October 03, 2022
Gold rose 1.8% this week to US$1,675/oz as expectations for weakening US economic data and rising interest rates in other countries led the market to expect a potential pullback in the US$, and a rise in gold, given their inverse relationship.
This week we look at a century of bear markets to determine how much farther down the current downturn may have to go and investigate shifts in valuations of the TSXV junior miners this year to see how the metals sectors have been relatively affected.
Gold was up 1.8% to US$1,675/oz this week on market expectations that US the economy is weakening, which could put pressure on the US$, and therefore potentially drive up gold, as the two tend to move inversely. The gold price jump was enough to drive up gold stocks, even though equity markets continued to slide, with the S&P 500 down -2.7% for the week, -8.8% in September, and -25.2% for the year, its worst performance since the 2008-2009 financial crisis. Another potential downward driver for the US$ is that rising interest rates, which over H1/22 had been mainly a US problem, are starting to go global. Other major economies have been forced to increase rates to both combat their own domestic inflation, but also defend their currencies against the continued surge in the US$.
A major related issue flared up the UK over the past week, with a new government
introducing a huge unexpected tax cut, but without much explanation as to how it
would be funded. This led the market to expect that there would be major new debt
issuance in the UK to finance the fiscal shortfall, and that the sudden stimulus from
the tax cuts would be inflationary. The expected new supply of debt issuance drove
the price of existing government bonds down and inversely their yields up, to over
4.0% (Figure 4). The tax cuts were also viewed as overstimulating an economy
already facing high inflation, which could require a response of higher interest rates.
Making matters even worse, this spilled over into the pension system, which invests heavily in funds which in turn actively use derivatives on these UK bonds. The plummeting bond prices at a level and speed well out of the normal trading range reduced the value of these derivatives and drove margin calls on these instruments, which fed back to pension funds themselves, putting their solvency at risk. This forced the Bank of England to intervene and put a floor on UK bond prices.
With all of this economic fallout driving a continued downtrend in the equity markets, it raises the question; how much farther down could they go? To answer this, we look at bear markets in the S&P 500 for the past 100 years, starting from 1920, to get an idea of the typical percentage drops in major market declines. The Great Depression saw the worst outcomes for the S&P 500 over the past century, with an -84% decline from 1929 to the early 1930s, the biggest decline of the past century by far, and then another -56% drop from the mid-1930s to early 1940s.
No subsequent periods have seen such major declines, let alone two major bear
markets in a single decade. This was because there was a particularly difficult set of
circumstances driving the problems, including an agriculturally-driven economy in the
US hit by drought, extreme global economic and political change and policy makers
with fewer tools to attempt to manage crises. This was a confluence of negative
factors that was simply unlikely to occur again all at once and with such severity.
The post-World War 2 period saw a strong uptrend in markets through the 1950s and into the mid-1960s broken only by a moderate bear market in the 1950s with a -17% decline. From the late 1960s onward, the markets were much more volatile, with four bear markets, with 17%, -29%, -43% and -16% drops, although interestingly, through it all the S&P 500 was really just oscillating around an average value of 100, effectively remaining near flat for about a decade. The 1980 through the 1990s saw a massive surge in markets, interrupted only by the -24% crash in 1987, which was very short compared to other bear markets.
The 2000s saw the start of another relatively volatile decade, with the dot.com crash of 2000 seeing a -44% bear market, the worst since the mid-1970s, and then the global financial crisis in 2008-2009, which saw the S&P 500 down -51%, close to the -56% drop of the second bear market of the Great Depression of the 1930s. The crash driven by the 2020 global crisis was relatively light, down just -19%, given the massive stimulus response by global governments to the crisis.
This brings us the to the current bear market, which has so far seen a -23% decline
from the peak. We can reasonably exclude the first -84% crash of the Great
Depression as a comparable, leaving us with -56% decline in the second Great
Depression bear market, the -43% drop in the mid-1970s, the -44% dot.com crash
and -51% in the global financial crisis of 2008-2009. All these point to somewhere
around a 50% decline peak to trough, which would suggest, that even in a worstcase scenario, we would be about halfway down in the bear market already.
This would indicate that valuations, while still likely not at troughs yet, are now well off the irrationally exuberant levels of the peak. History indicates that with another 10%-15% down from here, many stocks will have started to enter bargain territory. Given current trends, we could be heading towards such a trough in the markets in the next couple of months, so it could well be time to start value hunting for attractive juniors miners to add to portfolios especially heading into 2023.
In this context, this week we look at the changes in valuations for the largest TSXV mining companies, focusing on the top 15 gold and base metals stocks and the top 10 lithium and silver stocks (Figure 6). Combined, these stocks account for 48.7%, or nearly half of the market cap of the TSXV and probably give a decent indication of what is occurring for the valuations in the index overall. However, we note that these large companies do represent the 'successes' on the TSXV, that have comparably strong operational stories driving their large market caps. With a few hundred listed miners, it may well be the case especially for companies in the bottom 25% of the market cap that shifts in valuations have been more negative than what we see in the top 50%, especially given the pressure on small and microcap stocks in global equity markets overall this year.
Using price to book, or market cap over equity to value the sector, both the top 15 TSXV gold stocks, down from 4.3x to 2.5x and silver, down from 4.0x to 2.0x, have become far less expensive over the past year (Figure 7). While the gold and silver prices are down this year, by -8.5% and -15.3%, respectively, even taking into account that junior miners are leveraged to metals prices, this would not be enough to drive down valuations this much. Therefore we believe that these multiples are also being heavily affected by the broader decline in markets and economic malaise.
We show the composition of this price to book multiple, with the equity, or book value,
in Figure 8 and market cap or price, in Figure 9. Share prices could theoretically fall
because of a decline in the equity of the firm, maybe with cash depleted by
exploration costs while raising cash becomes more difficult in weak capital markets.
However, for both the gold and silver sectors, this has not been the case, with equity
for both increasing, suggesting the firms have continued to raise more capital than
they are spending. For junior miners, equity will not generally be rising because of
increased earnings, as they tend to be pre-production and have no revenue or profit.
The drop in the multiple has therefore come entirely from the price side, or the market cap, which indicates that the market is less confident that the company will be able to take this equity and make strong returns on it. We suspect that this is as much because of a general, global rising aversion to riskier small cap stocks in general than a particularly disdain for the junior miners specifically. For the base metals' stocks, the price to book has declined less, from 4.9x to 3.8x, suggesting the market is expecting more in terms of growth for these stocks than gold or silver currently, and their equity is up moderately over the past year. Lithium stands out as the only major TSXV junior mining segment where price to book has actually risen, from 7.6x to 8.8x, with the group's equity edging up but its market cap rising significantly, although as we show below, this has really been driven only by two firms.
So overall, we are not seeing many extreme bargains quite yet, which we would target as being valuations starting to head towards 1.0x or even lower, with only seven of the group of fifty we have included here near those levels. The gold and silver group's multiples at 2.0x to 2.5x we would consider moderate, and no longer excessive, but not obviously cheap. Base metals valuations are still a bit high at near 4.0x, and lithium stocks at 8.8x are still reasonably pricey, driven by a several hundred percent surge in a lithium price which has hardly come down even with as most of the other major metals go into a bear market. So in terms of value hunting, gold and silver might be the first place to look, followed by base metals, with lithium stocks much more of a high growth story than a value story right now.
Looking at the valuations underlying the aggregate P/B, for gold we see that valuations have declined for all the Top 10 except for Reunion Gold and Laurion Mineral Exploration, with most down significantly (Figure 10). For Base Metals, while two stocks have seen multiple expansion from operational gains, Patriot Battery and Collective Mining, the rise in P/B for NGEx and Sandfire Resources America has been more because of very low equity levels, and the P/B for the other has declined (Figure 11). For Lithium, all of the gains have actually been driven just by two stocks, Sigma and Frontier, which have seen major operating advances this year, with the multiples of the rest of the group declining, even given the major support from a strong lithium price (Figure 12). For Silver, only Abrasilver has seen a rise in its P/B multiple, with the rest of the group seeing declines (Figure 13).
Why do we use price to book instead of the more common valuation method for junior
miners like Price/NAV? Mainly this is because price to book is a widely available and
fixed measure that is easily comparable across firms. The often-used Price/NAV is
less useful for the aggregation we have done here, as there is no agreed upon NAV
for a firm, as it is calculated by individual analysts, incorporating many assumptions
about future production levels, costs and metals prices over many years. This means
that there can be a range of NAVs depending on who is doing the calculation, while
the is only one equity and market cap. With many junior mining firms not even covered
by analysts, there are no consensus NAV estimates even available.
What is actually in the price to book? The price half simple, it's the market cap, or the current price times the number of shares. What underlies the book, or equity value is somewhat more complex, comprising the total assets of the firm minus the liabilities. For a junior miner, the assets mainly consist of cash and exploration related assets, which can be previous exploration expenses that have been capitalized or current property plant and equipment related to mining exploration.
On the liabilities side, the big item for most companies is debt, but for junior miners, given their lack of revenue, they cannot generally borrow from banks because they have no cash flow to service the debt. So for a junior miner, equity tends to mainly comprise the cash they have and their exploration assets. Using the Top 15 TSXV gold an example, cash is 25% and exploration assets 60% of total aggregate assets, which comprises most of the equity, given that liabilities are just 15% of total assets (Figure 14). So what the market cap to equity, or price to book is really indicating, is how much the market expects the junior miner to take the cash it has on hand, and the cash it has already invested into exploration, and turn that into future cash flows. Price to book is therefore like a confidence measure for a given junior miner to develop a deposit and actually eventually deliver the metal to the market.
The producing gold miners were all up as gold gained on expectations weakening US economic growth could weigh on the US$ (Figure 15). Only the two industry giants issued major press releases this week, with Newmont announcing that EVP and Chief Financial Officer Nancy Buese would leave the company, replaced by interim CFO Brian Talbot, and Barrick reported the closing of two previously announce sales of royalty portfolios, from its subsidiary Nevada Gold Mines to Gold Royalty (GR) for $27.5mn in GR shares and to Maverix Metals for $50mn and $10 mn in contingent payments (Figure 17).
The majority of the larger TSXV gold juniors were up on the rise gold (Figure 16). For the Canadian juniors operating mainly domestically, New Found Gold reported results from the new Keats West Zone at Queensway, Artemis started early works at Blackwater to prepare for the start of major works by Q1/23 and Osisko Development closed its previously announced metals stream with Osisko Bermuda. Laurion completed its 2022 exploration program at Ishkoday and Amex Exploration reported drill results from the new Team Zone at the Perron project (Figure 18). For the Canadian juniors operating mainly internationally, Lion One reported the remaining drill results from the 2021-2022 program to support its Prefeasibility Study and Lumina closed its previously announced $13.3mn bought deal financing (Figure 19).
Disclaimer: This report is for informational use only and should not be used an alternative to the financial and legal advice of a qualified professional in business planning and investment. We do not represent that forecasts in this report will lead to a specific outcome or result, and are not liable in the event of any business action taken in whole or in part as a result of the contents of this report.