Description

We believe owning a basket of small cap gold stocks (producers or near producers) is a very compelling investment opportunity on three levels: 1) gold fundamentals are extremely favorable right now; 2) miners represent the best asymmetric risk/reward in the value chain and; 3) there exists a significant opportunity to essentially create a synthetic large cap gold company at a significant discount to the listed alternatives (diversifying away small cap company specific risks) with a basket of high quality small cap, undervalued, cash rich, geographically diversified junior producers (or near producers).

While we are not macro investors, we believe the investment case for gold is analyzable and that small cap gold miners specifically offer an attractive asymmetric risk-reward payoff structure similar to what we typically look for in company specific situations.  Simply put, if gold prices spike from current levels, these stocks are multi-baggers and if gold pulls back or trades sideways, we believe the macro environment is friendly enough to the gold story that simply the future threat of rising or spiking gold prices will provide relatively good downside protection.

Why Gold?  Why Now?

Paul Tudor Jones said it best in one of his recent letters, "...I have never been a gold bug.  It is just an asset that, like everything else in life, has its time and place.  And now is that time..." 

The reality is that the macro exercise is not nearly as complicated as it might appear and in this case actually resembles fundamental company specific analysis.  In fact, in some ways, the exercise is even easier as the revenues (US tax receipts) are relatively predictable and the expenses (government expenditures + interest on the national debt) are also quite predictable.  We don't have to worry about the typical risks of product obsolescence or new competitors, but are rather dealing with a fairly known set of facts (essentially a "closed system").  The math is pretty straightforward. 

In my opinion, the US is in the process of crossing a tipping point where its revenues ($2.2-$2.7 trillion) can no longer support its current and future expenditures (currently $3+ trillion, excluding the present value of $80 trillion in Medicare and Social Security benefits).  Add to this figure the current debt balance of approximately $17 trillion (including agency debt of approximately $5 trillion) and you have an entity that is essentially bankrupt in the classic definition.  In my mind, there is simply no politically feasible way to solve this problem other than a dramatic change in our national standard of living or via the various levers of government policy.  Naturally a democratic government will play to the populist will or find itself voted out (de Tocqueville's tyranny).  No individual group (military, poor, rich, etc.) will be willing to shoulder the burden alone for the benefit of the others, leaving government with no choice but to simply print money (via purchasing agency & Treasury securities as it has done so much of recently).  This likely works for some period of time (exact timing is clearly a negative for the investment case) given that the US is the world's reserve currency and it is "unthinkable" for the world's lone superpower to default on its debt obligations (allowing us to "get away with it" for much longer than any other country could), but this also essentially magnifies the size of the ultimate crash.  Of course, it wasn't that long ago that many people believed it was "unthinkable" that AIG, Lehman, Bear Stearns, Merrill Lynch, Citigroup, BofA, etc. could implode or nearly do so in only a matter of months! 

So what does printing money have to do with gold (a heavy, shiny metal with hardly any known industrial/productive applications)?  Throughout most of human history, gold has been used as the most accepted store of value ("money").  Fiat currencies (which are declared by a government to be legal tender, but are unrelated to any physical quantity of underlying "value" - this category now represents most national currencies including all of the world's major reserve currencies) have not been very common historically and have never lasted very long (the longest in history appears to be roughly 40 years).  The reason for this is fairly simple.  There is a structural mismatch between the populist needs/wants of a society and the ease (or perceived low cost) of printing money (at least in the short term).  Without the forced discipline of a gold standard (or some specie based system based on an exchange for a predetermined amount of a named physical commodity), it is only a matter of time before politics render a substantial blow to the value of fiat paper money through constant devaluations.  We are currently in the 38^th year of  the world's current experiment with fiat currencies (Nixon took the US off the gold exchange standard in 1971). 

Gold is not merely an "inflation hedge".  It is actually a hedge against the credibility of the world's central banks.  If governments continue to print money (effectively debasing their currencies) and the historical money multiplier is applied or increases (representing the velocity of money in our transaction based society), a cycle of hyperinflation will ensue and confidence in fiat currencies will first erode and then quickly collapse.  Alternatively, if central banks continue to print money, but the economy does not respond (ie, the multiplier decreases or remains depressed) and we are caught in a disinflationary or even deflationary environment, then the government would essentially go bankrupt even faster than it now appears it may.  This is because US tax revenues would remain flat to down but our national debt obligations would have risen substantially (leaving the US unable to pay its debts and forcing a revaluation of the currency).  We appear to be headed for a real financial disaster at some point whichever way the above scenario plays out.  In that sense, gold seems like a great asymmetric payoff structure given that it is neither a bet on inflation nor a bet on deflation, but rather simply a bet that the current goldilocks economic environment simply cannot last much longer.

Why gold miners and not gold?

There are two primary categorizations of commodities:  1) consumption commodities, which have value because they can be turned into cash and used in a productive process, and 2) storage commodities, which have value because they are used as a store of value (specie).  Obviously gold is the prime example of the latter.  In the current environment, it therefore makes the most sense to value a gold mining stock based upon the current or expected price of gold (or the market's forward curve) less the inflation adjusted costs of mining and refining the gold into gold bullion less some geological risk factor (which is generally captured in the geological reserve estimates) ("Fully Loaded Mining Costs").  The reason for this is that gold in the ground is not that much different to gold bullion in a vault (less the Fully Loaded Mining Costs) - in fact, the storage and security costs (typically the largest impediments to holding physical gold) can actually be lower.  The best way to think about this is if a bank (or central bank) owned 100% of a gold mine, they might mine the gold and store it and only sell enough of the commodity to pay for the costs of mining and storage.  They could essentially issue notes backed by the gold in the ground or the vault.  Since the gold is not needed for any productive purpose, there really isn't any need to extract it from the ground immediately (assuming of course that its quality and existence are proven by commonly accepted methods).  So, why buy gold at $1,150 an ounce when you can buy it for a mere fraction (adjusted for Fully Loaded Mining Costs) by owning a gold mining company (or a basket of them to offset any company specific risks)?

Why small cap gold miners versus large cap gold miners?

So, with the above in mind, which miners do you buy?  There is currently a VERY large valuation gap between the large mining companies (Newmont, Barrick, etc.) and the junior mining companies (producers or near producers).  The average large cap gold company currently trades at $350 per ounce of reserves while the average small cap producer trades at approximately just $75 per ounce.  So, by buying a typical small cap stock that has a current mining cost of say $300 an ounce and an enterprise value of $50 an ounce you are essentially buying gold today for $350 an ounce (a 70% discount to the current price of the listed commodity).  The only real difference is that you are storing it in the ground rather than in a bank vault. 

I believe the price of gold will increase parabolically at some point in the next 10 years (for the reasons discussed above) and the right way to play such a move in a risk adjusted manner is to own a high quality basket of small cap gold mining stocks.  The way I see it, you either make multiples of your money or you have purchased disaster insurance that remains essentially dead money at worst since the threat of spiking gold prices will exist as long as we have fiat monetary currencies and the current massive yawning fiscal imbalances.  And obviously by buying a basket of small cap gold stocks as apposed to a single or small handful of securities, you can diversify away the specific risks (geological, operational, country, management) of a small cap miner and synthetically create the risk profile of a large cap miner at a substantial discount to the listed alternatives! 

Below is a list of 41 small cap, undervalued, cash rich (further mitigates financing risk), geographically diversified junior producers or near producers (further mitigates geological risk), listed in alphabetical order.  Please note: I have obviously screened these on certain criteria, but have not done a deep dive and would welcome anyone who can add to the list or provide further insight into any of these (positive or negative).  I'd like to keep adjusting and updating this basket to improve it over time.  As this forum provides feedback, we can continue to improve the list by collectively combining all of our research efforts on small cap gold miners to produce an even higher quality investment for all of us.  My initial criteria for this basket were as follows:  1) strong balance sheet, 2) producing or near producing, 3) attractive valuation on an EV per ounce basis and/or a recommendation by a trusted source who has done work on the specific company.

One specific example:

Dynasty Metals and Mining (DMM CN) has mining operations in Ecuador (significant country risk).  The company has three gold projects (two advanced stage gold projects of which one is already producing 100,000 ounces per year).  The Company has 6 million ounces of gold resources and net cash on its balance sheet of CAD$6 million.  Dynasty forecasts it will be producing 350,000 ounces a year in 2-3 years at a cash cost of just CAD$250 an ounce (including royalties to Ecuador).  With gold prices currently at USD$1,150 an ounce, annual cash flow in 2-3 years could be CAD$315 million relative to the current market capitalization of just CAD$185 million!  Looked at another way, you are essentially paying CAD$280 per ounce (CAD$250 per ounce to mine the gold plus CAD$30 per ounce for the stock on an EV/oz basis).  So, with potential exploration and refining capacity to produce as many as 850,000 ounces in 5 to 10 years and gold prices currently at USD$1,150 per ounce, Dynasty could be throwing off CAD$770 million in cash flow.  Could you imagine if gold prices spike to $2,000 or $3,000?  Obviously, the latter scenarios describe an extreme bull case, but they also highlight the incredible optionality in these junior producers that simply don't exist when you buy a Newmont or Goldcorp (while maintaining most of the same downside risk / insurance features as long as a basket approach is employed).

Table of Potentially Attractive Small Cap Gold Producers:

Catalyst