Jul 26, 2016

Jon Case's Top Picks: July 26, 2016

BNN Bloomberg

Jon Case , BNN

Jon Case, Portfolio Manager, Sentry Investments

Focus: Precious Metals Stocks

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MARKET OUTLOOK:

Gold began 2016 with a strong fundamental backdrop. Supply is poised to fall over the coming years, and the industry is struggling to find and develop new mines, putting a floor underneath the gold price over the medium to long term. On the demand front, the fundamental buyers that represent 75 per cent of the market - jewelry fabricators and central bank buyer – made steady purchases in 2015. What has held gold back in recent years is investment demand, which registered outflows of about 150t/yr for the last several years, to mostly from ETF’s, as investors expected real rates to rise on the back of US led growth and moved into other asset classes.

Gold has broken out this year as expectations for higher real yields have reversed, and we believe gold has established a new bull market. The move in gold is being driven by renewed investment demand (+538t YTD), with ETF holdings surging, and for the first time in several years gold and the U.S. dollar have a positive correlation, an indication investment demand flow is partly driven by gold’s “safe haven” appeal.

Professional investors and institutions that are building positions are doing so for 3 reasons in my mind:

Monetary policy – Negative real yields in the U.S. out 7-years, Negative nominal in Europe and Japan. Gold is an attractive currency in an environment where it costs money to deposit money in a bank.
Equity market rotation - ZIRP (Zero Interest Rate Policy) has pushed investors into the equity market, where multiples have expanded due to a lack of alternatives. I believe some investors are making the call that equity markets are now overvalued and boosting allocations to gold as a result.
Tail risk - Negative interest rates and talk of helicopter money highlight this is a unique environment where there is rising tail risk. Brexit has brought these risks to the forefront in investors’ mind. Gold provides a form of insurance against unforeseen tail risks, and demand for this insurance is rising.

The challenge investors face is it is difficult to buy an asset class (gold equities) that is up 100 per cent, and it is natural to “wait for a pullback”. We see more upside than downside in the gold price as the metal appears to be technically well supported at current levels of $1,300/oz, with further upside. Gold should trade higher during the upcoming seasonal strong period of Q3/Q4. On gold equities, multiples have expanded modestly, but the expansion is consistent with mid-cycle, not late-cycle valuations. We believe investors are largely still underweight, and therefore with a constructive outlook on the metal, and reasonable multiples in the context of the current stage of the bull market, we remain bullish on gold equities.

Top Picks:

Detour Gold (DGC.TO)

Detour Gold is a single asset intermediate gold producer, producing 550 koz per year from the Detour Lake mine in Northern Ontario.

Why we like it:

Free Cash Flow: We expect Detour’s mine to ramp up FCF from $134M in 2016 to $340M 2018, a 8 per cent yield against the current EV (Sentry Estimates, $1,350 gold price)
Wealth Creation – Detour does some have wealth creation, or “exploration potential”, particularly to the south at its Detour North discovery where grades from announced drill results are much higher than what they are currently mining. This could have a significant impact on the future of the mine, as the fixed costs related to mine development have already been sunk.

Kirkland Lake Gold (KGI.TO)

Kirkland Lake Gold is a Canadian gold producer with production from 4 mines of totaling ~320koz at all in sustaining costs of $1,050 (Sentry Estimates, 2017E)

Why we like it:

Upside at Acquired Assets: Assets from St Andrew Goldfields (SAS) were acquired in late 2015; not too far from Kirkland Lake’s flagship asset. The assets were perpetually starved for capital, and we believe Kirkland Lake can uncover opportunities to surface value in the SAS assets with its stronger balance sheet.
Grade Profile and Impact on Cash flow: Kirkland Lake Gold’s flagship asset, the Macassa Mine Complex, has an interesting phenomenon where the grade increases with depth. The mine is expected to see grade increase from 15 g/t to 18 g/t over the next few years, which should see free cash flow expand by approximately 15-20 per cent as a result.
Valuation: Recently, Kirkland Lake’s (now former) CEO departed the company, which has led to speculation of an internal rift between management and the board on M&A. This has resulted in underperformance of 25 per cent since then. This under-performance for a quality Canadian gold producer with free cash flow is a buying opportunity, in our mind, notwithstanding concerns about the company’s strategic direction.

Torex Gold Resources (TXG.TO)

Torex Gold is an emerging gold producer that is ramping up production at its 100 per cent owned El Limon-Guajes (ELG) mine in Mexico. Annual production is expected to be 300 koz at AISC of $1,000/oz (Sentry Estimates, 2017E)

Why we like it:

Valuation – Torex is trading 1.1x NAV and 7.0x CF vs. producing peers at 1.3x NAV and 10x CF (Sentry Estimates). As Torex ramps up to steady state production, we would expect a further re-rating in the share to the group average and potentially beyond that.
Growth Potential / Valuation Upside – Torex’s main deposit is the 4 Moz ELG deposit. In recent years Torex made a new discovery, Media Luna, which too is another 4 Moz discovery. The company has been focused on delivering the ELG deposit into production, however Media Luna represents potential growth and a source of valuation upside that investors will pay more attention to once ELG is fully ramped up.