AdventuresinCapitalismSmall Companies--Big Upside

I like investing in commodities because they’re very simple to understand—it’s all about supply and demand. Naturally, I take a very strong interest in the increasing demand for gold coming out of China. You see, in the short run, the paper markets (leveraged traders) rule the day. In the longer run, the physical market is all that matters. In the past few months, we’ve seen some very important changes in the physical market for gold—China is hungry.

Monthly Chinese Gold Imports (excludes March's 63 Tons)

In this year’s first quarter, Chinese gold production hit a record around 80 tons, but that’s only part of the story. The real story is on the import side, where China imported 135.5 tons (up from 19.7 tons last year). In total, China is now consuming almost 30% of the world’s gold production. India is no longer the price setter—China is. Even more interestingly, gold imports are starting to rise rapidly, 32,948kg in January, 39,668kg in February and 62,913kg in March. If there is one true lesson from the past decade, it is to watch what China needs. When their internal production can no longer fill the need and they resort to imports, watch out!! Import demand starts small and grows forever.

If you’ve been paying attention to recent earnings from the mining sector, you will know that almost everyone missed their targets. Where growth did exist, other mines had shortfalls. There is minimal production growth from the industry. I don’t see substantial growth in gold production for at least a number of years. What happens when demand increases and supply cannot keep up?

Despite what the tin-foil-hatters may want you to think, in the end, gold is just another commodity where the majority of production still goes into jewelry, dental and industrial applications. At the margin, guys hoarding coins and central bank buying has mattered, but basic demand has really set the trend. Gold isn’t valued at much more than the marginal cost of bringing on new production. If you want to see big production increases, you need for the price to go substantially higher. Given the massive headache of operating a gold mine, you need to make at least a 20% return on capital to even consider it. We need much higher prices for new mines to earn those sorts of returns.

I mention all of this because I am watching as gold is in free-fall. Sentiment is at multi-year lows. Everyone thinks that gold is going lower. Yet, demand is ramping up while supply is stable.

The Chinese have finally found an asset class that they can put their money into and feel secure. Their current options are bank deposits with negative real yields at insolvent banks, fraudulent Chinese stock exchange companies or real estate in a real estate bubble. Gold is the answer that the whole country has been looking for. 63 tons of buying in March is a tiny number. It’s a mere $3 billion. Wait until a billion people decide to make the shift in allocations.

I’ve been long gold for almost a decade. There have been stunningly brutal selloffs in the past. This is another one of them. I think we are near the final legs of this sell-off. A few days back, I sold some of my miners to reduce my exposure as they weren’t “acting right.” Instead, I’m buying gold. I don’t have to worry about all the headaches of mining. This is a large position that I’m making larger. I want to own what China wants to own.

According to a friend, "Since XAU was first invented in 1984, there have only been six days when the ratio of XAU to spot gold has been lower than it was at this morning's bottom; all of those six days occurred during October-November 2008. The extreme unpopularity of gold mining shares is striking especially when compared with the eagerness of average people to consider precious metals in one form or another, such as via exchange-traded funds."

Let’s start with the obvious, just because a certain ratio has existed for 28 years, that doesn’t mean that it has magical predictive powers, or that it cannot get even more stretched. However, these ratios do tend to be useful indicators over time and 28 years is a lot of predictive history.  There are two ways that this ratio can get resolved in the next few months; either gold mining shares increase in price or the price of gold declines dramatically. With all the macro-economic issues in the world about to erupt again, I seriously doubt that gold drops substantially.

Is this a unique opportunity to own mining shares? Unquestionably it is. The bigger question is, are we at the bottom? Would I own the miners here? I already do, and I’ve been adding lots more in the past few days.

Let’s face it, they’re all terrible companies. I don’t have the skills needed to choose which are less terrible. Instead, I’ve bought mostly Market Vectors Gold Miners (GDX) and Market Vectors JR Gold Miners (GDXJ). This way, I can let a bunch of indexers choose which miners I’m stuck with. I’m sure I’ll get mostly the bad ones—but a few of the good ones too. In the end, it’s all one trade and these things are terribly oversold.

I wouldn’t want to own miners for a long term investment, but at these prices, even that seems enticing. Based on analyst estimates (and I don’t really trust analysts), the miners now trade at something like 5-7 times cash flow. They’re sending you some of this cash flow in dividends which are now approaching 2-3% and using the rest to reinvest in projects with returns on capital north of 20% using current metal prices. They all have cash flow—the dilutive capital raises are over. The debts are being paid down and the depletion issues are being solved as they ramp up exploration spending. Many of the newer mines are about to ramp up production. These are the mines that have been vexing investors for years as they have massive cost overruns. Once online, these will stabilize production costs.

In the next two weeks, the majority of the large cap producers will report earnings. I can already envision the press releases; reduced production guidance, missed earnings, cost overruns, lower than expected margins, rapidly increasing labor costs, government interference, too much rainfall, in general they will all bomb their quarters. What else is new in gold mining? But after the downgrades are finished, people will hopefully come to realize that most of the majors now have growing production pipelines and trade for very low multiples to current and future cash flows.  

I cannot remember seeing a sector that is more hated. The sentiment is just awful. None of my friends can even bare to look at their screens any more. According to the Hulbert Gold Newsletter Sentiment Index, the majority of gold newsletters are recommending that their readers get short gold. Remember, these are the same guys who mostly make their money selling subscriptions to lunatics who think the government is coming to confiscate their gold. These newsletters are now net-short and have been suggesting for their readers to get short for almost a month now!!! MarketVane and other sentiment indices say similar things. Of course, you can take a poll of my friends and get comparable results.

Me: “Why is Goldcorp down so much today?”

Friend: “It mines gold…:(”

Me: “Ugghhh”

I want to point out that this isn’t an investment for me—I no longer invest in gold mining stocks. However, I can see the potential for a multi-month trade with 20 to 30% upside and not much real downside besides a few day panic low. I’m finding my spots and adding to GDX and GDXJ. The miners feel like they're going to zero, which is usually about when you want to own them.

Disclosure: My fund is long GDX and GDXJ. It may add or reduce these positions without further notice. This is not a recommendation or solicitation to do anything. Caveat Emptor.

Energold reported earnings about two weeks ago. Since then, I have received about a dozen emails asking “my thoughts.” Look, if I have something to say, I’ll say it. I didn’t even bother to delve into the earnings report until yesterday. If you live and die by one quarter, you will get chopped to pieces. I own things because of long term macro themes—not because of how expenses and revenues get allocated during one quarter. The Energold thesis is very much alive and well. According to the Metals Economics Group, mineral exploration spending is expected to increase from USD $17.3b in 2011 to USD $20.3b in 2012 (up from USD $11.2b in 2010). Where else in this no-growth world can you find a sector growing at such rates? In Energold, you have a company that is constantly taking market share in a growing market.

Here are some quick numbers.

So you have a big increase in meters drilled, a big increase in revenue per meter and it leads to an even bigger increase in total revenue. Margins increased by 48.8%. By any metrics, this was a stunningly huge year for the company. They tracked ahead of the industry in an impressive way—true category killer in a growth industry.

In the past year, Energold has made two sizable acquisitions which made a mess of the accounting—Dando and Bertram. They paid $78,605 for Dando in January of 2011. Energold then invested a bunch of capital and expertise in Dando to turn it around. In Q4 of 2011, Dando earned $300,000. Not bad for a 9 month turn-around. What if run-rate earnings for Dando are $2-$4 million in a few years (up from $1.2m currently)? Will they make 30-50 times their investment annually? Those are numbers that the best investors in the world can only dream about. They’ve also guaranteed themselves a steady supply of drill equipment from an in-house provider—which is much more important than just the earnings.

Bertram is an even smarter acquisition. Previously, Energold had been almost entirely reliant on hard rock drilling. While I’m a huge bull on this sector, it is highly cyclical as we learned in 2008 and 2009. However, there is a region known as the tar sands, which is basically the northern half of Alberta. This whole region will end up getting 100 meter spacing drilling. Do you know how long it takes to drill out half of a province? 50 years? 100? No one knows, but it’s a forever job.

In March, I spent a day with Bertram on site in Fort McMurray. It’s a fantastic business. The economics are much better than I had expected. They’re actually better than the hard rock business, and they’re longer term contracts—so there’s much less downtime. The real kicker is that in the next few years, the business might go from being just 4 months a year, to year-round as new technologies are implemented. It’s still a long shot, but it completely changes the economics. In any case, Energold bought Bertram for a bit more than 60% of book—hence the funny accounting treatment in the fourth quarter. When you pay less than sale value for the rigs, you are getting a great bargain—and the Bertram brothers (true gentlemen and outstanding operators) came along with the deal for free (though with earn outs).

These two acquisitions muddy the accounting and somewhat confuse the numbers that previously were very simple. However, you build a business by creating value—not by making your accrual accounting increase sequentially in a linear format. I’m willing to deal with some accounting muddle as long as the key metrics are booming.

What did Energold earn in the fourth quarter? Depends on who you ask. Even the Praetorian Capital office is unsure. After cleaning up all the charges and 1-timers, we think that any number between 7 and 9 cents is about right. That compares to a penny or 2 in last year’s 4^th quarter. Was it a good quarter? Not bad is how I’d put it.

I should point out that Q4 is always the weakest quarter in the year. This is because the company only drills for about 10 weeks of the quarter, yet pays salaries for the full quarter. There is also substantial downtime for rigs that are located in cold northern regions. I should also point out that Energold is still in a rapid ramp-up phase. This will likely begin to trail off by next year as it gets increasingly difficult to grow at over 30% organically as the rig fleet increases from lower levels in prior years. I would expect this to create substantial additional earnings as ramp-up expenses come down.

In summary, Q4 was another fine quarter for Energold. I will say that my 2012 estimate of $1.00 may be a bit aggressive, but I think that $0.70-$0.90 should still be possible if you strip out ramp-up expenses. What do you pay for a business with such strong secular tail-winds that is growing so rapidly and with such high returns on capital? At a current $4.80 price, it seems that you’re paying somewhere between 5 and 7 times earnings and that excludes the earnings from impact silver. Sounds like one of the cheapest companies in the market to me.

On a final note, Q4 revenues per meter were $201, or the highest in the company's history. I think this is a very good omen for margin expansion in 2012.

A few weeks back, my good friends over at Capitalist Exploits did a very long and detailed piece on Japan. For anyone who is living in a cave, the Japanese Yen is about to begin a multi-decade bear market. Of course, one could have made the same arguments a few years back and been painfully early. However, I am increasingly starting to think that the top is in for the Yen. The structural problems are too great to overcome and the macro forces are increasingly swinging in the direction of a substantially lower Yen. I’ve been waiting for a bounce in the Yen to post this. Now that the Yen has rallied almost 5% from the recent lows, I think this piece is much more appropriate.

Of course, the Yen will be a trade much like gold—where every pullback is a chance to add to your position—put it on and max it out. Multi-decade trends do not simply end and reverse. There’s a lot of noise and volatility at the inflection point. There could still be some pain ahead if you are too big. However, current prices on the Yen feel like as good of a point as any to start a position.

Remember, that shorting the Yen has nothing to do with my take on Japan itself. I am a huge fan of the place. A lower Yen will only make travel cheaper and more enjoyable. It will also eventually help revive the export economy. All of these things will be good for the Japanese. It seems almost inevitable that the government will help this process along with aggressive JGB purchases.

With that out of the way, enjoy the report.

http://www.capitalistexploits.at/japan_debt/

What’s the most despised industry sector in the market today? Solar stocks? China frauds? Sure, you can average down on these to zero. What about a real industry that’s starting to finally hemorrhage cash flow? After a decade of continually disappointing investors, large cap gold stocks are finally cheap.

The XAU has been consolidating for two years now. Is it ready to go higher?

Will they continue to disappoint investors? Of course they will. They’re gold stocks after all, but they’re just too cheap. They’ve finally caught up with depletion. They’ve finally paid off debt. They’ve finally debugged big cap-ex projects and they’ve finally started to produce gold at prices that get them some cash flow. I don’t trust analyst estimates, but most analysts seem to imply that the 5 largest producers trade for around 6-8 times cash flow using about $1600 gold. Even with cost inflation, that just doesn’t seem too expensive. Sure, these things were overvalued when they were valued at 20 times cash flow, back in 2004, but single digit cash flow yields with growing production should finally get some investor attention.

Will the miners continue to overpay for assets? Will they continue to invest in countries that I wouldn’t dare go on vacation (think of my travel schedule—not yours)? Will they continue to invest in projects based on fantasy metrics where paybacks are below their cost of capital? C’mon, these are gold mining stocks. We all know they will. These things are run by some of the stupidest people I have ever met. But they just cannot seem to destroy enough value at these prices to go much lower—no matter how hard they try.

I won’t go through the individual numbers, because frankly, I refuse to own any one of these things. They’re all toxic. But an index of these things should insulate you a bit.

The chart above is a ratio of the XAU (Philadelphia Gold and Silver Index) divided by the price of the gold itself. As you can see, for most of the bull market in gold, at least until 2008, it traded at between 20% and 25% of the price of gold. As gold went up, so did the index. Then the crash came and investors were burnt by the miners. Since then, the miners have not come close to recovering the old ratio. Even more amazingly, the ratio is getting pretty close to the panic lows of late 2008. That turned out to be a great time to own the XAU as it proceeded to more than triple over the next year and change.

A zoomed in look at the ratio in collapse....

I’ll admit that I bought some GDX on Friday, more for giggles than a real position—I’ve sworn off individual miners on principle. However, I cannot ignore these charts—they really spell opportunity. What are they telling us? Either miners as a group are VERY cheap, or gold is about to implode in price. I really doubt that the latter is possible. Maybe gold stocks are just too cheap and ready to finally work higher for a change.