SGDM - SGDM: Opt For Gold Miners As A Recession Looms

2023-04-27 02:52:07 ET

Summary

• As shown by the inverted yield curve, the likelihood of a recession has increased considerably after the banking turmoil, while the inflation problem also persists.
• In these conditions, an investment in gold makes sense, but, it is important to choose wisely between investing in the commodity itself through GLD, or miners through Sprout's SGDM ETF.
• This article makes the case for SGDM as a recession-resilient ETF and it could rise by 25% this year.
• However, as seen by the charts, even gold-related investments are volatile and do carry downside risks, especially during the onset of the economic downturn.

Memories about a recession can be short, especially for the current generation of investors who have witnessed one of the fastest market recoveries in history. Well, this was in 2020 and the Federal Reserve had cut interest rates to near zero, and by September the SPDR S&P 500 ETF Trust ( SPY ) as shown in the deep blue chart below, had already made up for its March losses as shown below. However, the Sprott Gold Miners ETF ( SGDM ) in orange recovered even earlier, by May.

Well, the economic freeze induced by the Covid pandemic brought its own set of problems including the collapse of financial markets, but, the banking turmoil last month may have already provided us with a glimpse of things likely to come.

In this respect, unless you want to stay all in cash which is not always realistic, it becomes important to invest wisely and the aim of this thesis is to show that SGDM is the appropriate tool to invest in gold, and could appreciate by 25% in 2023 as a recession looms.

Increased Likelihood of a Recession

Coming back to 2020, more precisely in March, the coronavirus pandemic triggered the biggest market sell-off since the global financial crisis of 2008. As the economy literally collapsed due to lockdown measures impacting whole regions and countries, financial markets also crashed in March.

Generally speaking, a financial crisis happens when the value of assets falls rapidly or financial institutions experience liquidity problems, with both events leading to panic selling. While the triggering event (like a bank run) may be limited to a single location, it is now more likely to spread globally as stock markets have become highly interconnected.

Moreover, one common denominator in each of the world's recessions is the inversion of the yield curve. This is about the yield provided by short-dated bonds (like two-year treasuries) exceeding longer-dated ones (like ten-year ones). If this difference in yield between the 10-year and the 2-year which is also called the spread becomes negative, there is something abnormal going on. The reason is lenders should perceive higher interest rates when they loan money over a longer duration.

This abnormality has been used as a predictor of most recessions since the 1960s and looking deeper, the spread fell below zero at -0.04% in August 2019 with the recession occurring seven months later.

Now, the last time it went negative again was in July last year, but ten months later, the economy is still growing, but, as I explained in a recent thesis , the banking turmoil could precipitate things as it will likely tighten credit conditions further in an economic environment where monetary conditions are already tight.

SGDM's Miners Vs GLD's Commodities

Now, the idea of holding gold as a store of value due to higher consumer prices and periods of acute market volatility has been around for decades. To this end, central banks hold gold as a reserve asset and related purchases accelerated significantly in 2022, at their highest pace since 1967 . For these institutions, gold is also viewed as an asset diversifier after the war in Ukraine and the heightened stress level around Taiwan. For this purpose, the metal is often referred to as a "safe haven", meaning it is considered a relatively safe asset during stock market turbulence and in addition to central banks, it has gained many followers among individual investors and institutions.

Now, an investment into gold can take several forms like investing directly into the commodity through the SPDR Gold Shares ETF ( GLD ), incepted about 23 years ago in 2004 and highly popular with assets under management of $59.6 billion as tabled below.

However, it does not pay any dividends as does SGDM, which follows the Solactive Gold Miners Custom Factors Index, composed of stocks of companies engaged in mining and related services in the precious metals sector. It comes with an AUM of only $283.3 million but nonetheless exhibits an average daily dollar volume of $1.37 million .

Detailing the dividend part, at 1.2%, this is no great yield compared to buying 5% paying CDs (Certificate of Deposits) or treasuries, but, distributions have been progressing during the last five years. The yield also helps to offset the expense ratio of 0.5% . In addition, one-month and year-to-date price performances indicate that investors seem to be more enthralled by miners than the material they extract from the earth.

For this matter, SGDM, whose holdings are shown below holds predominantly Canadian stocks at 75% of its overall weighings with the U.S. far behind at 15%. Looking at holdings, Barrick Gold ( GOLD ) which constituted 11.69% of the ETF's weight as of April 21, has the highest market cap at $33 billion.

On the other hand, New Gold ( NGD ), which only accounts for 0.59%, has the lowest capitalization at $892 million. Hence, with its broad exposure, the ETF's weighted average company market cap comes to $14.5 billion, but, a look at the holdings' quarterly gross profits shows that these have been mostly trending downward during the last three years as charted below.

Profits and Low Supply Amid Sustained Demand

Moreover, the profitability peak coincided with the price of gold reaching a record high of around $2,060 an ounce back in August 2020, before falling to the $1,600 level. Now, that prices are up again, and went past $2,045, you would have expected more on the profitability side since miners do get more revenues for the same amount of gold mined. However, this has not happened and gross profits have been mostly trending downward.

This suggests that high inflation may have raised costs faster than these could be offset by revenues. Going into detail, this may be due to higher energy, labor, and supply chain costs which all mean higher mining expenses. Still, the fact that the majority of SGDM's holdings have been going up suggests that there are other factors at play here like supply.

In this respect, the cost of capital has gone up as a result most central banks throughout the world are still tightening monetary policy a result of which borrowing costs have gone higher. At the same time, obtaining permits for new projects in some parts of the world is becoming more difficult as the ESG (Environmental, Social, and Governance) criteria have now taken center stage, as per a study by Ernst and Young. This impacts investments, and helped by social media anti-mining environmentalists can easily attract the attention of millions, at the expense of less sensational matters like the demand-supply equation.

Furthermore, there are also social and governmental risks as more countries pursue a resource nationalism mandate, with geopolitical tensions encouraging governments to develop their own resources in isolation or among partnering countries.

These all point to lower supply while in addition to central banks and institutions, retail investors flock to physical gold, both for its glitter and as a store of value, according to the Gold Market report . To this end, some analysts are evoking the prospects of gold reaching $4,000 an ounce by the end of 2023 which means an approximate 100% rise from the current price of around $2,000. This may prove difficult as the Federal Reserve raising interest rates to tame inflation also bodes well for the greenback, which is unfavorable to commodities in general.

However, even with a 25% rise, gold could reach $2,500 an ounce which favors mining profits and, SGDM should be valued accordingly.

Valuing Miners as They Spend for Growth

Now, as shown in orange, the ETF's share price closely follows gold's signifying that a 25% rise in the commodity could lead to its value appreciating by the same amount, to $38.83 (29.46 x 1.25) based on the current value of $29.46. Coincidentally, this is about the same level reached in August 2020 .

However, as seen by the fluctuating charts above, volatility should persist especially at a time when the U.S. Central Bank has to adjust rates while balancing price and financial stability, and with the probability of a recession has gone up to more than 60% , there are reasons to expect less hawkishness in the second half of this year. This favors the yellow metal, but, another reason for being bullish is that, as evidenced by the growth in their quarterly capex over the last three years in the charts below, SGDM's main holdings are investing for growth at a time when supply is likely to be pressured.

Furthermore, in addition to spending money, there is a need for an increase in mining productivity through the implementation of new technologies, and in this respect, federal and state-level programs have been launched both in the U.S. and Canada for supporting innovation through digitalization, robotics, and automation.

Even Gold-Related Investments Carry Risks

In conclusion, this thesis has shown that an investment in gold miners makes sense at a time when recessionary risks have increased considerably. Additionally, more investors have been choosing dividend-paying SGDM instead of the commodity-holding GLD recently.

However, investors are cautioned that higher gold prices have not necessarily translated into better profitability for miners and higher inflation may exacerbate things. Still, they are investing money to produce more, in what is expected to be a supply-constrained environment, and, with signs of the banking crisis lingering , diversification into gold is a wiser option than keeping all your hard-earned money in a CD.

Finally, unless you short the market, do expect volatility even in gold-related investments, especially at the onset of a potential recession as illustrated in the introductory chart. Also, contrarily to 2020, monetary policy cannot just be loosened rapidly which means that it would take more time for stocks to recover. Thus, this would be more of a recession-resilient ETF, not a recession-proof one and more cautious investors could wait for the start of the economic downturn before investing.

Editor's Note: This article was submitted as part of Seeking Alpha's Best Investment Idea For A Potential Recession competition, which runs through April 28. This competition is open to all users and contributors; click here to find out more and submit your article today!

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