This week ushers in a wave of 3rd quarter earnings for many of the large cap gold stocks in Canada. We reference the term large cap loosely as the gold bear market of the last 4 years has wiped out the market capitalization of many gold miner darlings. In some cases 75% or more from their peak values. During that bloodletting, the damage was not just financial; in fact the real damage was psychological. Today, even the idea of buying a gold stock is immediately regarded with disdain, considered highly speculative and very much considered a losing proposition.
So why care or bother to pay attention?
Often the perspective of many investors is that the biggest profit opportunity is when a sector goes from “being bad to good”. Alternatively, over my many years of experience I have often found that there are opportunities for greatest returns when conditions in a sector have moved from being “very bad” to just being “less bad”.
So going into the earnings I will be looking for a few things:
- U.S. Dollar has not hurt gold - The U.S. Dollar rally has actually added a very interesting twist. In its natural correlation, gold prices should have considerably weakened during the dollar bull advance, instead, gold has stayed rather stable. In fact today’s gold price of $1180.00 is just $20.00 lower than its price in January of 2014 starting price near $1200.00. This has seen gold prices in Canadian dollars soar above $1500.00 an ounce, which is a 2 year high. Since much of the world’s gold production is not in America, the rising U.S. dollar is actually helping profitability.
- Production Costs – The miners have been diligently executing deep cost cuts. Driven by that rising U.S. dollar, cost cutting has been accelerated by the decline in costs in both energy and consumables.
- Negative Analyst Sentiment – Most analysts remain very cautious as they do not want to stick their necks out on the chopping block. Many remain focused on the ability of the companies to generate free cash flow which impacts the company’s ability to pay dividends or repay debt.
While the analysts are factually correct, I want to emphasize my starting point, often the greatest returns are when a sector goes from being “very bad” to being “less bad”. With a broad acceptance that the stock market is forward looking 6 months to a year, by the time the companies are actually reporting meaningful free cash flow, it is likely they may already be trading at much higher prices.
There are two schools of thought. One believes that gold will cease to have any meaningful value in our society and that many gold miners will cease to exist. The other believes that through history, all markets go through extensive bull and bear market phases and if you purchased shares at compelling prices at the end of bear markets, it represented a generational opportunity.
Which one do you believe?
If you are in the camp that all bear markets end and create opportunity, then this may represent a compelling time to take a risk. The problem with trying to catch a bottom is that even if a stock declined from $40.00 down to $10.00, the stock can still temporarily decline from $10.00 to $5.00 and still draw an investor down 50% on their investment. This is where speculating with call options represent a true asymmetric proposition.
Let’s look at an example using a long-term option on Yamana Gold (TSX:YRI)
- Yamana Gold is trading at $3.50 at the time of writing.
- We buy a deep-in-the-money $2.50 January 2018 call option which is asking $1.80. This represents $1.00 of intrinsic value and $0.80 of time value.
- Two years down the road, if we exercised the option, we would own the shares at an average cost base of $4.30 ($2.50 strike + $1.80 option cost).
Let’s explore the two scenarios:
Over the two years (Jan 2018), the stock returns to its 2014 peak prices in the $9.00-$10.00 range, which will value the option (purchased at $1.80) to having a value in the $6.50-$7.50 range.
Alternatively the stock proceeds to decline back to its lows near $2.00 later this year. In this case the option would still have a time value trading near $0.70-$1.00
Obviously your personal big picture bias on the prospects of gold will influence your decision. However the key observation for me is oriented around the fact we can define and contain risk with the option and have leveraged gains if in fact gold miners do recover.