In November 2019, we offered Five Reasons Why Gold Stocks Make Sense. Six months have passed and gold miners have climbed steadily, following the positive path we predicted.
Through April 30, 2020, gold mining stocks were up 11.01% year-to-date (YTD) and 57.87% over the 12-month period (YOY).1 This compares to -12.36% YTD and -7.91% YOY returns for the S&P 500 Index.2 In our view, gold mining equities still have a great deal of upside to offer, given that historically gold stocks tend to outperform the metal during gold bull markets (2-3x).
We believe that we are still in the early stages of the current gold bull market which began in May 2019. Rising demand for gold and higher gold prices are followed by strong gold mining stock performance.
Here are Sprott's six reasons why investing in gold equities may make sense right now.
Gold mining equities, despite their recent outperformance, are being ignored by most investors. This creates a value opportunity. My colleague John Hathaway, Senior Portfolio Manager, summed up this dilemma best in his recent interview with Jim Grant:
"As for gold-mining shares, John Hathaway, co-portfolio manager of the $1 billion-plus Sprott Gold Equity Fund, reports that interest is exactly nil. The Sprott bullion business is jumping, but not the mining-stock investment business....gold shares, in relation to bullion, are the cheapest they've been in his 20 years in the business: 'What astonishes me — I'm an old value investor — is that so many companies are generating free cash flow, and it is not hard to find companies with free cash flow yields of 10% or better.'"
Gold bullion has delivered strong performance in 2020 and was up 11.15% YTD through April 30, 2020, and 31.39% YOY.3 At the same time, as mentioned above, gold mining stocks have risen 11.01% YTD and 57.87% YOY.1
Gold broke through significant resistance in 2019, and in 2020, gold pushed above $1,700 in April (Figure 1). Global political and macroeconomic trends ignited this first stage of the gold rally with the economic fallout of COVID-19 acting as an accelerant.
Figure 1. Gold Bullion and Gold Stocks: A Close Relationship
Source: Bloomberg as of 5/20/2020.
According to the latest research from World Gold Council (WGC), the growth in gold exchange traded funds (ETFs) helped drive global demand for the yellow metal in the first quarter, as the world economy was crushed by the COVID-19 health crisis. Global gold-backed ETFs added 298 tonnes and net inflows of US$23 billion in Q1 2020 — the highest quarterly amount ever in absolute U.S. dollar terms and the largest tonnage additions since 2006.
Figure 2. Gold-Backed ETFs Reach Record Levels
Source: World Gold Council. Data as of 3/31/2020.
Price movements for physical gold and gold-mining stocks are not entirely in sync, but the relationship between them is strong and persistent, across economic cycles.
Historically, rising (and falling) gold prices have a two- to three-times multiplier effect on gold stocks: If the value of gold bullion increases by 10%, mining stocks tend to increase by 20-30%, and vice versa. The reason: Miners have significant fixed operating costs and high operating leverage, meaning big swings in physical gold prices have a larger impact on miners' profitability.
This relationship cuts both ways, which we saw after physical gold prices peaked in late 2011. As the value of gold subsequently declined, the value of gold stocks plummeted even more. Between 2011 and 2018, gold miners posted negative returns in six out of eight calendar years. Even with recent gains, gold mining stocks still have a long way to go to return to historical valuations. Figure 3 shows that since 2008 the relative valuation of gold equities to gold bullion has fallen 73% from the prior 25-year average, from 0.2497x to 0.0674x. The green line indicates the current gap and the potential outperformance of gold equities should they revert to the historical mean.
Figure 3. Gold Mining Equities are Undervalued Relative to Bullion
The ratio of XAU Index to Spot Gold (12/23/1983-4/30/2020)
Data as of 4/30/2020. Source: Bloomberg. 12/23/1983 represents the inception of the XAU.
While miners as a group still trade below their net asset values, the discounts of smaller, "junior" miners are especially extreme, as much of the recent rally has been driven by the largest, "senior" gold miners. The valuation gap between North American junior and senior gold miners is the widest it has ever been (Figure 4.)
Figure 4. Junior Miners are Trading at an 81% Discount
Senior miners are currently trading at a ~7% premium to their underlying net asset values (NAVs), while junior miners are trading at an ~81% discount.
Source: BMO Capital Markets, FactSet. North American senior vs. junior gold miners. As of 4/30/2020.
Most investors grasp the importance of investing in companies whose business models are protected by "competitive moats." Gold miners have this in spades, as it can take 15 years from the discovery of a new gold mine to successful ore production. The barriers to entry are enormous for newcomers in this sector, given the need for expensive and specialized equipment, environmental approvals and political considerations.
The supply of gold is finite and there have been increasingly fewer large-scale gold discoveries in recent years (Figure 5). This dynamic — combined with depressed valuations of junior gold miners — is driving consolidation in the industry. It is far cheaper for senior miners to buy new gold production than to "build" capacity themselves. Based on an analysis of recent transactions, there is a 35% discount for buying ounces in the market via acquisitions versus discovering new ounces (according to Scotiabank). Buying reserves eliminates the time and uncertainty associated with exploration.
Figure 5. Annual Global Gold Discoveries Drop
Source: © Copyright by S&P Global Market Intelligence. All rights reserved.
Although COVID-19 related lockdowns and supply chain disruptions are impacting gold producers, miners are benefiting from lower energy costs (as the global recession pushes oil costs lower) and U.S. dollar strength, both of which reduce the cost of production.
Despite the pandemic, there are ample signs the wind is shifting for the gold mining sector, and that earnings per share growth is accelerating, at a time when it is declining for the broader equity market. In Figure 6, we show 1-year forward earnings per share (EPS) revisions for the top-10 gold mining companies versus the average for the top 20 S&P 500 companies. EPS estimates are up ~65% for gold miners and down ~17% for the S&P 500.
Figure 6. Rising Gold Miners EPS Trend vs. Declining S&P 500 Trend
Source: Bloomberg as of 4/30/2020.
It is important to think about the role of gold stocks in the context of a broader portfolio. One common misconception is that gold stocks and physical gold are two sides of the same coin. While their fates are positively correlated, as asset classes they could not be more different.
Physical gold, whether it is in the form of coin, bar or a trust (for example, Sprott Physical Gold Trust, NYSE Arca: PHYS), should be viewed as a long-term store of value. Gold is counter-cyclical and has proven over centuries to be a safe haven asset that protects your purchasing power.
As such, we recommend that investors allocate between 5-10% of their assets to physical gold and other precious metals.
Gold stocks, conversely, should be viewed in the context of an investor's overall equity portfolio; the size of the allocation will depend on many factors, including risk tolerance. Strategists advocate owning gold stocks continuously, in part because they have low correlations to the broader market. However, most investors view gold stocks as tactical investments. When valuations are severely depressed and the price of gold is moving higher, as they are now, gold stocks may have the potential to outperform.
In summary, here is what is underpinning our belief in the rally for gold and gold stocks:
Support Remains in Place for the Gold Bull Market to Continue
The Case for Gold Equities
At Sprott, we believe that it may be time to consider investing in gold stocks, in addition to physical gold.
|1||Based on the performance of the NYSE Arca Gold Miners Index (GDM), a modified market capitalization weighted index comprised of publicly traded companies primarily involved in the mining of gold and silver in locations around the world.|
|2||The S&P 500 Index (SPX) is an index of 505 stocks issued by 500 large U.S. companies with market capitalizations of at least $6.1 billion. You cannot invest directly in an Index.|
|3||Based on the performance of the spot price of gold, which refers to the price of one ounce of gold at which the commodity could be transacted and delivered.|
Past performance is no guarantee of future results. You cannot invest directly in an index. Investments, commentary and statements are that of the author and may not be reflective of investments and commentary in other strategies managed by Sprott Asset Management USA, Inc., Sprott Asset Management LP, Sprott Inc., or any other Sprott entity or affiliate. Opinions expressed in this commentary are those of the author and may vary widely from opinions of other Sprott affiliated Portfolio Managers or investment professionals.
This content may not be reproduced in any form, or referred to in any other publication, without acknowledgment that it was produced by Sprott Asset Management LP and a reference to sprott.com. The opinions, estimates and projections (“information”) contained within this content are solely those of Sprott Asset Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. SAM LP is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. SAM LP and/or its affiliates may collectively beneficially own/control 1% or more of any class of the equity securities of the issuers mentioned in this report. SAM LP and/or its affiliates may hold short position in any class of the equity securities of the issuers mentioned in this report. During the preceding 12 months, SAM LP and/or its affiliates may have received remuneration other than normal course investment advisory or trade execution services from the issuers mentioned in this report.
SAM LP is the investment manager to the Sprott Physical Bullion Trusts (the “Trusts”). Important information about the Trusts, including the investment objectives and strategies, purchase options, applicable management fees, and expenses, is contained in the prospectus. Please read the document carefully before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication does not constitute an offer to sell or solicitation to purchase securities of the Trusts. You will usually pay brokerage fees to your dealer if you purchase or sell units of the Trusts on the Toronto Stock Exchange (“TSX”) or the New York Stock Exchange (“NYSE”). If the units are purchased or sold on the TSX or the NYSE, investors may pay more than the current net asset value when buying units or shares of the Trusts and may receive less than the current net asset value when selling them.
The risks associated with investing in a Trust depend on the securities and assets in which the Trust invests, based upon the Trust’s particular objectives. There is no assurance that any Trust will achieve its investment objective, and its net asset value, yield and investment return will fluctuate from time to time with market conditions. There is no guarantee that the full amount of your original investment in a Trust will be returned to you. The Trusts are not insured by the Canada Deposit Insurance Corporation or any other government deposit insurer. Please read a Trust’s prospectus before investing.
The information contained herein does not constitute an offer or solicitation to anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada or the United States should contact their financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction.
The information provided is general in nature and is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering or tax, legal, accounting or professional advice. Readers should consult with their own accountants and/or lawyers for advice on their specific circumstances before taking any action.
© 2022 Sprott Inc. All rights reserved.
You are now leaving sprottus.com and entering a linked website.Continue
You are now leaving Sprott.com and entering a linked website. Sprott has partnered with ALPS in offering Sprott ETFs. For fact sheets, marketing materials, prospectuses, performance, expense information and other details about the ETFs, you will be directed to the ALPS/Sprott website at SprottETFs.com.Continue to Sprott Exchange Traded Funds
You are now leaving Sprott.com and entering a linked website. Sprott Asset Management is a sub-advisor for several mutual funds on behalf of Ninepoint Partners. For details on these funds, you will be directed to the Ninepoint Partners website at ninepoint.com.Continue to Ninepoint Partners