Mining Industry Renaissance

We're at a key inflection point for the gold industry today.

?Due to the overwhelming pressure to adopt the green revolution, there has been a declining interest from miners in deploying capital to gold-focused projects.

?Perversely, this is very bullish for the industry.

Some brief history first.

Since the end of the Bretton Woods system in 1971, there have been two major gold bull markets:

Among the multiple idiosyncrasies causing the metal price to rise in each of them, one key macro driver precipitated the move higher in both:

?A multi-year decline in gold production worldwide.

?These contractions had a significant impact on fueling the strength and length of prior gold cycles. Today, we see the same macro development unfolding.

?Global gold production has been falling since 2019 and is likely in the early stages of a new secular downtrend. A raging one in the 1970s and another substantial one in the early 2000s.

Miners that have traditionally focused on precious metals have been redirecting their capital to battery metals and other mineral resources that comply with the green agenda.

?Many gold-focused miners have significantly shrunk their production.

Newmont, for example, the largest global gold miner, is merely producing the same amount of gold it did 16 years ago while its reserves are down 24% from their peak in 2011.?

?These supply constraints magnify the bullish long-term investment case for precious metals.

?It is important to highlight that during prior periods of similar significant decline in total global production of gold, like that which began in 2020, related mining stocks performed exceptionally well for the next decade.

?We've seen a similar setup unfold in the oil industry.

?Oil and gas stocks became “uninvestable” for many institutional investors having to follow certain ESG mandates over the last decade.

?After a cathartic purge during the initial Covid crisis, the overall sector has returned back-to-back years of market-leading performance.

?Ironically, the aggressive push for new wind and solar “renewable” energy production has created a voracious demand for hydrocarbons that have rendered them anything but extinct.

?Although we have seen some outstanding new gold discoveries in the last 1-2 years:

The aggregate number of ounces being added to global reserves has been peripheral compared to prior decades. It is becoming increasingly challenging to find precious metals. As a result, the reserves of the top 10 mining companies are down 33% over the last 15 years.

?Let’s not forget:

We have not seen a new precious metals project become a significant producing mine in a very long time.

The aftermath of the 1970s gold cycle unleashed one of the most significant exploration periods that we have seen in the history of the mining industry.

Over half a billion ounces of gold were found from early the 1980s to the late 1990s.

In contrast, today:

Not only do mining companies continue to deplete their existing reserves, but the quality of their remaining assets is drastically deteriorating.

The average grade for gold reserves by the top 10 miners in the world has been in a secular decline.

Aside from all these long-term supply drivers, it’s time for a comprehensive analysis of the overall thesis.

Let’s start with the macro part first.

The ultimate supporting thesis to invest in the mining industry boils down to what we call the “Trifecta of Macro Imbalances”:

?? Excessive debt-to-GDP levels

?? Highly elevated inflation rates

?? Financial assets at near record valuations

These economic issues necessitate a financially repressed environment where the cost of capital must remain lower than inflation, even in a structurally higher interest rate environment.

As a result, in our strong view, all roads eventually lead to gold.

The next chart illustrates one of the most important new secular theses in global macro today.

Central banks have been anything but shy in accumulating gold recently.

After forming a 20-year base, we are seeing the early signs of an upward move in gold holdings as a component of foreign reserves in relation to US Treasuries, German Bunds, UK Gilts, and JGBs.

Unsustainable debt-to-GDP imbalances worldwide, portend ongoing devaluation pressure on fiat currencies. Sovereign debt is becoming less and less attractive while gold’s appeal as a monetary metal is rising.

Central banks must consider the composition of their FX reserves in supporting the stability of their respective monetary systems.

This is setting the stage for gold to reemerge as a key asset in improving the credibility of central banks’ balance sheets. Rising geopolitical tensions only add to this thesis with gold being the perfect neutral alternative.

Now, it’s time to understand the overall cyclicality of gold and silver companies.

Tracking the fundamental changes in the mining industry is one of the most reliable ways to identify what stage of the gold cycle we are in.

?Measuring the level of activity of M&A transactions is one example.

Companies normally go on a buying spree at the peak of the gold market and, conversely, they tend to do the complete opposite near market bottoms. While we have seen the start of some transactions recently, the aggregate value is nowhere close to what we saw at the late stages of the prior cycle.

Nonetheless, it is important to note how miners continue to generate near-record levels of cash flows today.??

The strength of the balance sheets of mining companies is an important factor that tends to precede healthy M&A cycles. As shown in the chart below, the largest gold and silver companies have the highest cash levels that we have seen in decades.

Additionally, precious metals mining companies just went through a long deleveraging process. In other words, the industry had seven years of continuous debt repayment, net of new issuances.

This is a very healthy development for miners overall.

In such a capital-intensive industry where resource projects can take decades to be developed:

The capex cycle of these businesses can be critical in understanding the long-term supply and demand dynamics of metals.

Aggregate capex as a percentage of cash flows has been in a secular declining trend since the GFC. Even though mining companies have become more profitable over the years, they have been gradually decreasing the amount of capital that they re-invest in their businesses.

Furthermore, exploration budgets continue to be slashed as large mining companies have severely underinvested in greenfield projects.

Management teams have been focused on tapping existing reserves to generate cash flow to run their businesses rather than future growth.

This scenario has set the stage for a supply cliff among the majors.

They have left themselves with no other choice but to acquire deposits from outside to replenish their mineral resources.

Therefore, when the metals’ markets firm, the majors and mid-tiers will be tripping over each other in the M&A markets to acquire the limited new large, high-grade deposits.

There aren’t that many qualified ones out there, but indeed there are at least a few dozen of them in the hands of forward-thinking small-cap exploration focused companies.

The capex cycle often follows the gold prices with a lag.

Today, however, while gold is currently near its 2011 highs, capital spending for the miners remains at historically depressed levels.

Management teams remain excessively conservative despite a firming gold market.

After two decades of continuous equity dilution, the top ten gold and silver miners have had three years of record share buybacks.

These companies are going above and beyond to attract investors with accounting conservatism rather than investing for growth.

We are also seeing mining companies paying very excessive dividends recently.

With a long history of data, Newmont is a great example.

The company has increased its dividend in six of the last nine quarters and the stock now has the highest yield in 40 years.

Looking at traditional fundamental metrics, major mining companies are currently at one of the most undervalued levels in history.

The aggregate P/E ratio for the precious and base metals’ miners in the S&P 500 Metals Mining Index is at its lowest level since the Global Financial Crisis.

Precious metals mining is one of the most fundamentally attractive industry groups in the market today.

Interestingly, the gold price is almost back to its 2011 monthly highs. If that is the playbook for the miners, there is 85% upside from here.?

Let us not forget that knowing how bull markets for this industry tend to unfold, smaller companies with strong value propositions are likely to become multi-baggers in this cycle.

The metals and mining industry as part of the overall stock market is almost a rounding error.

We believe this chart will look completely different by the end of this decade.?Let us not forget that knowing how bull markets for this industry tend to unfold, smaller companies with strong value propositions are likely to become multi-baggers in this cycle.

The metals and mining industry as part of the overall stock market is almost a rounding error. We believe this chart will look completely different by the end of this decade.?

As part of the growth-to-value transition, and as investors begin to make larger allocations towards tangible assets, the mining industry is likely to gain significant traction over the next several years.

If we are indeed on the cusp of another long-term precious metals cycle, silver at its current price is perhaps the cheapest resource on earth.

When looking at the metal relative to M2 money supply, it may have recently just reached a historic double-bottom after re-testing the early 2000s levels, which preceded a major upward move in silver prices.

Extreme daily moves in the dollar index should also be noted as part of the bullish thesis for precious metals.

We recently saw the largest 2-day drop in the DXY index since the Plaza Accord in '85 when major central banks coordinated to depreciate the USD relative to other fiat currencies.

After that agreement and the initial downward jolt in the USD, gold prices nearly doubled in 2 yrs.

There was another significant decline in the DXY that occurred right at the depth of the GFC in 2008 which marked the bottom for precious metals.

Price changes of such magnitude have coincided with major bottoms for gold. We believe that will be the case again today.

Silver is showing similar signs.

In October, the metal had an explosive daily move. The last time it did that was in November 2008, which marked the end of a major correction in precious metals.?Silver then proceeded to charge up 400% in just two-and-a-half years.

Also, it’s important to remember that just three months ago silver was having its worst year-to-date performance in 30 years.

The worst is likely behind us.??

We believe it is time to aggressively be long precious metals. Lastly, if we look at monthly returns, silver just had its strongest November performance in 52 years.

Silver has significantly lagged behind other commodities since 2020.

We believe the metal is poised for a major catch-up. After two years of frustrating investors, silver looks ripe for an explosive and sustainable move to the upside.

Without calling out any names, market sentiment has been so negative towards gold that even experts in our industry are losing faith in the metal. In a recent dinner with several geologists, one of them asked:

What is the moral reason for mining gold if it is not used to function the global economy?

Well, that is inaccurate to begin with. With highly conductive properties and unmatched malleability, ductility, durability, approximately 10% of gold’s demand comes from technology, including electronics, which establishes a strong floor for its intrinsic value.

The metal’s broad range of uses and incredible level of natural scarcity is the reason it is one of the most desirable resources on earth. As a result, it has been a universal monetary asset for millennia.

But, to be fair:

Today’s skepticism towards gold, particularly by younger generations, is completely logical.

The last 30 years were graced with a prosperous period of cheap labor, abundant natural resources, and an exceptionally globalized macro environment. All these factors have been severely reversed today.

Decades of cheap money allowed countries to accumulate debt while generating gradually less units of economic growth. Such a lack of monetary discipline is unsustainable. We are now in the early stages of seeing the consequences of these macro imbalances:

?? Rising inequality

?? Political polarization

?? Geopolitical conflict

?? Rising cost of living

?? Shortages of natural resources, etc...

Skeptics are likely to soon learn a valuable lesson as to why gold is such a critical part of the world’s monetary system.??

Let’s not forget that throughout history:

Major positive inflection points start from ultra-depressed sentiment.

On that note, it was encouraging to note that, two months ago, the Wall Street Journal published the following print on the front page of its business section stating:

“Gold Loses Status as Haven”

This article helped to spur what appears to us to have been a major cyclical capitulation bottom for gold just four days later.

From a macro perspective:

There is a profusion of indicators supporting our precious metals thesis today. However, the one measurement every investor should pay close attention to today, is the percentage of inversions in the US Treasury curve.

We created this indicator in 2018 after noticing how independent yield spreads often provided very premature signals about the risk of a recession.

To help our investment process:

We built a much more comprehensive indicator that calculates the percentage of inversions across all possible yield spreads in the Treasury curve. What we found is that every time this indicator went above the 70% handle, it coincided with a steep recession since 1970.

More importantly, for portfolio positioning purposes, this indicator gives our strongest macro signal to buy gold and sell stocks.?

Empirically, when the percentage of yield curve inversions goes above the 70% handle:

It is time to be long gold and short the S&P 500.

In the 24 months after all seven prior instances of the signal, equal dollars invested on each side of this trade returned an average of 72% before dividends.

What is even more interesting is to look at how it performed in the two economic environments that are most comparable to the one we observe today. We believe that the current macro climate most closely resembles the ones that preceded both the 1973-74 stagflationary recession and the early 2000s tech bust.

Using these two periods as analogs, buying the traditional central bank reserve metal and selling short the most popular US equity benchmark averaged an even more impressive 147% over the next two years excluding dividends.

Interestingly, the recent chart of the gold-to-S&P 500 ratio looks incredibly compelling.

With such a strong macro tailwind, the ratio appears ripe for a major breakout from its multi-year resistance.??

I hope this thread was helpful.

-- Tavi Costa