John Hathaway: Gold Stocks "Ridiculously Cheap," What Will Make Them Move?

Sprott's John Hathaway shares his thoughts on the disconnect between the gold price and gold stocks, explaining why it's happening, whether he's seen it before and what could make gold stocks finally start moving.

Video Transcript

Charlotte McLeod: I'm Charlotte McLeod with Here with me is John Hathaway, Managing Partner at Sprott and Senior Portfolio Manager at Sprott Asset Management USA. Thank you so much for joining me. It's great to have you here.

John Hathaway: A pleasure. Thanks, Charlotte.

Charlotte McLeod: I’m really excited to be speaking with you. For some context, I had a friend send me your report on the investment case for gold. When I read it, I thought it would be great to go through that for our audience because I know we have a lot of people who see the gold price historically high and wonder what's going on with the gold stocks.

We're going to get into that today. But we could start by setting the stage historically and looking back and seeing if we've ever seen a disconnect like this.

John Hathaway: Not to my knowledge, and I guess I've been doing this for 25 years. This is the greatest disconnect I've ever seen.

Charlotte McLeod: All the more reason to talk about that. And let's get into the main reasons for this disconnect. Everybody knows that it's there. They can see it happening. What are the reasons that we've seen this build-up? As I understand it, compared to the previous bull market, gold miners have been cleaning up their balance sheets. They've improved profitability. What's the reason?

John Hathaway: One of the biggest culprits or explanations is passive investing. We've seen a lot about this lately. I believe there was a very good piece in the Financial Times, saying that passive investing dominates the markets today and doesn't favor smaller sectors. The market cap in the gold mining sector is about the same as that of Mastercard or Home Depot. 

Another factor that's an offshoot of the same point is that in 2004, the [first] gold ETF [GLD] was launched by the World Gold Council, and since then, there have been quite a few more.

Before that, it was difficult for equity investors to position the macro thesis behind gold, which we can probably talk about at some point, without owning gold stocks. But gradually, over the last 20 years, it's been increasingly easy to buy GLD or the equivalent, of which there are many. It took a lot of the thinking out of the equation.

Therefore, it's fair to say that the gold-backed ETFs have cannibalized demand for gold mining equities. Those are two of the biggest reasons I can think of.

Charlotte McLeod: That's an interesting point about the ETFs and the rise of passive investing. We have so many options that people have to date for investing. They can look at crypto; they can look at other trendy investments. Do you think gold miners have a responsibility or should they look at ways to make themselves more interesting to investors? What are your thoughts there?

John Hathaway: That bundles up a lot of questions. You mentioned crypto, which has certainly taken some of the air out of the room for gold mining stocks. That's especially true for the generation, let's call a dividing line somewhere in the 40s. People under 40 are going to think seriously about crypto. That's another factor that you could mention.

What could the gold miners do to make themselves more attractive? Frankly, they're already so attractive. I don't think they have to do a whole lot. This is a soapbox I've been on lately: they should be buying back stock because they are so ridiculously cheap. There's a better return on capital from share buybacks than investing in a big new mine. That's saying that the industry should be, or at least the market is saying, and management should think seriously about semi-liquidation.

Why build a billion-dollar new gold mine? It takes up a lot of capital and takes on risk for shareholders, whereas buying back undervalued equity provides a sure return to investors. It's a way of taking advantage of the fact that nobody cares. I think there's a lot more return from doing that than there is for necessarily building a big new mining project.

That would be a controversial view to many in mining management, but I believe it should be strongly considered instead of taking many capital risks. These companies are penalized for growing. They can only sustain themselves by investing heavily in new mining assets, and the returns on a new mine don't become apparent for probably five years or 10 years.

That is my thought. But the best thing the mining industry could do would be to take advantage of the heavy discounts they're being valued at and enhance shareholder returns.

Charlotte McLeod: I was going to ask if you see any companies that might be looking to do this, but then you mentioned it's controversial. I guess perhaps not at this point.

John Hathaway: Some are doing it, but it's not enthusiastic. They're doing it because people like me and other portfolio managers and analysts in the gold mining space tell them it's a good idea. They go along with it, but not wholeheartedly. And that's fine. As time passes, these stocks should remain as ridiculously inexpensive as they are.

Looking at other industries that are out of favor, you could talk about base metals mining, steel, oil and gas. They're all engaged in share buybacks and try to create shareholder value that way. I think the mining industry is behind the curve in that particular aspect.

Charlotte McLeod: It's really interesting to go over that. I want to return to that disconnect between gold prices and stocks. When I ask people whom I've interviewed in the past, what makes the gold stocks catch up? I am often told the gold price is historically high, but we need to see it a little bit higher, and maybe that's when the stocks start moving. But you had written in your note that perhaps they could catch up just if we see a reversion to mean. I thought that was quite an interesting idea, and I wondered if you could talk about that.

John Hathaway: Sure. You brought up one thing: a higher gold price, but we have a higher gold price. I can't remember how many days we've closed over the magic $2,000 number, but it's probably been a couple of months' worth, and it hasn't done a darn thing to generate interest in mining stocks. Is it a little higher? I think it is higher. Is it $2,100? Is it $2,500? Somewhere along the way, higher gold prices will generate interest in gold mining stocks because they're leveraged to the gold price, and there is no need to go into it in any depth.

I think that that's the conundrum. We have what we've always wished for as investors in gold mining. One of my partners, way back when we started the gold fund 25 years ago, said, "The only reason anybody should own a gold stock is because they expect the gold price to go up." He was right until now when that hasn't been right. How much higher does the gold price need to go? I don't know the answer.

But at some point, higher gold prices will lead to incredible cash flow and profitability so that even this tiny little space will catch somebody's eye. I noted recently that Stanley Druckenmiller, the legendary investor, has started to sell his Magnificent Seven stocks, and he's starting to buy big-cap names like Newmont and Barrick. I'd like to think he's right. He's usually been right. I guess that there are still some value investors out there.

There are still active investors, even though passive investing dominates the markets. But because the space is so small and because, collectively, the market cap is tiny relative to the capital flows in today's markets, it doesn't take a whole lot of change to generate potentially outsized returns. I'm sitting here expecting that to happen. I've been waiting longer than I thought, but I still think I'm on the right track.

Charlotte McLeod: I want to spend a little bit of time looking at the gold price this coming year. I think the consensus is definitely that we're going higher. We don't necessarily know when or how much in what period, but the trajectory looks higher. I hope we can talk just a bit about gold in 2024 and the drivers you see. Of course, everyone is watching the Fed. There's an election year; we have geopolitical things. We have central bank buying going on. Just a quick look at your thoughts on gold drivers this year.

John Hathaway: You bring up the Fed, and this narrative of higher for longer interest rates has been a real headwind for the gold price, but it hasn't hurt the gold price. In fact, we've had higher interest rates for a long time, and despite that, the price of gold is trading at record levels. Interestingly, it has happened without participation by investors in Western capital markets; I'd say the U.S. and Europe are the main ones.

Why has the gold price gone up? It's gone up because central bank buying is taking place at record levels. I guess the question is, why are central banks buying when nobody else is? They're doing it because they diversify away from the U.S. dollar and settle trade balances in gold, not in US treasuries. I read recently that 20% of oil is now traded away from the U.S. dollar.

We have gold trading at record prices, and the level of interest in Western capital markets is absolutely negative. It's zero. Gold-backed ETFs have lost assets for the last two years, yet the gold price has increased. Just imagine what could happen if people in our part of the world decided they should probably have a bigger exposure to gold.

Again, it is hard to say when that will happen, but remember that when gold peaked 10 years ago, Western investors were heavy buyers of ETFs, which helped propel gold to the 10-year peak or the previous peak 10 years ago. Should that happen again? We could guess all day as to why it wouldn't happen, but I'd be happy to supply some thoughts.

It wouldn't be unbelievable to think of gold trading in a sustained range north of $2,500, $2,500 to $3,000, if people in our part of the world decided they wanted to increase their exposure to the metal. Should that happen, I shouldn’t need to guess too hard to see what would happen to gold mining stocks.

Charlotte McLeod: Yes, that is what I wanted to ask you about gold mining stocks. Eventually, they're going to move. I think that's probably a given at this point. How do you think that will play out? Usually, we hear that when stocks start to move, the larger ones move first and then on down to the bottom of the chain. But now we have this pent-up; everything is waiting to move. I wondered if you thought it might play out differently.

John Hathaway: Sure. I think that's a good point. The big cap names, Barrick and Newmont, in particular, have been dogs, and they've been dogs for a couple of reasons. They dominate GDX, the VanEck Gold Miners ETF. That creates a negative impression for the entire space. But if you look down deep into the components of GDX and then look at companies that are even in the ETF, smaller companies, mid-cap and smaller, they're holding up pretty well. They're doing better than the headline names.

I think that is a sign of how inexpensive they are. Maybe they're better managed. Maybe there's more ownership by management and alignment with shareholders than you see with the big names, the two of which I've mentioned; there are others as well.

I think that the ray of sunlight that I would point to is the relative performance, the good relative performance of mid to smaller-cap gold mining stocks. Particularly those that are located in countries that have a rule of law. I think that in today's world, that eliminates a lot of the service of the globe. But companies in the U.S., Canada, and Australia are important in gold mining, and that's where we're investing. We're not investing as much as we used to in Latin America or Africa.

Charlotte McLeod: That's a bit on jurisdiction regarding what you're looking at. Can you add any other criteria you are focusing on regarding gold stocks?

John Hathaway: We pay a lot of attention to something I mentioned earlier: management ownership of shares and alignment with shareholders. That doesn't exist in the large-cap names as much as it does in the mid to smaller-cap space. That's a really important aspect of what we look at. You mentioned jurisdiction, and that's a critical component. There are some great mines in Africa, South America and Asia. Still, you have to be super picky about where you're investing in those areas because there are so many bad headlines out of several countries.

But the rule of law is a vanishing concept in many parts of the world. Sad to say, but true. Therefore, we think investors will appreciate the difference between one jurisdiction and another when they return to this space. I think the kinds of things that we own will trade at significant premiums to the rest of the space. Right now, nobody cares, so everything is muddled together. But when generalist investors start picking over the inexpensive and attractive names, they will focus on jurisdiction as one of the major criteria.

Charlotte McLeod: I also want to touch on the M&A angle because you mentioned earlier that the large miners ' reserves are depleted. There's been underinvestment in exploration. Your report on the investment case for gold stocks made an interesting point about Marathon Gold, which Calibre Mining ultimately bought. But I think you mentioned there were almost 20 interested entities. It feels, again, like this is an environment where we might see M&A. I wondered if you could give some flavor on what we might see, what level we might see it at and how much.

John Hathaway: That's a very important thing to talk about. We've seen two kinds of mergers. One is mergers of equals, where there's really no value creation, even though the participants would say otherwise. They're done at no premium, and there aren't any synergies. There are always some, but they're not meaningful in terms of value creation.

On the other hand, the one you just mentioned, Calibre buying Marathon, is an example of a smart merger. There are others that we could talk about of the same kind, but there is a premium involved, and there is a case to be made for a rerate on a bunch of scores. In that example, a company based in Nicaragua generates a lot of cash flow. A team from Australia manages it.

They bought Marathon, which was poorly managed in capital raising but was located in Canada, New Finland. It is a terrific asset that is in the final stages of construction. It will be produced within, I think, another year. You have a company rated at three or four times cash flow. I'm making this up to make the example because I can't recall the exact number off the top of my head.

That should be trading at least 50% or twice that valuation once the jurisdictional advantage of having a significant component of your cash flow coming out of Canada. Then I think that that tends to diffuse the fact that although they have very good mining operations in Nicaragua, I think you blend the two. Investors can be more reassured of the continuity of the business. That's a long-winded answer, but there are examples of that and other examples, and they don't make headlines because the companies involved are small.

That's the thing I'm thinking of. They are value-creating, and I think we will see more of that. One last point: instead of starting from scratch to build a new mine, which involves huge capital risk, there's a huge discount for buying existing operations in the market. We figure it's as much as 30% to 50% versus starting from scratch and building a new mine. Again, the astute managers in the space, and there are many of them, are seeing this opportunity in taking advantage of it. Of course, we applaud that.

Charlotte McLeod: Thank you for going through that. I think we'll wrap it up here. This has been a really good run-through of gold and gold stocks, and I encourage everyone to call in and read the report you put together. I'll have it linked in the video description. But just before I let you go, I'll put it back to you and ask if there are any final topics that you would leave investors with.

John Hathaway: We didn't talk about what could happen to make people think about this space. One thing, of course, is a higher gold price. But what would that be? I think it would be a reversion to mean not just in the gold mining space, but a reversion to mean in the external markets. We all know that seven names have driven the stock market. Huge concentration.

Again, if you're a contrarian, it's an easy trade to make. Sell the Mag Seven like Druckenmiller did, and look for something completely discounted. It's not just the gold mining space. You could talk about oil and gas. You could talk about some cyclical names. I think that's one thing. The other is I think there is some potential in the world of banking. We've been reading about how commercial real estate is in trouble, not just in the US but also in Europe. There are potential issues in the banking system that nobody is paying attention to. I think that's another thing.

In a way, you could have a combination of the dot-com crash in 2000 and 2001 and the global financial crisis in 2007 and 2008, combining to turn consensus investment banking upside down. That's the thing that would lead investors to look for diversification, which gold represents.

Again, we've noted that nobody in our corner of the world is there. A small trickle of interest, driven by, I've just suggested, two possibilities for things to change. I believe that's the scenario I would point to for the gold mining industry and gold itself to return to favor.

Charlotte McLeod: Thank you for adding that on to tie everything together. I think that leaves us in a good position to wrap it up. Thank you so much for coming on to talk.

John Hathaway: Thanks, Charlotte. I appreciate it.

Charlotte McLeod: Of course. Once again, I'm Charlotte McLeod with, and this is John Hathaway.

Thank you for watching. If you like this video, make sure you've subscribed to our channel. We'd also love to hear your thoughts, so comment below. We'll see you next time.

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This material must be preceded or accompanied by a prospectus. Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectus which should be considered carefully before investing. Click here to obtain the prospectus or call 888.622.1813.

Past performance is not a guarantee of future results.  All data is in U.S. dollars unless otherwise noted. Sprott Gold Equity Fund invests in gold and other precious metals, which involves additional and special risks, such as the possibility for substantial price fluctuations over a short period of time; the market for gold/precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. The Fund may also invest in foreign securities, which are subject to special risks including: differences in accounting methods; the value of foreign currencies may decline relative to the U.S. dollar; a foreign government may expropriate the Fund’s assets; and political, social or economic instability in a foreign country in which the Fund invests may cause the value of the Fund’s investments to decline. The Fund is non-diversified, meaning it may concentrate its assets in fewer individual holdings than a diversified fund. Therefore, the Fund is more exposed to individual stock volatility than a diversified fund.


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John Hathaway
John Hathaway, CFA
Managing Partner, Sprott Inc.; Senior Portfolio Manager, Sprott Asset Management USA
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