first majestic silver

Are The Gold Stocks Overvalued Today?

Founder of Adrian Day Asset Management
September 18, 2020

Money manager Adrian Day takes a look at the gold stocks—the senior miners, in particular—and discusses whether they remain undervalued or whether they have moved too far, too fast.

We discussed recently how the policies of the Federal Reserve and other global central banks were extremely bullish for gold. If the various quantitative easings (QEs) after 2008 took gold on a five-year bull market that saw the price of gold almost triple, while the major mining index (XAU) went up over 3.5 times, and many juniors far more, today's even more extreme "policy," dubbed "QE Infinity," could have an even longer and greater impact on the price of gold.

Yet despite increased interest in gold and gold stocks—despite the XAU having more than doubled since March—the gold stocks remain undervalued. This is true of pretty much every subsector of the gold space, other than the major royalty companies. (We still like these companies, for reason we have discussed many times, but they are not, as a group, particularly undervalued today.) There are individual stocks—among the producers, developers and exploration—that are not cheap, of course, but as a group, they are very undervalued today, including the major mining companies.

One factor that contributes to whether gold stocks are cheap or not, of course, is the price of gold itself. If the price of gold were to move up significantly from here, then we would expect the gold stocks generally to move up as well. Conversely, a major drop in the gold price would see the gold stocks drop. (That is not the only factor, of course, and the relationship between the gold stocks on the one hand, and the gold price and the broad market on the other, is a complex one.)

Is gold due for a correction?

Is gold due for a correction? Certainly it has moved above its longer-term trend, though the drop in early August and sideways movement since has brought gold back to its trend line since the end of March.

Typically, of course, we would expect a decline below the trend after a move above it, (such as we saw in the second half of July and into August). Inflows into gold seems to have leveled off; in August, inflows into global gold exchange-traded funds (ETFs) were the lowest since January, and only just over a quarter the monthly average this year. That would lead to concern about a reversal, and thence a price decline.

However, though there were some days at the end of August that saw net outflows, overall for the month, inflows on an historical basis were still strong, while the last 12 days have seen inflows every day, albeit still as a lower price than the last several months.

Technically, gold is at a critical level, very close to its 50-day moving average (MA), and just above support that has held since the early August drop. Should gold break below either support or the MA (and it would likely be both), then it could drop to the next support level, which is also around the 100-day moving average, in the $1,800–$1,820/ounce level. Though a drop like that would by no means break the longer-term trend, it would shake the gold stocks.

In short, the possibility of a $100–150 decline is real; gold has been very resilient, quickly reversing any intra-day declines. And should we see a pullback, I suspect it will be both shallow and brief. There is simply too much buying on the sidelines waiting for a pullback.

Large gold miners well below highs

First, the gold stocks have been lagging bullion since 2011, and the gap continues to be wide. In fact, the gap between gold and gold stocks is wider today than it ever has been. If you are bullish on gold, you should be even more bullish on gold stocks.

Second, the gold stocks remain considerable cheaper than they were in 2010–2012. Despite the big run-up in gold stocks this year—and they are up 350% since early 2016—they are still significantly less expensive than they were at the previous peak. The XAU index would have to rise more than 50% from here to equal the level of those years.

But we should bear in mind that leading components of the index are the royalty companies, which generally performed very well over the past decade. Remove those stocks, and the miners generally would have to double from here to get back to the levels they were a decade ago, the last time gold was at the same price as today.

Gold stocks remain well below average valuation levels

More important than mere price is value. If we look at valuations, the story is even more compelling. On every valuation metric, the gold stocks today, despite record gold prices, are in the lowest quartile on a historical basis.

On a price-to-book value, the gold stocks over the past five years have traded at the lowest multiples ever. As stock prices have gone up, so too have the book values of mining companies. At 1.3 times book, the major miners are trading at a better than a 40% discount to their trading range from the early 1980s to 2013.

Even more compelling is price-to-cash flow: Other than the last quarter of 2018, the gold stocks have never been cheaper! For most of the past 35 years, gold stocks have traded at two to three times the current valuations. And when the gold price is strong, multiples tend to expand, so it would be usual were valuations above average today.

Today's situation does not make any sense. Today we have record gold prices and an extremely bullish outlook. We have arguably better, more disciplined mining companies, with better managements and better balance sheets for the most part, yet prices and valuations far less than in 2011–2013.

There have been changes in miner management

The disastrous management decisions in 2001–2013—most notably overpaying for marginal deposits—and the 80%-plus decline in the XAU, soured generalist investors on the sector. Managements were wholesale sacked and replaced, while corporate "visions" of "growth at all costs" were replaced by "profitable ounces." Despite this, generalists who do not follow the industry in great detail are reluctant and slow—understandably—to return to the sector.

But over time, as gold continues to move up, they will return to the sector. Indeed, we are already beginning to see this.

It is unusual that after gold itself has moved so much (over 30% this year; 50% in the past year), the major companies are still inexpensive. Investors are in a very unusual and advantageous position now that, with gold strong and the outlook even stronger, the largest and best companies remain inexpensive. One does not have to go "down market" to the juniors and exploration stocks, where the potential, but also the risk, is far higher.

The major miners as a group are also more "certain" to move as gold moves higher. Gold stocks remain about the most idiosyncratic of any sector; one company can be a disaster even while the sector is strong. So selection remains critical. But this is unquestionably the time to take advantage of this anomaly in prices and valuations of the largest mining companies.

Which are the "best" gold companies?

I am often asked, which are your top gold stocks? There is no easy answer because the question lacks precision. Top for greatest short-term potential? Top for lowest risk? Top for long-term holdings? Or certainty of moving up with gold? And so on. "Top" can mean a lot of different things, and it usually does to different investors.

What to buy for newcomers?

For someone completely new to the gold sector, we shall answer this question: If I were to buy four gold and silver companies today, to hold for the next three or more years, what would be those companies be? In framing the question thus, I assume the investor wants stocks with reasonable certitude to rise if the gold price rises; he wants low risk; and he doesn't want to be figuring out every week if he should continue to own. In this list, I am less concerned about a stock's price today; we are buying companies rather than stocks. On that basis, here are my "top "gold stocks.

First, Franco-Nevada Corp. (FNV:TSX; FNV:NYSE, US$144.93) the largest of the royalty companies. We favor it over Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX) because it has a strong balance sheet, a more diversified revenue base and a deeper pipeline.

Second, Barrick Gold Corp. (ABX:TSX; GOLD:NYSE, US$29.76). I favor Barrick, the world's second-largest gold miner, over Newmont Corp. (NEM:NYSE) (#1) because of better management, a stronger balance sheet and higher free-cash flow.

Agnico Eagle Mines Ltd. (AEM:TSX; AEM:NYSE, US$82.18), along with Barrick, is my favorite of the big cap miners. With a focus on Canada, it has first-rate management, solid balance sheet, a good pipeline and spends money on exploration and alliances with exploration companies.

Lastly, Pan American Silver Corp. (PAAS:TSX; PAAS:NASDAQ, US$34.46), the largest of the silver producers outside of Mexico, has a diversified asset base, strong balance sheet and two high-potential assets (acquired from troubled companies), either one of which could add significantly to the company's production and net asset value (NAV).

The best, and add some spice

Now, as an investor or trader, we would not necessarily buy each of these at today's price. You know this from our recent comments on Franco, for example. But, if you want to buy four great companies and hold for the next few years, this basket represents the best of the best.

And if you want to add a few of smaller companies with high potential, we would pick Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE, US$6.92), a growing gold and silver company, very undervalued relative to other silver miners; Midland Exploration Inc. (MD:TSX.V, 1.03) for its strong management, solid balance sheet and diversified portfolio of exploration projects, many in joint venture with seniors; and Orogen Royalties (OGN:TSX.V, 0.39), again for its strong management, solid balance sheet, and two key royalties, one near term and one further out, both on projects being developed by other companies.

A portfolio, such as the our list of "Current Holdings," is accumulated over time and quirks arise. One can buy a particularly depressed stock at one point and continuing holding because the long-term prospects look attractive. It may not be one's favorite in the sector, but at the time, the favorite was expensive, and instead one bought a very depressed stock for a turnaround. Or one can buy Stock "A," which gets taken over; hence we hold Newmont (which acquired Goldcorp, which got onto our list after it bought the Eleonore deposit from Virginia, the stock we originally purchased). In a future letter, we shall examine our portfolio as a whole, and make some changes.

Originally posted on Sept. 12, 2020.

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."


Adrian Day

Adrian Day is 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."

A medical study in France during the early twentieth century suggests that gold is an effective treatment for rheumatoid arthritis.
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