Active engagement being used to turn-around a mis-managed industry of Gold Mining
Sophisticated investors increasingly focus on co-investment opportunities and unique, special situations. For this Insights report, we spoke with Coast Capital, a highly respected activist and event-driven fund that takes a private equity approach to investing in mid-cap public companies. Coast has shared a compelling example of active engagement being used to turn-around a mis-managed industry – with the potential to yield great returns for investors.
Opportunity Set in Gold Mining
The gold mining industry currently presents an extraordinary, timely, and under-explored investment opportunity.
Valuations are at or near all-time lows, and earnings at the average company are depressed due to onerous and unnecessary corporate overhead and exploration costs. Meanwhile, the average company is still very profitable – producing gold for approximately 950 per Oz. and selling it for 1250 to 1300 (25% margins). Finally, major gold producers around the world are running out of reserves, which sets the stage for an important, and unprecedented, wave of consolidation.
We believe that this set of circumstances– all time low valuations on earnings that can be improved, need for consolidation, and positive cash flows, makes for an extraordinarily attractive investment for an actively engaged / activist fund.
A Cash Generative, Yet Mismanaged Industry
The entire gold mining industry has a combined market value of ~$200 billion. Since 2010, the top 25 gold miners alone have generated more than $130 billion in operating cash flow. Over that same timeframe, they have destroyed $150 billion in capital by investing in worthless projects, and buying assets high, selling them low. The almost unilaterally under-performing CEOs have paid themselves nearly $1 billion despite horrid performance.
In fact, since 2006 the price of gold has doubled, while the value of gold miners has fallen by more than 50%.
Given this long history of poor management, misaligned incentives, and capital destruction, investors have lost faith and sector valuations are now at all-time lows. However, consolidation and greater returns are now inevitable for specific companies.
Catalyst: A Wave of Consolidation
Senior gold miners, which are valued at upwards of 150% premiums to intermediates (due to generally higher margins, larger ETF weightings), are now experiencing declining productions and reserves. This is exacerbated by the following facts:
We are not discovering gold as before: Gold miners are now spending nearly 3x more on exploration than they did in the mid 1990’s but are only finding 5% of the gold. The quality of the found gold (measured in grams/ton) is half of what it was 20 years ago. We produced 90m oz. of gold last year and found only 20m oz. – the last time we found 90m oz. was more than 10 years ago!
Mine lives are falling: Reserves / mine lives have already fallen 30% from peak levels and will continue to decline - yet M&A has been minimal since 2012.
Industry is overly fragmented: There are 3x as many gold miners in the small and mid-cap range as there are producers of any other metal including copper / zinc / iron ore / silver.
The only way for major gold miners to maintain production rates and hence premium valuations is through industry consolidation.
Catalyst: Synergies & Value Creation
In addition, most companies stand to greatly benefit from G&A and exploration cost reductions (these account for 33% and up to 100% of operating margins). Investors and advisors now realize that there are too many companies with sub-scale or non-core assets that, though attractive, do not belong together. A restructuring and divestment of these businesses creates enormous value for investors.
Now is the Time to Invest
Despite looming consolidation, scarcity of reserves, and room for value creation through synergies, equity valuations are at or near all-time lows. This is doubly remarkable as Central Banks are now adding to (and not selling) their gold reserves, and middle classes in EM’s (China, India) stand to lead to new demand growth. Furthermore, gold outperforms in times of:
Expanding global leverage (global debt is at an all-time high and 2x what it was prior to the global financial crisis)
Pressure on fiat currencies
Investors’ under-allocation to gold (investors allocating only 0.5% to gold compared to historical averages closer to 3%).
Gold has traditionally thrived with volatility and presented a great late cycle investment given its inverse correlation with stocks.
The industry presents specific challenges as well. A successful investor needs a developed understanding of jurisdiction risk, geology, and a historical perspective which allows them to understand which assets belong with whom, over time.
Consolidation Thesis is Incorrect: The gold mining sector is already beginning to consolidate: Barrick Gold’s merger with Randgold Resources kicked off the process with a big bang in September 2018. Since then, we have seen Newmont merge with Goldcorp (in January 2019), Pan American Silver Acquire Tahoe Resources, among others.
Bullion Risk: While the price of bullion affects the fortunes of miners (they do not hedge), the correlation broke down spectacularly in 2006 (the price of gold is up over 100% since then, while the average mining company has lost over 50% of its market value). Having under-performed so dramatically despite important underlying profitability, we believe the sector is poised to generate returns for active /activist investors even at a notably lower gold price.
Geology and Jurisdiction Risk: These important risks cannot be entirely mitigated, we believe that Coast’s industry experts have the developed perspective and background to help us navigated these risks.
Implementation Approach to Investing in Gold Companies
The gold mining sector holds great appeal for value and event investors. Indeed, sector valuations are at all-time-lows. The senior miners, which are about to enter a period of declining production and reserves, still trade at massive premia to their smaller, faster growing peers, which makes for a forceful wave of consolidation. Meanwhile, the average company is saddled with a bloated cost structure, the elimination of which (through consolidation or restructuring) can create great value.
Special Thank You to Our Contributor
Coast Capital is a highly respected activist and event-driven fund that takes a private equity approach to investing in mid-cap public companies.
Coast Capital Management, LP
P: +1 (917) 622-5454