IAUM - Why Are Gold Stocks Undervalued?

Summary

• Daily borrowing in the US Fed Funds market surged to the highest in at least seven years last week.
• This is an important indicator because it provides insights into bank liquidity.
• Big moves in the Fed Funds market are telegraphing the expectations of big players. Namely that they expect the cost of capital to go up.
• And this has a big effect on gold producers.

Daily borrowing in the US Fed Funds market surged to the highest in at least seven years this week. This is an important indicator because it provides insights into bank liquidity.

When liquidity gets below minimum thresholds, banks borrow in the Fed Funds market to boost their reserves. Daily borrowing in federal funds rose to $120 billion on January 27th and that marked the highest level since at least 2016.

The Fed's Morse Code

Big moves in the Fed Funds market are telegraphing the expectations of big players. Namely that they expect the cost of capital to go up.

This past Wednesday the United States Federal reserve came out and increased rates another 25 basis points , further fueling the fastest tightening cycle we have seen in decades.

Central banks and governments around the world have followed suit which has alleviated some of the upwards pressure on the US Dollar.

This has created a tailwind for gold which has increased nearly $300 per ounce over the past few months, catching even die hard gold investors off guard.

The Gold Playbook of Perfection

In early November at the same time as the bounce in gold began, I outlined a playbook to capital on gold stock tax loss selling. At the time, the Gold Bugs Index and similar ETFs like the [[GDX]] or [[GDXJ]] were down nearly 30% for the year.

• Putting the tax loss strategy to work could have led you to a quick 30% gain in the span of a few months.

That trounced the performance of major market indices like the S&P 500 (+5%) and Nasdaq (+6%).

What I find interesting is that even though gold is in the $1950/oz range and within hitting its all-time high, gold stocks are nowhere near their all-time highs.

Why Aren't Gold Stocks Doing Exceptionally Well With Gold's Rise?

It might surprise you, but to put it in perspective, since 2021 gold stocks are down nearly 30% as measured by the Gold Bugs Index.

Whereas bullion has generated a positive return over the same timeframe.

The main driver in the disconnect is likely due to cost control .

Inflationary costs hit the miners hard as everything from drilling costs to milling equipment increased in price.

The biggest miners in the world like Barrick (GOLD) and Newmont (NEM) have seen their AISC (All in Sustaining Costs) go up 25%.

Why? Because mandatory mine site items like ANFO (bulk explosives) are up over 50% globally, tires are up over 40% and gasoline for trucks is up. Not to mention the delays for truck parts (and prices up significantly).

In fact…

• Truck suppliers are stripping down brand new pieces of trucks and selling off individual parts - making more money than selling a whole new truck!

These are just a few of the inflationary signals at the mine site.

Add in COLA contracts (Cost of Living Adjustment) with the unionized mines and the miners bottom lines are getting squeezed hard. Higher costs reduce profit margins and cash flows which in turn negatively impacts share prices.

With this massive disconnect, the million-dollar question is are miners pricing in this gold price ? With such a big disconnect, one might be quick to say no, miners are dirt cheap.

Pro-Tip: The Devil in the Details

The chart below shows the consensus 1-year forward price to cash flow estimates for the Gold Bugs Index, which is an index of 20+ publicly traded miners.

• The higher the ratio - the more expensive the index is.
• The lower the ratio - the cheaper the index is.

You'll see that on average, miners in the index have traded around 6.8x its projected cash flows generated in the following 12 months.

Today, the index is hovering around 7.6 times next years' cash flow after spiking as high as 11.7x at the end of 2022.

Now this is only 1 of many metrics an investor should have in their analysis toolkit, and just because it shows prices are above normal valuations, doesn't mean share prices can't go higher.

What you can see is that when gold was pushing for $2000/oz, 2 out of 3 times, valuations went up above 8x future cash flow. This does leave the door open for some additional upside.

However, we also infer from this chart that we'll need a scenario where gold prices must rise for gold stocks to accelerate and play catchup.

Marin, When is The Mother of all Rallies Coming!?

Contrary to what all precious metals bug spend decades waiting for, I don't see a major rally coming for the miners without a continued lift in gold prices.

The simple reason is that the cost of capital is increasing for the miners. The Fed just raised rates again, this means it costs of equity and debt will also go up.

• Raising money is going to get harder and will become more dilutive for miners (that's bad for shareholders).

For the producers, we are still seeing inflationary pressures which crimps the ability to generate outsized cash flows, and the actual mine sites will be the last to feel the disinflation when it eventually comes.

That's not to say there won't be many mini spikes and rallies along the way before the big commodity supercycle hits and goes into overdrive.

Regards,

Marin Katusa

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