Current valuations of gold mining stocks appear extraordinarily cheap
Angelos Damaskos | March 30, 2020 | SmallCapPower: In a remarkably short period of time, the world has been gripped by panic as the new coronavirus (COVID-19) spreads. Humankind has been prone to viral outbreaks since the dawn of civilization and has always managed to survive and prosper in the aftermath. Whilst the main focus of every individual and the respective regional and national government is, and should be, to protect and help the most physically vulnerable, the resultant and necessary travel restrictions, lock-downs and social distancing are causing significant economic damage.
(The following article was originally published on minersandinvestors.com on March 24, 2020)
Equity markets have arguably been overvalued by most metrics before the crisis. Low interest rates encouraged the accumulation of debt, which in many cases was used to dress-up earnings growth via share buybacks. Shares of several technology giants, such as Amazon, that led the charge in market appreciation traded at over one hundred times their annual earnings, in a belief of seemingly unstoppable business earnings growth. As investor confidence in the future economic outlook is now clouded, those shares that performed the best are the ones sold first. It is reasonable to assume, given the prognosis of epidemiologists, that the virus is containable and ultimately there will be a cure, regardless of how long it might take to test and approve medication. Even when the world reaches this desirable aim, however, it is probably unlikely that valuations will return to the levels seen before the pandemic.
Markets have reacted violently to the spread of the virus around the world, with the quickest falls in equity markets in history. Since the global financial crisis of 2008-9, central bank quantitative easing and other liquidity measures, including persistently low interest rates, encouraged the accumulation of government and private debt, which more than doubled, reaching over 300% of global GDP in early 2020. Corporate and government leverage stimulated a rise in asset valuations to historic highs and the proliferation of Exchange Traded Fund products and computer-driven investment strategies. Many such investment products are built on a significant liquidity mismatch between the unitholders’ ability to advance and withdraw capital and the underlying asset spreads in the marketplace. As large redemptions force the liquidation of assets at prevailing market prices, a rise in volatility causes dramatically larger moves during times of market stress and therefore bigger costs than normal. The relatively “passive” investment strategies also support quicker redemption decisions, thus exacerbating market stress.
As markets convulse trying to find some stability, policymakers have responded with yet further quantitative easing and provision of liquidity. Interest rates have been slashed to near zero or negative and central banks again commit to buy stressed assets. Whilst all such measures are designed to help the economy deal with the ultimate recession caused by the lockdowns, they also serve to raise the global debt burden even further. Importantly, a heavier global debt load would make it harder to deal with even small rises in interest rates post a coronavirus recovery. It is also unfortunate that large parts of the support programmes announced by governments around the world aim to provide liquidity assistance to workers laid-off or furloughed without pay due to the need to stay at home. This is necessary to support the vulnerable, but government debt raised to finance it will ultimately be a further burden to an already overleveraged economy. The ultimate cost of such massive liquidity injections is likely to be currency debasement. Safe haven assets such as gold are, therefore, set to rise in value, fulfilling their role as a hedge against turmoil and uncertainty.
The scenario is reminiscent of market action during late 2008, at the height of the global financial crisis that brought Lehman Brothers down and almost bankrupted major banks and global corporations. Erratic trading patterns and volatility reaching multi-decade highs serve to unnerve investors gripped with fear of the unknown. Even safe-haven assets such as gold get caught in the general scramble for liquidity. Gold bullion, nevertheless, is outperforming most other asset classes just as it did in late 2008. Shares of gold mining companies have been sold off along with the markets as they are, after all, equities and traders need to liquidate portfolios to meet cash calls. This is again what happened in 2008 but back then, when the general selling was exhausted later that year, gold bullion and gold mining shares delivered significant outperformance to other assets for the next three years. Whilst the cause of the current selloff and the likely time it could take to restore some order in the world are very different to the circumstances prevailing in 2008, it is likely that gold will again serve its role as ultimate safe haven, retaining strong relative value and supporting cash-flow generation of the precious metals miners. The next phase would the realization by investors of the resultant profitability and financial strength of mining companies, which should re-rate oversold shares.
The current valuations of gold mining companies appear extraordinarily cheap. As gold remains at six-year high levels, miners generate strong positive cash flows. Furthermore, gold trades at all-time highs in many major currencies such as the Australian and Canadian dollars. These countries also have large gold mining operations that are benefiting from record revenues and low operating costs. Operations in Latin America and Africa are similarly well positioned too. What is particularly interesting, though, is that many of the larger companies seem to have relatively short mine lives and declining average reserve grades. These companies are now looking to buy new assets for future development and several large transactions have been executed in recent months. In the current environment of depressed valuations for smaller, earlier-stage mining companies, we expect corporate activity to intensify. Those smaller companies with proven resources and development-ready projects are likely to be the first to receive approaches for merger, joint venture or outright takeover. It is also likely the general market will start discounting this prospect into the share prices of such companies once some relative stability has been established.
Angelos Damaskos is CEO of Sector Investment Management and Manager of the JUNIOR GOLD FUND
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