that the production growth rates will be significantly higher in the junior stocks. They continue to trade at discounted valuations, and we believe they offer the best opportunity to build exposure. Margin expansion is the key metric for this industry, and the market is now acknowledging the miners’ improvement in margin capture – which has occurred despite the increase in capital and operating costs (see Chart D). We meet with a large number of gold mining management teams on a weekly basis, and based on those meetings, it appears that the average cost of producing an ounce of gold today, all in, is now around $800. At $1,200 gold, these companies can capture roughly $400 in EBITDA. At $1800 gold, however, they’re now capturing $1,000 per ounce in EBITDA - representing an increase of 150% in profit margin. That is significantly far above what any other equity sector has been able to generate over the past year.
Amazingly – despite this new reality for gold producers, we are still finding opportunities in select gold and silver mining companies that can be purchased today at 2-3 times their 2-year-out forecasted cash flow. These multiples are based on the current gold and silver spot price, and if these companies hit their production targets, and gold and silver continue their appreciation – we may discover that these stocks were trading at less than 1 times 2-year-out cash flow today. Having been in the business for many years, we can tell you that investing in a stock at 1 times 2-year-out cash flow tends to be a winning proposition – let alone in an industry that literally mines the world’s reserve currency out of the ground.
Chart C
Source: Bloomberg
Chart D
Source: BMO Capital Markets
In our view, gold stocks represent a bona fide growth sector in an otherwise dreadful equity market. All other equity sectors are weakening due to sovereign uncertainty and the reemergence of soundly weak economic data. The recent disconnect between gold equities and bullion isn’t new either. We’ve seen it before over the past decade, and the returns generated after previous divergences have averaged around 26% (see Table 2). Given the recent performance correlations, the HUI’s breakout above 600 and spot gold now firmly above $1600, we expect this rebound in gold equities to be prolonged and much more significant in percentage terms.
Equity investors shouldn’t let $1800 gold dissuade them from participating in precious metals equities. The world is still dramatically underexposed to gold, and we firmly believe it should represent a higher percentage of investors’ total portfolios today. The fact remains that both gold and silver continue to trade well below their inflation-adjusted highs in nominal terms, and the market is now beginning to acknowledge the profit potential that precious metals equities offer at today’s bullion prices. We believe the equities will offer more upside than the bullion over time. Many of the smaller names are well priced and have momentum behind them. The prospects for gold stocks look extremely bright.
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Look at Homestake mining in the (1st) Great Depression. Dividends in the middle of the depression were higher than the stock price at the beginning, IIRC.
Does he mean PHYS will include mining equities or other funds?
Brave but foolish. Canada and Australia are about to implode via China's major implosion. Miners debt/equity will send a slew of juniors bankrupt.
Trading physical for paper? - yikes.
When the stock/paper markets blow up, so will the gold/silver stocks.
I know why he is doing it, but it's not a smart move IMO.
arkel,
You're buying stock in the company, not fiat. Just because it's priced in dollars does't mean it's fiat.
Stock is paper, and is it redeemable in metals?.
Uh, nope.Don't get me wrong, he's far ahead of most sages, and me for sure.
I just cannot risk the downside.Esp on Jr's, and the good one's are already well priced ^^^
"Margin expansion is the key metric for this industry, and the market is now acknowledging the miners’ improvement in margin capture – which has occurred despite the increase in capital and operating costs."
Even using historical prices, the silver miners I own are producing 40% plus in net margins as reported during the past 6 months. These miners are building up huge cash reserves and I would expect a wave of buyouts to become the norm during the next 6 months.
My bet is someone will make a run at HL soon, given management's performance and many pissed off shareholders...just a guess.
"Margin expansion is the key metric for this industry, and the market is now acknowledging the miners’ improvement in margin capture – which has occurred despite the increase in capital and operating costs."
Operating margins of 40% plus now being reported by silver miners......
Is he talking his book?
Miners will rip until you see Erik Estrada on TV selling timeshare commercials for gold mines.
He doesn't discuss the future costs. $800/ounce production cost is not likely to conitnue IMHO. Mines are missing their estimates by ever wider margins. Easy gold strikes just aren't there anymore.
Nationalization of mines and something on the order of "windfall profits tax" will almost certainly come into play if these stocks go ballistic. I fully expect gold producers to be treated differently by governments than golf ball producers.
I thought Hugo cleared this up for everyone. Anything other than physical is for fools.
The underling physical IS the mining stocks. Picking the right ones is the problem but there is no physical without the companies that locate it and or pull it out of the ground. To suggest that investing in a sector which is essential to future gold/silver reserves is foolish, is foolish!
Sprott is doing what managers get paid to do. If his investors felt the way many off us feel, they wouldn't need Sprott. They would just accumulate the physical and be done with it.
I did the research a couple years ago. The mutual fund with best exposure to junior miners is UNWPX.
Amazing. Someone has started an HFT bear raid on gold at a time I've never seen before (9/14/11 6:50 PM Pacific Standard Time). I've noticed the raids starting earlier and earlier, but since they are not having a lasting effect, they are moving toward 24 hour manipulation.
The waterfall declines in gold will continue until market morale improves!
What about illegal naked shorting of mining shares by the PPT?
Not much you can do to stop that! Though it is my understanding that there are a couple of ways to make such illegal activity more obvious and subsequently more difficult for regulators to ignore:
1. If you invest in a company (as opposed to simply day trading for a short term return) demand an actual share certificate from your broker. (I know, I know: ugh, hard-copy)
2. Every day put your shares up for sale at a level well above where they are currently trading (and you would actually not be too upset to part with them, should the bid hit). To my knowledge this should effectively remove them from the pool for 'borrowing'.
The more shareholders of your company who do this, the more profound the effect should be.
Disclaimer: I am not your Momma. Investing in fucking anything is bleeding risky as you could lose every last one of your bitz and bytes of pretty polly, your shirt and your wife besides. Above suggestions void where prohibited and intended for entertainment purposes only. All results and effects are mere conjecture on my part. Do your own due diligence; do your due-D dude.
I thought Sprott was smarter than that...
EPIC! Telling you gold is going down.
So the strategy fits right into today. Silver down 2% but SVM up 2%.