April 17, 2013

Sprott: Gold Juniors: Crisis or Opportunity?

Guest post by Michael Kosowan of Sprott

“The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity.  In a crisis, be aware of the danger--but recognize the opportunity.” 

John F. Kennedy
They tell me that there is a “crisis” brewing in the gold stock industry, but before throwing up our hands and crying “uncle”, let’s ponder Kennedy’s quote. Dangerandopportunityside by side, but how to capitalize on it?

We need to understand the crucial elements at play. A simple visual will go a long way in helping to explain the current “crisis” happening in the gold stock industry.

Imagine a boat bobbing happily on the water.  The water level undulates in tune with the natural ups and downs of  a large body of water; there are rogue waves from time to time which toss the boat about, but for the most part, the water’s movement in no way threatens to capsize our boat.  Now imagine our boat taking on water at a tremendous rate, submerging and sinking well below the surface, but NOT on account of a storm or holes in the boat, or any other obvious reason for that matter! 

In the junior gold company equities market, our boat represents the companies’ share prices. Like a ship in water, these companies are rocked by fluctuations in the price of gold. The price of gold goes up and down, but not nearly to the extent that would capsize and submerge gold share prices to the degree we witness in the current marketplace.  So, how does this make sense???  The short answer is, it doesn’t.

Consider the GDXJ Index.  This index is an equity index of junior gold mining companies that are already producing gold; there are, in fact, over 70 junior precious metals producers included in this sampling.   Over the past two years, the GDXJ Index has fallen by a startling 70%  while the price of gold, although volatile and moving both up and down, has not sunken to new lows, but in fact has continued totrend upwards since the crash of 2008.  Wouldn’t it make sense that our boat continue to at least float?  Oh!  But inflation and the costs of production have risen since 2008, and that is why we see share prices fall, I hear the naysayers cry.  This is perhaps true to some degree. However, these marginal increases could not possibly be totally responsible for the complete havoc and carnage we have witnessed to date on the price of gold stocks.  Ireiterate, the marginal rises in inflation and cost of production over the past 2 years, is in no way equivalent or justifiable to a 70% dip in GDXJ--it just does not make economic sense.

Let us also look at the flip side; what happens when we take a look at a NON-production marker of health in the gold industry?  “Enterprise value per ounce,” for example, is a ratio that represents the raw value the market is assigning to a company’s mineral inventory.  In 2011, the market was willing to pay roughly $72 per ounce, but in the current market, that figure has been reduced to $32 per ounce, approximately 56% lower!  Remember, we are talking about the mineral inventory here, which has not changed for a NON-producing gold company.  So let’s step back. The price of gold has risen since 2008 and even in this week’s landslide, has not dipped below 2010 prices, but the value the market has placed on the unchanged mineral inventory has been cut in half?  WHAT???

Let’s review.  The index of producing juniors and raw value of gold companies’ mineral inventories, two separate but important industry markers for evaluating the health of the gold industry, havebothdropped byover 50%since 2011. However, earnings are arguably the same!  Earnings are generally considered the single most important element to the stock price—and gold companies are selling their stocks at the lowest P/E ratios ever.  Intact earnings and record low P/E ratios should make for amazing investments!  Is THIS the “crisis” my friends are referring to??  What a wonderful world it would be if every crisis were this lucrative!

The reality however, is that the boat has indeed been pulled under the surface by a set of mysterious forces.  I suggest we look deeper into those murky waters.  How are market conditions influencing this apparent “crisis”??

Market Risk & Other Influences
Gold stocks, like all other equities, are subject to the vagaries of the marketplace.  In particular, gold stocks are prone to risks associated with political stability, taxes, and access to capital. These factors easily tip the balance in this volatile sector and all of these risks are seemingly poised to enter DEFCON 3.  In addition to world-wide financial and geopolitical tensions, four other factors havefurther depressedshare prices in the sector, including:

I)    Institutional selling and redemptions
II)  Market uncertainty and negative sentiment towards commodities
III) Risk aversion from small cap, illiquid and volatile equities
IV) Performance in equity and currency alternatives (S&P 500 is up 20% over the last two years, US$ remains stable)

From my perspective, these factors, in whole or in part, have significantly added to share price declines in an otherwise flat earnings field.  The recent market ride has not been for the faint of heart to be sure, but neither is it the time to capitulate and despair.  Let's be objective about the dangers in front of us before throwing in the towel and jumping overboard.  Yes, the rising water levels are unnerving,but as any good captain knows, staying with the boat and hangingon will preventyou fromsinking to the bottom!  Stay with the boat -- it floats -- even when filled with water!!!

gold ten year history

Come on people!  We have all seen this movie before!!! The title says it all.

Recall the Scene of March 2008, when the price of gold stood at $1000 per oz.  By November of that same year, the price had fallen to $720/oz, a stupefying drop of 28%. Now jump forward to Scene 2, set in current time; in and around September 2011 the price of gold enjoyed a perch of $1900 per oz, what a wonderful time to own gold stock!  Wait for it………...Shock and Horrors!  The Killer returns!  April 16, 2013, the price of gold drops $530 to $1370/oz, arepeated fallof 28%, the villain prevails!  Or does it??
Stand back and look at the wider picture.  There is a subtler undercurrent running through this film noir.  Move back from the chart a distance of 15 feet, and squint your eyes.  Do you SEE the continuous and steady UPTREND in the price of Gold since 2003???

This recurrent and rogue swing in the price of gold merely illustrates a cyclical decline in a secular gold bull market; there is NO need to panic.  As Rick Rule, a good friend and associate of mine, would remind us, “In this type of market you can be a contrarian OR a victim.  Which do YOU want to be?”

Let’s go back to our submerged boat.  To a drowning victim, it will appear as the cause of their demise, but to a contrarian, it will look like an opportunity to get a bigger boat.

 cycle of investor emotions
Source: Optionalpha.com

Never let a good crisis go to waste!
Astute and courageous investors should take heed from what government officials around the globe have been telling us for centuries; never let a great crisis go to waste.  Look for the silver lining, therealwaysis one.   How can I make this “crisis” work FOR me and not against me???

Over the past two years, junior mining companies have endured a relentless and unforgiving storm of market volatility and disdain.  Capitulation is apparent, stock prices are low, with valuations at levels that have not been seen since the late 1999 gold market.  Gold mining equity markets appear to be having a virtual fire sale!

In my opinion, the low price and high valuation of gold stocks will win in the long term.  In the short term, challenges and risks associated with the marketplace are still very much a threat and could flare up into gale force winds at a moment’s notice, as this week’s plunge in the price of gold demonstrated, but in the ensuing melee don’t fail torecognizethe opportunity!

I take heart in the knowledge that history has a way of repeating itself.  I need only look at the course of events we all witnessed in the gold market of 2007-2008 to recognize that within the seemingly treacherous and tumultuous waters, there often lays a safe and steadily rising tide.

Danger—YES!  Opportunity—Definitely!
Point of fact is that the short term past has been so prone to loss that investors within and without the sector cannot conceive a reason for a turn around. Investors are unwilling to put capital to work without an obvious direct driver for the gold juniors.  Prevailing market conditions and a sentiment of dissolution place the capital intensive business of gold mining in a very tight spot.  Investors are focused on cash balances, costs and survival. This leaves very little room for failed exploration plans, high capital expenditures and delays to the return of investor’s capital.  The level of tolerance and degree of patience for the sector is on a short leash.   DANGER- DANGER- DANGER

However, on the brighter side, the lopsided share prices and Profit Earnings Ratios make this “crisis” too difficult to ignore.   Going forward, limited supply for gold ultimately bodes well for recovery for the price of gold; the only question is: when?  In our current global climate of monetary debasement, the “race to debase” has all major governments creating more money in order to correct and disguise their fiscal blunders; long term this will only serve to drive the demand for gold even higher as astute investors recognize it as a currency hedge.  Add to that the rock solid stability of the fundamentals for gold over the long term, this planet’s NEED for metal, and gold’s limited supply. OPPORTUNITY-OPPORTUNITY-OPPORTUNITY
With their backs to the wall, wary investors are simultaneously faced with two brush strokes -- danger and opportunity.  One thing is for sure, navigating these waters is not for the faint of heart.  Stock selection and portfolio management become paramount—making the right choices iscrucial. Given the current market scenario, ALL gold price shares have been painted with the same brush, rendering a bleak and colorless landscape; the true stars of the show are unable to stand out and shine against this backdrop.  The resulting whitewash has taken the good with the bad, but perhaps this clearing of the weaker sisters will prove to be a positive step.  Nietzsche was right when he said, "That which is about to fall deserves to be pushed."   “Culling the herd” now will ensure its future health and longevity.

In my next submission, I describe some of the key elements to consider when evaluating and making stock selections - how to “pick the stars” so to speak.  I’ll provide you with an investors’ checklist for scrutinizing a gold company before taking the plunge, things such as what characteristics are in a good stock pick?  What signs of stability do we need to look at when evaluating a company’s financial condition, and other insightful tips.

Michael Kosowan has been an Investment Executive since 2000 and proudly learned the ropes and untied the knots during the “rumored gold crises” of 2000 and 2008.Contact Michael at mkosowan@sprottglobal.com.