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Craig Jerusalem, senior portfolio manager at CIBC Asset Management
Throughout my investment career I’ve perpetually been underweight gold stocks. And why is that? Well, it largely has to do with the industry’s horrific track record of destroying shareholder wealth over time, combined with a historically self-serving management team, flat to falling commodities throughout much of the past 30 years. And even during those periods of rapid rising balloon prices like 2006 to 2011, many of the majors rewarded managements with lucrative payouts, sunk excess capital into empire building and mergers and acquisitions, or plowed earnings back into much needed development projects to sustain mine lives. But today things are quite different, both from a sustainability perspective and the quality of the top tier senior producers.
So, first on the commodity and where do we think gold can go from here? Well, I’d be lying to either you or myself if I said I knew where gold price was going, but the fundamental backdrop for the commodity is quite supportive. Inflation and, more importantly, inflation expectations could finally be on the rise. Real interest rates are negative, which is positive due to the lower cost of carry. The U.S. dollar is weak, which lends support to bullion. Fiscal deficits, central bank balance sheets and stimulus measures are all flooding the market with ample liquidity. Then finally supply-demand fundamentals are strong too. Supply is not growing, as large-scale deposits are no longer being discovered. And even though jewelry demand is down, industrial use and, more importantly, ETF and central bank buying is making up for it.
So, what are the risks? There’s four main risks that I see: mergers and acquisitions, geopolitics, financial risk and operating risk. So let’s hit all of those.
In terms of mergers and acquisitions, we do know that mine lives are at generational lows. So once this Covid lockdown ends, mergers and acquisitions will surely heat up again. This could be a risk or an opportunity depending on what price the majors pay.
On geopolitics, when the commodity price rise, greed seems to kick in and governments in certain riskier countries begin to demand a bigger slice of the economic pie.
Then for financial risks, balance sheets as a whole are actually quite healthy for the industry, so this is on the lower risk side of the equation for now. And finally on operating risks, despite the odd misstep, the senior producers are generally good operators and offer much better diversification relative to the single mine operators.
Then we have a few obvious positives. Margins are at cycle highs and generally when bullion prices rise, a good portion of that margin gets eroded by higher commodity prices and labour costs. But, partly due to the Covid situation and partly due to weak energy prices, much more of that top line gain is falling straight to the bottom line today, which is clearly a positive.
And that leads to the next big positive, which is free cash flow. At spot prices, if even a fraction of the unallocated free cash flow — in other words, the cash not earmarked for exploration and maintenance — if any of that gets returned to shareholders in the form of dividends, it could suggest a yield well above the S&P 500. So, look for companies to continue raising dividends in the near term, similar to how Barrick recently raised their dividends 14% during this last quarter.
So, to sum up, these are still commodity companies, which implies that there is a lot of cyclicality in them. But, with a positive backdrop and the increase in quality for many of the senior producers, investors will likely benefit from having some exposure to gold stocks when properly incorporated into a well diversified portfolio. That’s even true for the high-quality portfolios.
In terms of some of the other commodities, such as copper and iron ore, we’re actually seeing the price for many of those commodities rise as well despite some of the economic sensitivity that’s occurring due to Covid. The reason for that is that there’s still a lot of government stimulus investing in infrastructure, investing to keep their economies rolling. So even though overall economies are weak, which typically results in weaker commodity prices, we’re actually seeing some nice strength in some of the base metals, such as copper and iron ore for the reasons outlined.