For most of the past few years it was easy to make the case that precious metals mining stocks were cheap. They’d suffered through an epic bear market, and in some cases were down 90% or more from their 2011 highs. How much more could they fall?
But through it all, Sprott Asset Management’s Rick Rule — a voice of reason in this frequently-unreasonable sector — was warning investors off of the miners, saying that “capitulation” hadn’t yet occurred and until it did there remained way too much downside risk.
Turned out he was right. The miners just kept falling through 2014 and most of 2015, while a lengthening list of once-promising juniors died quiet deaths, taking 100% of their investors’ capital along for the ride. Here’s a chart of the HUI index of gold miners priced in gold, showing that even as gold was falling the mining stocks were declining faster.
Given the enormous size of the US treasury market and the small size of the gold market, a small transfer of funds from Treasuries to gold — which we are seeing in the last three months — has an outsized impact on the gold market. Gold and gold equities currently occupy between 1/4 and 1/3 of 1% of the savings and investment matrix in the US, while the comparable number in 1980 was 8.
What I am arguing for is a total or partial reversion to the mean which if it occurred would take gold as a part of the savings and investment matrix from 1/4 or 1/3 of 1% up to as high as 1.5%. That relatively small gain in market share would have an absolutely dramatic impact on gold and gold stocks. Will it occur immediately? No. Might gold retest support before it continues? Yes. But I believe that we are beginning to witness a little tiny bit of disintermediation out of Treasuries in favor of gold, and I think that is extremely bullish.
Another thing to remember is that the certificated gold products, the ETFs, GLD in particular, have witnessed dishoarding. That is they have witnessed really substantial selling for 18 months. But lately there has been an absolutely incredible influx of cash into GLD. The consequence of that is that GLD has to take on gold or has to take on gold depository receipts.
Remember that for the last six or seven years the paper market has driven the physicals market and the paper market itself has been driven by the ETFs. ETF demand is positive now rather than negative, so the ETFs are stocking rather than destocking gold. I am inclined to believe that the paper markets will now take gold up the same way the paper markets took gold up in 2009 and 2010 rather than taking gold markets down.
The gold mining industry had a very close brush with capital inadequacy and the increase in demand for gold equities is going to be met by an absolute rush of bought deals among the seniors and intermediates. I think the offer that you saw the other day of Franco Nevada is indicative of what you are going to see. [So] no hurry on the big and intermediate miners. Longer term (a year or year and a half), gold miners at all levels I think will be relatively attractive.
I expect the mining industry to avoid making disastrous mistakes for at least two or three years. The consequence of an increasing gold price and increasing free cash flow per share that is not wasted for two or three years should be an increased cash flow on a per share basis. I suspect that an increasing gold price and increasing corporate performance will have a very good impact on gold equities.
Remember that when gold moves, the first thing that moves is gold itself. Listeners underinvested in gold need to address that and begin to buy.
The second place that you go is, of course, the high-quality senior producers with balance sheet flexibility that can generate free cash and growing revenues. It is important that you do not buy the waterfront; that instead you buy the best issuers. I would draw your attention to names like Franco Nevada, Goldcorp, Randgold; companies that have a history of operational efficiency, capital discipline, good balance sheets, and relatively low costs. One then can apply the same discipline in the intermediate size producers which generally come up after the big producers.
Of course, the most spectacular moves are always going to be in the speculative stocks. I suspect that we will not see a move, a real move, in the speculative stocks for as much as nine months. Of course, extra caution is required buying the speculative names. But for those listeners who have been in the game as long as some of your listeners have, who have paid the tuition, who pay attention to the numbers with regards to the juniors rather than the narratives, I think this will be a spectacular market. It is really important to understand the depth and severity of the bear market and what that means for the bull market.
In the juniors, measured by the TSXV [Toronto Venture Exchange], is a market that fell by half and then it fell by half again and then it fell by half again. This is a market that is down by 90% in real terms which means it is precisely arithmetically 90% more attractive than it was in 2011. This is a market that can double and make up as a consequence of doubling 15% of the decline that it suffered. This is a market that has a long, long way run if you select your stock correctly.
As for the royalty and streaming companies, remember that they have no sustaining capital requirements, so their margins are incredible. They are in one sense better, pure vehicles with less operational and implementation risk. But what is much more important is the once in a generation opportunity, an arbitrage opportunity. The base metals mining industry is producing virtually every commodity that they produced at a loss right now. The need for capital in the base metals mining industry is extreme and their cost of capital is extraordinary.
Precious metals by-product streams in a base metals cash flow wrapper, a wrapper like Freeport or Vale or Vedanta or Teck, command a six or seven times cash flow multiple. But that same cash flow stream stripped out, made into a precious metals stream, in a company like Royal Gold or Franco Nevada or Silver Wheaton commands a fifteen to seventeen times multiple. The base metals mining industry needs to find $10 or $12 billion in equity for sustaining capital investments and debt pay downs, and the lowest cost of capital available to it is by selling these precious metals streams. At the same time that the sale of this stream is accretive to the base metals company, it is also accretive to the precious metals streaming company by giving them access to sustainable visible cash flows for very long periods of time on very high quality mines.
The recent success you saw in the bought deal by Franco Nevada and the upcoming, I believe, debt issuance by Franco Nevada, herald a period where as much as $10 or $12 billion worth of by-product precious metals streams passes from base metals mining companies to precious metals streaming companies which will set up the visibility of per share cash flows and per share dividends in the streaming companies almost irrespective of the precious metals price. If you get this increased quality and increased visibility of a revenue stream and you combine that with the upside in precious metals prices, both in terms of the free cash flow that these companies enjoy from the mineralization that is already economic and combine it with the optionality of mineralized material in these mines that is not economic at $1,100 but would be economic at $1,500, this has the potential to really transform the streaming business which is already very attractive in an absolute sense and particularly attractive in a relative sense against other mining companies.
I love optionality. It has treated me so well. Just to acquaint your listeners with why the subject means so much to me, I think back to the last cycle, 1998 to 2002, and, frankly, to the cycle before that, 1991 to 1992, I can think of optionality companies like Silver Standard, $0.74 to $45; Pan American Silver, $0.50 to $45; Lumina Copper, $0.65, if my memory is correct, to $160. This is not a typo. It is pretty simple. At the bottom of the cycle there are very large deposits that were drilled off with the application of tens of millions of dollars that have no net present value at the then prevailing commodity prices. These deposits are occasionally sold for some amount of money that at least resembles the net present value which is zero.
The right thing to do right now for these companies is to acquire additional ounces and do nothing else. Develop the projects later as the commodity price rises and the attractiveness of the deposits is obvious to the markets and the cost of capital goes down. I suspect – I do not know because past is never completely prologue – but I suspect that the easiest and the most dramatic upside that we will experience in this market other than the occasional discovery will be from optionality, provided that the management team really understands how to deliver the benefits of optionality to the owners of the company, the shareholders.
I was at Roundup, a technical conference in Vancouver, and there was a couple of issuers there, Kootenay Silver and Northair Mines, that announced an amalgamation. I think the combined market caps of the companies were about $8 million, and a $30,000 buy order took the price of Kootenay Silver from $0.20 to $0.32. We are in a market where, yes, the buyers are exhausted but the sellers are exhausted, too. You will see evidence of $3 and $4 million market capitalizations in companies that used to be $70 million market capitalizations getting outsized moves simply because there is a bid of some sort.