Finding golden opportunities through inefficient pricing
Editor's Note: The following is an exclusive article by Sean Fieler, the president and CIO of Equinox Partners
For most investors, finding inefficientlypriced securities is a clear opportunity for profit, but one our age ofinformation does not typically provide. However, in some overlooked markets,these value plays are still prevalent. One such sector is the junior goldmining space.
For most miners, Net Asset Value (NAV) isthe tool of choice for valuation. NAV is the sum of all future free cash flowsfrom an asset discounted back to the present. Unlike valuation ratios such asenterprise value to cash flow, NAV attempts to capture the economic value of amining project over its entire life - an important detail for an investmentthat requires a longer horizon to realize gains.
In an ideal world, variations in NAV wouldhinge on the well-informed differences of opinion of mine engineers andgeologists. Well-informed analysts will have differing estimates of a project'sbuild time and cost. Unfortunately, this is not the differing opinion thattends to drive the variance in NAV estimates. The problem with this, however,is many calculations tend to incorporate unrelated assumptions, such as: 1)commodity prices; 2) discount rates; 3) assets included/excluded; 4) NAVmultiples; 5) estimated future dilution.
Each sell-side firm makes its own gold andsilver price forecasts. This is useful. What is not useful is that eachincorporates its metals price forecasts into NAV calculations. As a result, twosell-side firms can arrive at the same NAV estimate for the same mine, but withone model assuming higher production and lower costs, while the other assuminghigher metal prices. To be fair, some also offer NAV calculations at spotpricing, but most sell-side NAV calculations incorporate disparate metal priceestimates. Notably, sell-side gold price projections not only vary widely fromfirm to firm but may reflect a very pessimistic view of gold's futurevalue.
Discount rate assumptions are another criticalaspect of NAV calculations that often prevent like-for-like comparisons.Duringthe last bull market in gold mining stocks, the sell-side convention for goldminers was a 0% discount rate, i.e. future free cash flows were equal in valueto present free cash flows. This only makes sense if metals prices keep pacewith discount rates. If not, two development projects could have the same NAV,but drastically different internal rates of return based on the timing ofcapital expenditures and cash flow.After the global financial crisis,the sell-side changed their convention to a - - - -5% discount, which is a moreuseful starting point for cash flow analysis even though it punishes long-livedassets.
While 5% is areasonable norm, sell-side models do not employ it uniformly. Even within thesame company's NAV calculation, some assets may be discounted at 5% whileothers are discounted at 8%. For some miners, assets in better jurisdictionsare discounted at 5% while assets in more challenging jurisdictions arediscounted at 8-10%. This creates the risk of double discounting: NAVcalculations are lowered and then companies in more challenging jurisdictionstrade at large discounts to those already reduced NAVcalculations.
The principal flaw in many calculationsisn't the math but what is and what isn't discounted. Imagine twocompanies with the same costs, the same reserves and resources, the sameproduction profile, and very different exploration potentials. Their NAVcalculations would be identical, while one of the two companies is obviouslymore valuable. NAV calculations struggle to incorporate value that isindeterminate or contingent.
Putting a value on a future unpredictableasset is far from straightforward. However, excluding an asset with potentialvalue does not make sense either. Assets that require assumptions and lackclear economics are often omitted or severely discounted from sell-side modelsbecause the underlying math is impossible to defend.
While NAV capturesthe sum of discounted free cash flow, all free cash flow is not created equaland different assets should trade at different NAV multiples. Most obviously,royalty companies should receive higher NAV multiples than mining companies,and high-quality ounces should receive higher NAV multiples than low-qualityounces. In particular, large NAV premiums do not make sense for very largeroyalty companies that will struggle to grow their attributable ounces ofactual gold production.
At the other end of the NAV valuationspectrum are projects that require equity financing. Given the uncertainty ofequity dilution and the timing of project commencement, some additionaldiscount makes sense. The extent of the discount, however, is often extreme. Itis not uncommon to find unfinanced projects valued at a tenfold difference invaluation. While the distinction makes sense in many specific cases, the extentof the variance in the valuation often does not. Therefore, well-informedjudgement calls about the instances in which these discounts and premiums getout of line are particularly valuable in today's market.
There continues to be attractiveopportunities among gold and silver miners in development. The process throughwhich one goes from a project that requires financing, to a producing assetproviding free cash flow, tends to coincide with a substantial revaluation. Themarket is just beginning to see real cost pressure creep into constructionprojects. While it is difficult to generalize across geographies, the cost to bringa mine online has risen in the past two years, but we are far from theoverheating phase of the last cycle during which costs and timelines blow out.
Equinox Partners is a leading long-term value investor incontrarian markets, notably high-quality precious metals miners. As aresponsible steward of investor capital with a 25+ year track record, Equinox'shigh conviction approach to fundamental investing involves a strong, activefocus on junior miners and corporate governance. The Connecticut-based firm hasapproximately $700m in AuM.Sean Fieler, the CIO and President of the firm, has over 20years' experience owning gold/silver miners.
By Kitco NewsContributing tokitco.com
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