It’s been a volatile month thus far for the precious metals market, with the price of gold (GLD) briefly trying to break higher this week before being rejected back into its trading range. On a year-to-date basis, gold continues to massively underperform other assets like the S&P-500 (SPY) and Bitcoin (BTC), but this underperformance continues to breed negative sentiment, with miners and gold becoming the most hated they’ve been in years. This is evidenced by the fact that some sentiment readings for gold and miners dropped below their 2018 lows during the recent correction in March, at a time when gold was 40% lower at $1,200/oz, and many miners were 60% lower and hitting new multi-year lows. Typically, the best time to begin accumulating miners is when the market is this hated. While gold does not pay dividends, the miners are paying them, with many names trading at mid-single-digit to low double-digit free cash flow yields. In this update, we’ll look at one miner that continues to fire on all cylinders and the long-term outlook for gold:
(Source: TC2000.com)
As shown in the chart above, gold continues to build a handle to its massive cup base but has made little upside progress since breaking out of this base during July of last year. This poor performance has many investors wondering whether this is a false breakout or a bull market peak that we’ve just seen, but with the silver/gold ratio acting the best it has in years, the likelihood that we saw peak gold prices last year seems low. This is because the silver/gold ratio typically breaks down in a massive way when a bull market peak is approaching, just as we saw in late Q2 and early Q3 2011. Currently, the silver/gold ratio is trying to make another higher low after making a new multi-year high in Q1, the exact opposite of what we saw during the 2011 peak for gold. When it comes to the health of precious metals bull markets, new highs in gold are great, but it’s new highs in silver that are the most encouraging and those that should be applauded. With a new multi-year high for silver reached earlier this year and the silver/gold ratio continuing to remain strong, this suggests the buy-the-dip trade remains in place for miners, and one of the best candidates continues to be Kirkland Lake Gold (KL).
(Source: TC2000.com)
As shown in the monthly chart above, the gold price continues to remain above its prior quarterly high close of $1,765/oz, a bullish sign. As long as gold remains above $1,765/oz, I see no reason to believe that the market has to retest its lows at the $1,670/oz level, and I see no reason to lose faith in the bullish picture. This is because markets often retest major levels before continuing higher, and new secular bull markets typically begin with the majority being non-believers, and many that entered the trade looking for a violent resumption higher finally throwing in the towel. This is precisely what we’ve seen to date, with many investors hoping for a breakout in Q2 2020 beyond exhausted with this trade. Meanwhile, anyone entering on the dip is also sick of the volatile price action with minimal upside progress.
This poor sentiment has also leaked over to the miners, with many trading at double-digit free cash flow yields on a trailing-twelve-month basis following the correction since last August. It’s worth noting that these yields are artificially low due to moderate disruptions to output related to COVID-19 for more than 70% of miners. Looking ahead, these free cash flow yields are likely to get even larger, assuming prices stay at the same levels, with the most attractive gold miner in the space, KL, trading at a free cash flow yield near 7.0% while paying a dividend of just below 2.00%.
(Source: Company Filings, Author’s Table)
Many investors understandably avoid investing in gold because it pays no dividends, it hasn’t been an inflation hedge, and one is lucky to return 20% in any given year by holding GLD. However, for investors willing to be patient and buy on dips, KL has been an incredible performer in the sector, offering returns of 153%, 191%, 68%, and 69% in 2016 through 2019. In the most recent two years, the stock has cooled off after a historic run, and this pullback that has soured sentiment looks to have created a buying opportunity. This is because the stock is trading at just 11x FY2023 annual EPS estimates ($4.02), sitting on over $3.00 in cash, and enjoying the highest margins in the sector of any million-ounce producer.
This makes KL a defensive play on the sector, like the royalty companies, because it thrives with higher gold prices but still maintains its 50% plus all-in sustaining cost margins if the gold price dips below $1,625/oz. Based on what I believe to be a fair earnings multiple of 15, I maintain my 18-month target price of $60.30, translating to more than 40% upside from current levels. It’s worth noting that as a small bonus, KL pays a dividend yield of $0.75 per share, and this dividend is likely to be increased to $1.00 per share by FY2023, giving investors an opportunity to purchase the stock and get a more than 2.30% yield on cost. Given the solid outlook with industry-leading margins, I would view dips below $38.50 as low-risk buying opportunities.
(Source: YCharts.com, Author’s Chart)
So, what’s the best course of action?
For those looking for less volatility and a pure play on the gold price, I continue to remain long-term bullish on GLD, and I would view pullbacks below $160.00 as low-risk buying opportunities to add to one’s position. Given that I prefer getting leverage to the gold price, I see the best way to play the sector as KL and continue to rate the stock as a Buy at $42.00 per share. If the stock were to dip back below $34.50 per share, the stock would move onto a Strong Buy rating, where I would consider doubling my position.
It’s easy to get worn out after 9 months of choppy action in the precious metals market, but it’s these periods of underperformance that often precede violent up moves, with the market typically moving just as the majority have given up on the trade. While there’s no guarantee that I’m correct, I don’t see any reason to be bearish on an asset that has corrected 4% year-to-date after making a new 10-year high, and I certainly don’t see any reason to be bearish on a company like KL with a forward earnings ratio of 12, margins of more than 40%, and nearly $1BB in cash and no debt. Given the poor sentiment abound, I continue to remain optimistic, and I would view any sharp pullbacks in the month of August as opportunities to add to positions.
Disclosure: I am long SLV, GLD, KL
Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.