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Finding golden opportunities through inefficient pricing

Commentaries & Views

Editor's Note: The following is an exclusive article by Sean Fieler, the president and CIO of Equinox Partners

For most investors, finding inefficiently priced securities is a clear opportunity for profit, but one our age of information does not typically provide. However, in some overlooked markets, these value plays are still prevalent. One such sector is the junior gold mining space.

For most miners, Net Asset Value (NAV) is the tool of choice for valuation. NAV is the sum of all future free cash flows from an asset discounted back to the present. Unlike valuation ratios such as enterprise value to cash flow, NAV attempts to capture the economic value of a mining project over its entire life – an important detail for an investment that requires a longer horizon to realize gains.

In an ideal world, variations in NAV would hinge on the well-informed differences of opinion of mine engineers and geologists. Well-informed analysts will have differing estimates of a project’s build time and cost. Unfortunately, this is not the differing opinion that tends 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) NAV multiples; 5) estimated future dilution.

Each sell-side firm makes its own gold and silver price forecasts. This is useful. What is not useful is that each incorporates its metals price forecasts into NAV calculations. As a result, two sell-side firms can arrive at the same NAV estimate for the same mine, but with one model assuming higher production and lower costs, while the other assuming higher metal prices. To be fair, some also offer NAV calculations at spot pricing, but most sell-side NAV calculations incorporate disparate metal price estimates. Notably, sell-side gold price projections not only vary widely from firm to firm but may reflect a very pessimistic view of gold's future value.

Discount rate assumptions are another critical aspect of NAV calculations that often prevent like-for-like comparisons. During the last bull market in gold mining stocks, the sell-side convention for gold miners was a 0% discount rate, i.e. future free cash flows were equal in value to present free cash flows. This only makes sense if metals prices keep pace with discount rates. If not, two development projects could have the same NAV, but drastically different internal rates of return based on the timing of capital expenditures and cash flow. After the global financial crisis, the sell-side changed their convention to a ­­­­5% discount, which is a more useful starting point for cash flow analysis even though it punishes long-lived assets.

While 5% is a reasonable norm, sell-side models do not employ it uniformly. Even within the same company’s NAV calculation, some assets may be discounted at 5% while others are discounted at 8%. For some miners, assets in better jurisdictions are discounted at 5% while assets in more challenging jurisdictions are discounted at 8-10%. This creates the risk of double discounting: NAV calculations are lowered and then companies in more challenging jurisdictions trade at large discounts to those already reduced NAV calculations.

The principal flaw in many calculations isn’t the math but what is and what isn’t discounted. Imagine two companies with the same costs, the same reserves and resources, the same production profile, and very different exploration potentials. Their NAV calculations would be identical, while one of the two companies is obviously more valuable. NAV calculations struggle to incorporate value that is indeterminate or contingent.

Putting a value on a future unpredictable asset is far from straightforward. However, excluding an asset with potential value does not make sense either. Assets that require assumptions and lack clear economics are often omitted or severely discounted from sell-side models because the underlying math is impossible to defend.

While NAV captures the sum of discounted free cash flow, all free cash flow is not created equal and 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-quality ounces. In particular, large NAV premiums do not make sense for very large royalty companies that will struggle to grow their attributable ounces of actual gold production.
At the other end of the NAV valuation spectrum are projects that require equity financing. Given the uncertainty of equity dilution and the timing of project commencement, some additional discount makes sense. The extent of the discount, however, is often extreme. It is not uncommon to find unfinanced projects valued at a tenfold difference in valuation. While the distinction makes sense in many specific cases, the extent of the variance in the valuation often does not. Therefore, well-informed judgement calls about the instances in which these discounts and premiums get out of line are particularly valuable in today's market.

There continues to be attractive opportunities among gold and silver miners in development. The process through which one goes from a project that requires financing, to a producing asset providing free cash flow, tends to coincide with a substantial revaluation. The market is just beginning to see real cost pressure creep into construction projects. While it is difficult to generalize across geographies, the cost to bring a mine online has risen in the past two years, but we are far from the overheating phase of the last cycle during which costs and timelines blow out.

Equinox Partners is a leading long-term value investor in contrarian markets, notably high-quality precious metals miners. As a responsible steward of investor capital with a 25+ year track record, Equinox’s high conviction approach to fundamental investing involves a strong, active focus on junior miners and corporate governance. The Connecticut-based firm has approximately $700m in AuM. Sean Fieler, the CIO and President of the firm, has over 20 years’ experience owning gold/silver miners.

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.