Highlights:
- Negative sentiment towards precious metals persisted during the quarter.
- The return of inflation and limited scope for monetary policy tightening presents a potential catalyst for higher gold prices.
- Many precious metals miners are largely in a healthy state, having maintained capital discipline amid signs of cost inflation.
Q3 Top performers:
- Kirkland Lake
- Endeavour Mining
- Pretium Resources
Q3 Underperformers:
- K92 Mining
- Hecla Mining
- Coeur Mining
Fund Performance
The ES Baker Steel Gold and Precious Metals Fund (“the Fund”) fell -11.8% (B Class) during the quarter compared with the EMIX Global Mining Gold Index (“the Index”) which fell -10.8%, while gold rose +1.8% (in GBP terms). Full details of Fund performance can be found here.
The gold sector remained under pressure during the quarter, with subdued sentiment towards precious metals miners persisting. The sector’s lacklustre performance comes despite an ostensibly positive macroeconomic environment for gold, which we have consistently highlighted in our recent communications. Most importantly for gold, low and negative real interest rates appear likely to persist despite forecasts for modest nominal interest rate hikes, while historic levels of economic stimulus continue to drive unprecedented money supply growth.
We see three key reasons behind precious metals’ lack of momentum despite these positive market conditions. Firstly, there is still a belief that inflation is transitory, as has been widely communicated by the US Fed and other central banks, although the recent change in the tone of policymakers is notable. Secondly, US dollar strength (while not always negative for gold) has been a headwind for precious metals for much of the year. Thirdly, the prospect of tapering of US bond purchases and the spectre of a nominal US interest rate hike has weakened sentiment towards gold and silver.
Despite the recent pressure on the sector, we do not believe that these factors will perpetuate, and at the time of writing we consider the headwinds for precious metals appear to be abating. Furthermore, we consider that many producers are in good shape and we have positioned the Fund for the recovery phase we see ahead. Through continuing to focus on value, asset quality, ESG and shareholder returns we maintain our conviction that this strategy offers the potential for superior risk-adjusted returns relative to its peer group and passive investment vehicles.
Market Update
A dominant market theme during the quarter has been speculation over the timing of US nominal interest rate hikes in response to the strong US economic recovery and rising inflation. Undoubtedly this has resulted in weaker investor sentiment towards precious metals, despite the limited scope for tightening by the Fed. What remains to be seen is whether higher inflation rates will prove persistent, as supply chain disruption, rising energy costs and rebounding consumer demand drive prices higher, amid a shift by central banks towards average inflation targeting. Gold has historically thrived as an effective inflation hedge and a period of heightened inflation could drive gold prices sharply higher. Furthermore, we note that real interest rates (not nominal) are highly likely to remain low or negative, despite a projected modest rate hike, in the face of growing evidence that inflation is here to stay for longer than policymakers expect. Given the extent of negative sentiment towards gold and the likely temporary nature of the negative forces impeding the sector, it is our view that a growing recognition of the threat of rising inflation presents a likely catalyst for higher gold prices in the months ahead.
“Growing recognition that we are entering a protracted period of higher inflation is a key catalyst for higher gold prices”
Yet while the prospect of a period of higher inflation is a bullish factor for gold, the Fed’s June comments regarding potential nominal interest rate hikes provided a catalyst for a sharp sell-off across the precious metals sector. Gold fell c.USD 100/oz on expectations of two hikes in 2023 and potential tapering of bond purchases. The sector has recovered somewhat in recent weeks, but in our view remains oversold. Notwithstanding a slightly more hawkish Fed, nothing has changed the medium- to long-term positive outlook for gold, as outlined above. Should higher inflation persist, gold will likely be an effective inflation hedge. The Fed’s scope to raise interest rates is limited and, at the same time, central bankers focus on inflation averaging rather than capping.
Gold and silver miners remain undervalued on a fundamental and relative basis. Gold equities (XAU Index) have operating margins of 30.8% but are trading at 7.2x EV/EBITDA, representing substantially better value relative to broader equity markets. Both the S&P500 index and NASDAQ have operating margins of around 13% but trade at 15.2x and 24.4x EV/EBITDA (all data as at 30 June 2021). These multiples give some idea of the extent of relative undervaluation in the precious metals sector, alongside the fundamental value which we seek as active, value-driven investors.
“The Fund is positioned for the recovery of the precious metals sector and maintains a sizable weighting to silver miners”
Despite the ongoing pressure on precious metals prices, miners are in a strong position. Our team attended the Denver Gold Show during September which highlighted that much of the sector has maintained capital discipline, with many mid- to large-cap companies using gold prices of USD 1200-1350/oz for reserves and planning. As a result, margins are strong and companies are continuing to increase dividends. Encouragingly companies are also increasingly engaged with ESG issues, a core area of our research process. A further significant update for the gold sector, has been the announcement of the merger of Agnico Eagle Mines and Kirkland Lake Gold, creating the 3rd largest gold miner in the world. Kirkland Lake Gold has been one of the Fund’s largest holdings and we consider meaningful consolidation such as this to be a positive indication of the health of the industry.
Performance Attribution
Top performers during Q3 2021 included Kirkland Lake, Endeavour Mining and Pretium Resources. Kirkland Lake (5.2% NAV) gained +10.4% (CAD) during the quarter. As mentioned above, the company’s merger with Agnico Eagle will create one of the world’s top gold producers, offering advantages for investors relative to some of the other gold majors. Synergies resulting from the merger should unlock further value and we expect the combined company to continue to focus on shareholder returns via dividends and potentially buybacks. Kirkland has a portfolio of high-quality assets; Detour Lake’s value and growth potentially highlighted by the recent updated technical study, while the company’s Macassa and Fosterville Mines are both high grade assets whose potential we believe is not yet properly recognised by the market.
“The merger of Agnico Eagle Mines and Kirkland Lake Gold is a meaningful consolidation and positive indicator of the health of the sector.
Endeavour (4.0% NAV) gained +7.1% (CAD) during the quarter. The company has a very strong story, including a particularly favourable returns policy, with dividend and share buyback generating a combined yield in the region of 3.4%. Endeavour has delivered solid operating results and, following its consolidation spree and exploration commitment, now has a measured growth profile which it can fund internally.
Pretium Resources (2.5% NAV) gained +3.3% (CAD) during the quarter. The company operates the Brucejack Mine, a high-grade underground mine in British Columbia. Following the quarter-end the company announced its acquisition by Newcrest Mining, at a 23% premium. As investors in both Pretium and Newcrest we consider this to be a beneficial deal, which allows Newcrest to add a high-quality asset in a Tier 1 jurisdiction, while increasing the mine’s long-term potential through investment by Newcrest.
“Exploration investment is being increased by quality companies, yielding encouraging results”
Underperforming positions during Q2 2021 included K92 Mining, Hecla Mining and Coeur Mining. K92 Mining (2.1% NAV) fell -32.0% (CAD) during the quarter. The company’s operations have continued to be impacted by staff shortages related to COVID-19. Production guidance was also lower than expected for Q3 2021, however cost control was encouraging. K92 shows strong margins and recovery potential for the stock is strong.
Hecla Mining (3.7% NAV) fell -26.1% (USD) during the quarter. A leading silver producer with strong by-product credits, Hecla has been negatively impacted by weak sentiment to Silver during Q3. Hecla is the USA’s largest silver producer.
Coeur Mining (4.1% NAV) fell -30.5% (USD) during the quarter. The company, which offers effective silver exposure, was negatively impacted by subdued investor sentiment towards silver. Despite its lagging performance, Coeur is growing its silver production from 12mozpa to over 18mozpa with the development of its Rochester project in Nevada. Furthermore, the largest spending on exploration in the company’s history is now generating some encouraging results.
Outlook
While the year-to-date performance of precious metals has been disappointing, with the gold price remaining -15.0% (in USD terms) below its 2020 highs, we consider there is much more to come from the sector in this cycle. Rising inflation and the shifting tone of central bankers towards interest rates present key potential catalysts for the next phase for the bull market in the gold sector. Most importantly, many precious metals miners are in healthy shape, maintaining discipline in the face of signs of cost inflation. With strong margins, this selection of producers is well-positioned to continue to raise dividends and have the potential for a significant re-rating as the gold price moves higher.
“We consider there is much more to come from the gold sector in this cycle, amid rising inflation and a shift in central bankers’ attitudes towards interest rates”
As the current period of consolidation gives way to recovery, we expect heightened volatility may continue, amplified by paper gold trading and program trading. Yet our investment approach remains unchanged. The Fund continues to focus on those companies with the best assets, effective management, attractive shareholder returns and that operate in an ethical and sustainable manner in line with our own ESG principles. A key additional theme for us is to focus on companies that are less exposed to, or can better manage, cost pressure. As in previous recovery periods, it is our view that the Fund’s value-driven investment approach offers the best risk-reward opportunity for investors once upward momentum returns to the sector.
David Baker, Mark Burridge & Trevor Steel
Important
Please Note: This report is a financial promotion and is issued by Baker Steel Capital Managers LLP (a limited liability partnership registered in England, No. OC301191 and authorised and regulated by the Financial Conduct Authority) on behalf of ES Baker Steel Gold & Precious Metals Fund (“the Fund”). Full details of the Fund, including risk warnings, are published in the Fund’s Prospectus and the Key Information Documents (KID) which are available on request and at www.equitytrustees.com. We strongly recommend prospective investors seek independent professional advice prior to investing. This document does not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe or purchase any shares or any other interests nor shall it or the fact of its distribution form the basis of, or be relied on in connection with, any contract therefor. The distribution of this information does not constitute or form part of any offer to participate in any investment. This report does not purport to give investment advice in any way. Past performance should not be relied upon as an indication of future performance. Future performance may be materially worse than past performance and may cause substantial or total loss. Some figures are approximate and are for information only, being drawn from different sources. Data and statements are as at end of reporting period unless otherwise stated. The Fund is authorised and regulated in the United Kingdom by the Financial Conduct Authority.