WMA Cara Report for week ending September 22, 2017
  • September 25, 2017 05:20 pm
  • by Bill Cara

Crunch Time For Gold Investors.

 

The central banks of the United States, Canada, UK and Europe are heading inexorably toward economic tightening and higher rates, which helps clean up their over-extended balance sheets. Although there are many who disagree, policy-based action like this will probably have a negative impact on precious metal prices.

In the absence of extreme inflation, Gold and Silver bullion typically under-performs the broad equity market indexes under market conditions being organized now by central banks. As long-term investors, we avoid fighting the Fed, especially at times the major central banks are as aligned in policy matters as they say they will be.

During the past ten trading days since our September 8 Weekly Report, the GDX ETF is down -7.01% from US$25.24 to US$23.47. As noted, we were extremely cautious two weeks ago while heading into a major meeting and policy statement from the Fed, and these results proved us right.

That was not a time to be Bullish. Among the highly leveraged mining-based funds favored by speculators, the Direxion Senior Goldminers 3x ETF (NUGT) and Junior Goldminers 3x ETF (JNUG) and the ProShares Ultra Silver 2x ETF (AGQ) also lost -20.24%, -21.10% and -11.42%, respectively in the past two weeks. As well, the share prices of the four Goldminers that we look at today, Newmont (NEM), Franco-Nevada (FNV), IAMgold (IAG) and Fortuna Silver (FSM), dropped -3.42%, -5.96%, -10.24%, and -7.69% respectively since September 8.

These are major losses, which speaks to the extreme volatility of the industry.

As long-cycle investors, we make decisions based on how the macroeconomic drivers are likely to impact sector and industry growth potential. After extensive corporate research to determine what we believe are the fundamentally soundest companies in the space, we monitor the stock prices to deploy investment funds at close to their cycle lows when the companies are most under-valued in the market.

There are also new services from companies like Intrinio we have begun to consider that combine their computing power and big-data sets with our fundamentally-based bottom-up stock-picking skills to test a variety of value hypotheses.

For the Intrinio valuation app, start here: app.intrinio.com and type in NEM and hit “Value It”.

You’ll see all of Newmont’s historical financial statements as well as the Weighted Average Cost of Capital (WACC) and Discounted Cash Flow (DCF) valuation methodologies. While the Intrinio model and data isn’t pretty for Newmont, the basic valuation app uses Wall Street consensus estimates, which may differ from your own. Importantly, the app also enables users to adjust assumptions.

The Goldmining industry is not one of growth. Capex has been falling and notable discoveries in rapid decline. Environmentalist-leaning governments have been for the most part restrictive. Revenue growth, if noteworthy, would be based mostly on higher precious metal prices and mergers and acquisitions activity, which only in some cases is reflected in higher earnings. But corporate earnings across the board are generally not high and debt levels in many cases are too high for us to be wanting to invest in big positions in these companies.

That said, the industry story as we see it is in the ability of some of these companies to significantly reduce costs and increase operating efficiencies. These are the companies we would be interested in, especially if they show industry-leading Compound Annual Growth Rates (CAGR) in production.

Our assessment of these four companies (Newmont, Franco-Nevada, IAMGold and Fortuna Silver) is that their shares are trading amid a long-cycle Bear phase, likely not to present extreme valuation opportunities for about a year. The mid-cycle peak came on September 8 this month, which happens to be the date we published our cautionary Weekly Report on Gold and the Goldminers (“Are Goldminers Over-Hyped?”)

This report is a follow up to that one.

The major driver to the price of Goldminer shares is obviously the price of Gold and to have an opinion on that requires one to understand Fed policy and action in the context of an inflationary or deflationary environment.

This is not to say that the Goldbugs are wrong in expecting much higher Gold prices, possibly based on their assessment of the U.S. Dollar trend; however, we disagree. We believe that Gold is in a long-term Bear trend, possibly going to reach a long-cycle bottom at about 1070, down from 1300 today, perhaps a year from now. That price, should it occur, will be led by a massive outflow of funds in the major ETF’s GLD and IAU as well as GDX and GDXJ, and the outcome would not be kind to the individual share prices of Goldminers whether they be solid companies or not.

As far as the US Dollar (DXY), we believe the mid-cycle decline from January through into September this month is starting a recovery, creating a base from a possible bottom at 91.02. This level corresponds to a 50% retracement of the rally off 2014 lows to the early 2017 high. The recent break below 2016 lows may prove to be another fake-out, as we’ve become accustomed to in today’s capital markets. That said, we are not yet bullish on the USD because there are two important meetings of the Fed coming up, one on Oct 31-Nov 1, which is not a rate hike meeting and the one on Dec 12-13, at which time we anticipate a rate hike and verbiage to the effect that the Fed is taking additional specific Quantitative Tightening (QT) action to reduce the size of their balance sheet, and are doing it despite the omission of warning signs of inflation. For the USD to rally on Fed news at this stage, rate tightening / balance sheet reduction must go beyond what the consensus is pricing in.

Between Nov 1 and 13, we believe the market will price into the USD and Gold, the anticipated Fed action, which will marginally strengthen the USD and weaken Gold.

The USD (DXY) today at ~92.19 would need to move up through 92.90-93 before we would call that a sign of the turn, and a price of 95.59 would then give us 98% confidence the USD Bull has returned.

As for Gold, which is presently at 1299-1300, any rally we believe would soon be stopped at 1310. We anticipate lower highs and lower lows as this pattern is one of the Gold Bear. The first drop from 1350-1362 mid-cycle peak found support at the ~1296-1298 level. After the next roll-over, probably starting in the coming week, we anticipate further selling down to the 1261-1279 level into the Fed’s late-Oct meeting. After that, November might be a very difficult one for the Gold Bulls as investors begin to understand that other central banks are moving into alignment with the Fed, and that money is going to tighten around the world.

As noted previously, Gold can still rally when the Fed is raising rates; however, in our experience that only happens in periods of extreme inflation when speculation is running rampant. If rates are raised at a time that inflation is under control, common sense tells us that the Fed is happy about economic growth and that the extremes of the past 10 years of easing must be reversed. We believe they will punch hard when able to do so, only letting up when capital market prices are crashing. To our thinking, despite performance in the interim that falls short of most investor expectations, the crash will not occur until after the Fed raises rates into the 3.50% range, sometime in 2020-2021, By then all those 10-year Treasury bonds the Fed had to buy following the 2008 market crash will have cleared the system.

Anybody who thinks the Fed is our friend is flat wrong. Despite what the Fed says it does for U.S. jobs and the economy and so forth, it is simply a money controlling machine, put in place by Congress just over 100 years ago to create money as required during periods of population growth and economic expansion. The Fed’s real job is to protect their commercial bank shareholders, the organization we refer to as Humongous Bank & Broker (HB&B). Only one of the regional Fed banks is important. The Fed of New York under Bill Dudley is the executioner, the one in charge of Federal Open Market Operations (FOMC) using computer algos and many hundreds of desk traders. The Fed, in our view, would be less an enemy to private investors if the US Government were in capable hands, making more prudent budget decisions.

While most of us understand the reasons for anti-Fed, anti-government and pro-Gold sentiment, since we are all involved, as investors we must control these emotions and stick to practical investments, ones that we understand from the bottom-up and the top-down.

There is a reason to hold positions in Gold and Goldminers. Sometimes the evidence is strong enough for us to be significantly long and sometimes to be minimally long. Depending on your time horizon, i.e., whether you are a long-cycle investor/swing trader or a very short-term trader/speculator, your ideas and market assessment may vary from ours.

In any case, we invest in companies we know. Of the four Gold/Silver Miners we look at today; there are three solid companies, but only one we have interest to invest in in the foreseeable future. For various reasons, whether it be our assessment of extremely high valuations, slow revenue growth, low earnings, high debt, deficient management, or whatever, we have not been a keen investor in Newmont Mining, Franco- Nevada, or IAMgold. Yes, we have held positions in Franco-Nevada and IAMGold in the past 18 months, but not often and not for long. On the other hand, we believe that Fortuna Silver Mines is one of the good ones. We like the company a lot. Unfortunately, perhaps, we do not like the stock so much today.

 

Fortuna Silver Mines (NYSE:FSM and TSX:FVI) ) [Market cap: US$735.6 M]

Fortuna Silver Mines is more than Silver. In Mexico and Peru, the company produces gold, lead and zinc as well as silver. We love the company but are presently underwhelmed with the stock.

Let us give you the bad before the good.

The stock has been a sideways trader in the US$4.25 to 5.15 range following its collapse from almost US$10 the week of Aug 1, 2016 to its low of US$4.11 the week of May 8, 2017. Interestingly, when at that US$9.75 peak price was reached in 2016, Gold was at the 1335-1350 level. So why is FSM now trading at ~US$4.68, right in the middle of its six-month trading range with Gold at 1350 two weeks ago?

From US$2.00 in the week of Jan 18, 2016 through to its US$9.75 high seven months later, the stock zoomed +388 per cent. We believe that during this period too many day traders and speculative hedge funds got too long the silver space, and subsequently got burned. Hecla (HL) and Coeur (CDE) met similar fates to Fortuna Silver (FSM).

Short-term traders today seem to be trading FSM more sensibly, mostly inside the US$4.40-4.98 channel, but this trading is not being done based on rigorous investment analysis, which is our concern. Most precious metal prices are being established by computer algorithms and by ETF speculators. And, as you know, these ETF’s hold the shares of the good, the bad and the ugly.

Chart-wise today, the FSM stock seems to us to be a bit oversold at present and seeking to recover, but after three or more failed attempts at a channel break-out, we do not understand the ongoing enthusiasm that the next shot at it will be a success.

While there is some support at US$4.63, long-term oriented investors are likely not interested. They first need to see what the Fed’s next move is likely to be and toward that end they anticipate some pain.

Would we as investors buy the stock here? Absolutely not – at least not without a breakout above US$5.20. Obviously, we are not day traders, but at best, we can see a move to US$4.83 from today’s US$4.68, possibly then under downward pressure falling by the end of the month back to the US$4.40-$4.50 channel bottom.

Gold has weakened but not broken down yet; whereas many of the Gold/Silver Miner stocks have fallen more than 50% from their 2016 highs despite the metal prices being still quite high. Although not always, stock prices typically precede moves in the commodity prices; so, we remain wary of the price of Gold.

As to the negatives, despite being down -39.6% YTD, the best we can say about FSM is that the stock has not totally broken down, and a quick review of the corporate fundamentals gives us some reasons. The same reasons are why we await our next purchase of the stock.

The corporate presentation can be found here. It paints a very impressive picture.

Fortuna’s excellent management team led by company co-founder and CEO Jorge Ganoza has done a brilliant job of reducing the AISC (All-In Sustainable Cost) of its primary product Silver to US$8.22/oz for the last quarter. Silver today is trading at about US$17.04, up over +21% from US$14 in Jan 2016. With the higher price of Silver, Fortuna’s net earnings have jumped from US$1.2 mil to US$21.9 mil. Revenue in 1H2017 soared +48%. Sales of metal are not hedged. Cash to start 2H2017 is US$188.0 mil (working cap is $186.8 mil) while long-term debt (due mid 2019) is just $39.8 mil, with almost nil short-term debt. Consolidated production for 2017 will be about 15 Million oz of Silver, double that of 2013. From 2007 through 2017E, the Compound Annual Growth Rate of Silver production is +25% and for Gold is +32%. These are strong numbers, unrivalled by the other companies we look at today.

Fortuna today is likely to be much larger soon. In a few weeks, the company plans to announce a production decision on its huge Argentine gold porphyry property (that has some minor copper content). A US$239 mil investment in an open pit heap leach gold mine would be built and commissioned by 2Q2019, a time when we believe that the price of gold will be on the rise, possibly moving from our projected long-cycle low of about 1070 to at least 1350-1400 at that point.

If this plan comes together under the guidance of co-founder and chairman Simon Ridgway, an industry leader I respect, and his partner and CEO Jorge Ganoza, then FSM may well triple in 24 to 36 months.

From all appearances, Fortuna Silver Mines is a sound investment. As noted, the stock requires a better entry point than what is the case today. There is no need to rush.

 

Newmont Mining Corporation (NYSE:NEM) [Market cap: US$20.07 B]

Newmont is one of the world’s largest Gold producers with operations and advanced development projects in five countries on four continents.

As noted in the preliminary remarks there is not much we can say to the good either for the company or the stock price. But Newmont has been around since the Great Depression and it will likely survive and grow for many years into the future.

What we don’t like is:

  • PE of 93 after a period of relatively high precious metal prices when earnings should have been high
  • A loss, not income, is expected for 2018 even if the Gold price remains at 1300
  • Revenues have been declining
  • Price to Book is excessive
  • Price to Free Cash Flow is extremely high
  • Substantial debt at a time the Fed is tightening

Yes, Newmont does have positives for those who are interested in precious metal investment – just not nearly enough to persuade us to become an investor.

 

The positives are:

  • Take-over candidate, possibly by Barrick Gold (ABX) as discussed for several years
  • Diversified global mine operations
  • Dividends paid
  • Lots of cash
  • Institutional ownership in the 84% range
  • Market liquidity
  • Relatively low volatility

From a data perspective; however, the negatives far out-weigh the positives.

We do not expect to be an investor going forward as we have not been in the past.

 

Franco-Nevada Corporation (NYSE, TSX: FNV) [Market cap: US$14.64 B]

Franco-Nevada is the world’s leading gold royalty and streaming company with the largest and most diversified portfolio of assets. Its business model provides investors with gold price and exploration optionality with less exposure to operating risks.

We will take a different tack with this one. We will even say, what’s not to love?

  • Outstanding management in chairman Pierre Lassonde and CEO David Harquail.
  • Outstanding assets that are a cash cow.
  • No carrying, exploration or development costs.
  • No debt.
  • Dividends and a dividend reinvestment plan.

All good. Read the corporate presentations: We think you’ll be impressed.

The stumbling block for us is the market cap. We think the stock is considerably over-valued with a PE at an astronomical 100 and not expected to fall dramatically for a few years unless the share price falls a lot or the price of Gold zooms.

Given our outlook for the price of Gold, we anticipate a significant sell-off of FNV shares in the next year during a period of max pain due to global Quantitative Tightening (QT) that the precious metals industry might be facing. In other words, we have no intention of fighting the Fed.

FNV’s 52-week range of US53.31-85.03 is in our view likely to be expanded considerably on the downside in the next year. If that should happen, we would be re-examining the company and the stock price with our usual rigorous investment analysis.

Note that the stock hit its all-time high the day we published our Weekly Report on Gold and Goldminers on Sept 8. That drop of -7.0% in two weeks to today’s close at US$79.32 is a pittance compared to what might be the case for 1H2018.

In any case, we have held the stock in the past based on Franco-Nevada being a top-quality company, and we will hold it again following a re-entry price that we find desirable.

 

IAMGold Corporation (NYSE, TSX: IAG) [Market cap: US$2.96 B]

IAG hit a three-and-a-half-year high price of US$7.25 on Sept 8, the date we published our Weekly Report on Gold and Goldminers (“Are Goldminers Over-Hyped?”. Today, IAG closed the week at US$6.30, down – 13.1%, which is a substantial decline in just two weeks. But, as behooves a stock we have held, there are some very good reasons to like the company. Besides, IAG is up +62.3% YTD.

IAG hit a high at about US$22 in March 2011. It had been over-hyped and over-priced at the time, but the biggest problem it faced was that the price of Gold was then peaking from over US$1400 at that point to a mania-driven US$1900 four or five months later. Most of the precious metals stocks started collapsing in price during that period as major funds were unloading ETF’s; however, despite the price of Gold topping 1350 two weeks ago, IAG shares have not come close to its former high.

The problem, as we see it, is that Goldminers are not big profit generators. Mining is a tough business. Results seldom match expectations.

As a company, we know IAMGold explores for and develops mines for gold, silver, niobium, copper, zinc and diamond deposits in West Africa, South America and Ontario and Québec Canada. With good management, the company does a fine job of that as reflected in their corporate presentation.

Gold production is the equivalent of 800,000 oz per year. AISC (All-In Sustainable Costs) are US$1056/oz Gold, which is close to our projected cycle low for Gold in the coming year, which ought to be a driver of much lower share prices should that occur. But, if it did happen or be somewhat close, we would be again become an IAG investor at the entry prices that would be available.

 

Conclusion

The over 5-year bear market in gold has almost run its course. However the macro backdrop – notably the absence of inflation – precludes us from jumping into the gold miners with both feet. A better entry point lies ahead. Patient investors in select, fundamentally strong goldminers will be able to easily double their investment money in the coming years.


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