Sentiment in gold is extremely negative, but Adrian says there is a strong case to be made that the recovery could be very sharp. Here’s why…
Gold has had a difficult few months. After a modestly upward trend until mid-April, gold then started its downward trajectory, falling from $1,350 to well under the psychologically important $1,200 mark in a (final?) collapse the last week. The U.S. economy, stock market, and particularly the dollar have all been broadly positive for most of the year, making it a difficult environment for gold, with demand for the metal sliding; U.S. coin sales hit 10-year lows, reflective of this lack of demand.
But indifference has now turned to hostility, as, in the last couple of weeks, amid its currency crisis, Turkey is thought to have been a heavy seller of physical gold. It makes sense; after China and India, Turkey and Russia have been the largest buyers of physical gold since 2008, with a pick-up over the last three years. In a crisis, one sells liquid assets, all the more if the price has gone up in local currency terms (viz. Venezuela).
If this is the main cause of gold’s sharp decline in the last week or so, then it is of necessity a temporary phenomenon. The U.S. economy, stocks and the dollar may stay reasonably strong—for now at any rate—so gold won’t suddenly explode upwards, but we could reasonably expect a near-term return above $1,200 towards the mid-$1,200s. (On Friday, gold bounced $11 from its low of $1,174.)
Vanguard out of gold business
Amid this gold decline and a collapse in sentiment, Vanguard decided to get out of the gold market. The largest precious metals fund by far—virtually twice the size of the next largest—is to change its name and mandate from the Precious Metals Fund to the Global Capital Cycles Fund; it has already replaced its London-based gold manager to a U.S. firm not known for any gold expertise or interest.
We suspect that the heavy volumes on many gold stocks reflect the new manager cleaning house, a typical phenomenon when a new manager takes over a fund. This has been going on since the new manager took over at the end of July, with the XAU index down from over 77 to under 66 this month. But in the last week, amid the drop in gold, this decline changed to a cascade, with some big-cap miners seeing one-day declines of 5%–9% on heavy volume.
Vanguard shunning gold at this point may prove to be a contrary indicator of historical proportions. Again, if this is the explanation for much of the gold selling, then it too is a temporary phenomenon, and we can equally expect a bounce in the gold stocks once the selling precious is off. (The XAU moved from 64.29 to 65.92 on Friday.)
Capitulation in gold
Amid all this, sentiment has turned extremely negative, as evidenced by the latest CFTC data, showing speculators went net short for the first time since the end of 2001. At that time, gold was $275 an ounce and within a year was at $348, within six years at $900.
Peter Boockvar of Bleakley Advisory Group, to whom acknowledgements for pointing out the data, comments “it’s tough to find a more contrarian indicator.”
This, plus the largest gold fund changing its mandate, is as close to capitulation as one can get. The short-term recovery could be as sharp as the decline, once the selling pressure is gone. This gives us the opportunity to buy great companies on sale, as well as to make some short-term trades is grossly oversold stocks.
Buy the best at bargain levels
Friend Rick Rule likes to say “don’t buy hamburger when the fillet is on sale.” The fillet, nay, the wagyu of the gold market is Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), on sale now at under $67 (FNV, NY, 66.78), its lowest price in over a year. The stock fell as low as $64.57 on Thursday. Significantly, Franco fell 2.5% on a day when other gold stocks plunged by two or three times that amount.
You can run but you can’t hide
The royalty business model limits risk in the gold mining business, but does not eliminate it, and certainly does not mean that royalty companies are not exposed to lower gold prices. Thus, in latest results just released, Franco said its “gold equivalent ounces” declined on the previous year, and revenue was also marginally lower.
The decline in ounces resulted primarily from lower grades and recoveries at one of its major assets, the Candelaria mine. Franco expects this to be a short-term problem, while also pointing out that the mine is now delivering more ounces than originally expected at the time of Franco’s acquisition of a royalty on the mine. Another of its major assets, the Antamina mine, delivered fewer silver ounces than expected. These are two of Franco’s cornerstone assets, four large copper mines from which the company receives gold and silver by-product streams, which together account for some 50% of total revenues.
Oil and gas to the rescue
The average gold price in the second quarter was also the lowest of the past five quarters, driving down the metals revenue received. Offsetting that were the oil and gas revenues, which saw a very strong quarter with both increased production and higher prices than both the previous quarter and the year-ago quarter.
Franco has just boosted its exposure by a new strategic relationship with Continental Resources essentially to fund exploration in Oklahoma. Franco has made an initial payment of $220 million and will pay $100 million per year for the next three years.
Taking on debt again
With its cash at low levels—just $72 million—Franco will draw into its $1 billion credit facility for the acquisition as well as the final payment due later this year on the Cobre Panama stream acquisition. Next year, with revenue starting from that large copper mine in Panama, as well as other revenue, Franco expects to “easily pay off” the credit line. This will be only the second time in its history that Franco has gone into debt, and, as with the last time, it will be only for a very short term.
Franco’s objective remains to generate at least 80% of its revenue from precious metals, and despite the recent acquisitions in oil and gas, it is still above that goal today.
We have discussed before the advantages of the royalty model as well as the reasons we consider Franco-Nevada to be the premier gold company around. Diversified assets, a deep pipeline, a strong balance sheet, and disciplined, counter-cyclical management make Franco a sleep-well-at-night gold stock. Down from $75 at the beginning of last month, Franco is a strong buy at the current price, under $67.
Difficulties at mines affect Royal’s results
Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX, US$78.09), also had a difficult quarter, experiencing problems at both its largest and its newest mine. As previously discussed, the operators of the Mt. Milligan mine, representing about 27% of both NAV and revenues for Royal Gold, are experiencing water supply issues. The mine was forced to shut down earlier this year, and could experience production shortfalls if there are delays in receiving a permit to draw water from nearby sources.
The newest mine, Rainy River is “not yet hitting on all cylinders,” as the company put it, with significant start-up issues. The operator also said it now expected higher costs for the life of mine. Since production should be the same, this won’t affect Royal Gold, as the stream holder, but there is always a risk that the problems eventually affect production.
Royal has a strong balance sheet, with modest net debt, and, like Franco, over $1 billion in available credit. As a U.S. company, Royal is also the only one of the major royalty and streaming companies not affected by Canadian tax audits on offshore streams. If you do not own Royal Gold, this is a good price to buy.
Trade the gold stocks
In addition to Franco Nevada, among other senior gold stocks on our list, Osisko Gold Royalties Ltd. (OR:TSX; OR:NYSE, US$8.05) is also a strong buy. Goldcorp Inc. (G:TSX; GG:NYSE, US$10.74), Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX, US$78.09) and Wheaton Precious Metals Corp. (WPM:TSX; WPM:NYSE, US$18.43)are good trades.
Most of the other gold companies on our list are good buys now, in particular Almaden Minerals Ltd. (AMM:TSX; AAU:NYSE, US$0.625), Midland Exploration Inc. (MD:TSX.V, 0.79) and Vista Gold Corp. (VGZ:NYSE.MKT; VGZ:TSX, US$0.516); and among resource companies Altius Minerals Corp. (ALS:TSX.V, CA$11.90), and Lara Exploration Ltd. (LRA:TSX.V, CA$0.60).
Adrian Day, London-born and a graduate of the London School of Economics, heads the money management firm Adrian Day Asset Management, where he manages discretionary accounts in both global and resource areas. Day is also sub-adviser to the EuroPacific Gold Fund (EPGFX). His latest book is “Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks.”