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If only they rang a bell at the bottom!

Gold miners’ extreme relative valuations signal recovery ahead

Research and Insights

December 14, 2021

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For investors in the natural resources sector, one of the most surprising features of 2021 has been the underperformance of precious metals relative to other commodities and general equity markets, despite an ostensibly positive macroeconomic backdrop for gold and silver. Factors such as persistent low and negative real interest rates and higher than expected inflation, alongside rapid expansion of US money supply and debt, have historically pushed precious metals prices higher, yet gold and gold miners spent much of the year treading water.

Despite its recent lacklustre performance, we believe that gold remains in a long-term upcycle and consider that the headwinds which have held the sector back over the past year are fading. But the question of where we are in that cycle, as well as the likely timeline for the next major breakout, remain open to speculation. While it is almost impossible to ‘pick the bottom’ following a mid-cycle sell-off such as we have seen over the past year, a range of indicators suggests a rebound for this beleaguered sector may be near:

  1. Gold miners are deeply undervalued - On a fundamental, relative, and historical basis the sector is undeniably attractively valued. Market multiples show miners’ relative valuations are near record lows compared to broader markets, while Baker Steel’s proprietary “GenVal” tool estimates c.90% fundamental upside potential for Baker Steel’s gold equities strategy, just at spot gold prices.
  2. We see signs the sector has bottomed - Short-term market indicators, most notably the ratio of gold equities to general equities, signal that the market is bottoming out and a turning point is near.  We are seeking to increase beta through stocks which show high sensitivity to rising gold prices as well as outstanding value.
  3. The long-term bullish picture for gold is unchanged - The headwinds for gold and gold miners are easing, while the core macroeconomic drivers remain in place.

Are we near the start of a recovery phase for gold and gold equities?

Our team has frequently publicised our bullish views on the gold sector (which can be read here), particularly for gold equites, which appear substantially undervalued while offering operational leverage to higher gold prices. Gold’s consolidation over the past 15 month has surely left many investors disheartened with the sector, yet a shift in sentiment may be near.  Over the past month a marked divergence has occurred between selected gold equities, a relationship that in recent years has signalled a major gold market low, prompting research by our team into what this could mean. A notable indicator of this is the ratio of one of our favoured gold/silver miners to the Nasdaq. The chart below highlights that historically extreme levels in this ratio have preceded a sharp rally in gold miners.

Source: Bloomberg, Baker Steel internal. Data at 6 December 2021. *The example company is a core holding in BAKERSTEEL Precious Metals Fund.

Whilst past performance is no guarantee of future performance, recent history suggests we could expect some mean reversion in the weeks and months ahead. After all, the largest global gold producers, Barrick Gold and Newmont Mining, are now trading on yields that are competitive with US Junk bond ETFs and, if historic relationships hold, should have yields that are positively correlated to inflation.

Miners are once again undertaking M&A activity, signalling increased confidence.  Inflation appears anything but transitory, while energy security in the Northern Hemisphere has raised the risk of panic buying just as winter raises its ugly head.  Collectively, these signals have prompted our team to rotate into favoured undervalued companies which offer beta.  Only time will tell if the turning point has indeed been reached for the gold sector, but if the historical relationships hold true the bell may have been rung just in time for the annual Santa Rally.

Gold equities – An undervalued sector in strong shape for recovery

The undervaluation of gold miners can be measured in a number of ways. Firstly, simple market multiples provide a guide as to the valuation disparity between gold equities and broader markets. As highlighted by the chart above, gold miners, as represented by the XAU Index of large-cap producers, trades on a current EV/EBITDA multiple of 9.1x with an operating margin of 31.1%. This stands in sharp contrast to the NASDAQ which currently trades at 36.5x EV/EBITDA with an operating margin of just 9.2% (data at 6 December 2021). This sharp comparison highlights gold miners’ attractive valuations and strong profitability.

While market metrics give a broad overview of relative valuation, as value investors we seek to invest in fundamentally undervalued producers, and it is here we see compelling opportunities. Baker Steel’s proprietary in-house valuation tool “GenVal” allows our Fund Managers to value assets and companies at a fundamental level, drawing on 20 years of data and research. Currently GenVal indicates estimated upside potential of c.90% at the time of writing for Baker Steel’ precious metals equities strategy at spot gold prices, compared with c.60% for the sector. These are high upside estimates by historic standards and substantially higher numbers are indicated when the portfolio is tested against higher gold prices. At a gold price of USD 2500/oz theoretical indicted upside for Baker Steel’s precious metals strategy reaches almost 300%*.

Overall, we consider the gold sector today is likely poised for a period of outperformance, if historic examples are any guide. Gold and silver remain far from their historic highs and would have to recover approximately +15% and +120% (in USD terms) respectively just to regain these levels. Ultimately, we would expect these previous highs to be eclipsed as the gold recovery unfolds. These moves would likely drive a significantly larger appreciation of miners’ share prices, while in contrast US major equity indices are already at or around all-time highs. Furthermore, gold miners are in healthy shape, following years of steadily rising gold prices and a focus on capital discipline in the wake of a tough decade for the sector. Many gold producers are on substantial yields and generally have stronger balance sheets than at any time in recent years. Selectivity remains the key for successful investing however, particularly as some producers face higher CAPEX costs under an inflationary environment.

Baker Steel – Targeting superior risk adjusted returns through active management

The situation facing the gold sector today highlights some of the key advantages of being an active investment manager in this sector.  Stock selection, bottom-up research and a deep knowledge of the sector, coupled with an understanding of the long-term underlying macro trends, are needed to identify those companies best-positioned to thrive during the next leg of gold’s bull market cycle. With several decades of experience covering multiple cycles, Baker Steel’s team has a unique level of specialist sector knowledge, as well as quantitative tools, most notably GenVal and our other in-house screening tools covering yield, margins and beta. Our objective is to deliver superior risk adjusted returns relative to a passive investment in the sector

The timing of the next big move for gold is up for debate, yet our sense is that signs are increasingly in favour of a sizeable recovery for the sector. Underlying the various signs of undervaluation which we have discussed here, it is important to note that a range of macroeconomic catalysts are in place for gold, with potentially profound implications for the sector. Unprecedented money supply growth has taken place over the past two years, with likely far more to come, given central bankers’ doubtful ability to maintain economic stability without easy money. Furthermore, it is increasingly clear that inflation will remain persistently higher than forecast. Most importantly for gold, US real interest rates appear set to remain negative, or at least remain very low, as it becomes increasingly clear that the US Fed has limited scope to raise nominal interest rates, given the risk of severe damage to the US’s indebted businesses and consumers.

2021 may have been a year of consolidation for the gold sector, but as we have seen in previous cycles sentiment and momentum can change rapidly. The key drivers for gold remain in place, while gold stocks show substantial value and upside potential. Meanwhile the headwinds which have dogged the sector this year, namely the belief that inflation would be transitory and the spectre of a hawkish rate hike program, are fading as the new global economic reality sets in.


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