It’s been a volatile start to the year for the precious metals space, with gold (GLD) being one of the worst-performing assets year-to-date, down 8% for the year. However, while this performance is disappointing, especially against the S&P-500’s (SPY) relentless rise, it’s essential to put things in context, given that gold massively outperformed the S&P-500 last year with a 25% return.
So, while the 8% giveback year-to-date is frustrating, it has done nothing to damage the long-term trend, nor has it invalidated gold’s breakout to new all-time highs last year. The best way to play a recovery in the metal looks to be buying dips below $1,700/oz, and for those looking to gain leverage on the metal, Kirkland Lake Gold (KL) offers the best reward/risk propositions in the metals space. Let’s take a closer look below:
(Source: Daily Sentiment Index Data, Author’s Chart)
Beginning with bullish sentiment for gold, we can see it’s been a very emotional trade the past decade, with calls for gold to drop below $1,000/oz when sentiment is in the dumps and incessant calls for gold to break $3,000/oz when the metal is doing well. Unfortunately, for the bulls, the $3,000/oz and $5,000/oz chants came out in full force last August, and this put a massive dent in the bull thesis short-term. This is because the metal performs its worst when there are more than four bulls for every one bear in the trade, and it often runs out of gas just when the calls for the metal to double get trotted out. As the chart above shows, we’ve seen six major signals of peak exuberance over the past eleven years, and all of them have led to lower prices over the next six months.
So, why is this relevant?
For bulls that piled into this trade during August, the trade certainly hasn’t been enjoyable, given that the metal has pulled back nearly 20% from its highs. However, while the newest chants of gold being obsolete are being trotted out, the metal’s sentiment is nearing its buy zone, sitting at a reading just below 30% bulls. While this doesn’t guarantee a low in the metal, it does mean that there’s now enough disgust and despondence surrounding the metal and the gold miners that we could see a significant rally in the remainder of 2021. It also means that if we do see additional weakness and the metal does break back below $1,700/oz, it’s unlikely to stay down there for long, because many of the sellers have already been exhausted.
While complete disgust with this trade would be completely normal if gold were in a bear market, this is not the case at all, which is the opportunity here. As the chart above shows, gold looks to be building a 1-year handle to its massive cup base that it’s been building over the past decade, and this pullback has only marginally undercut the breakout level, suggesting that there’s no reason to give up on the bull thesis. The metal also held its long-term moving average last month and closed well off its lows, suggesting that there are eager buys below $1,700/oz. There are obviously no guarantees that gold reverses and exits its violent intermediate correction. Still, with the metal sitting on long-term support with few bulls left in the trade, this is finally the time to start getting excited about this setup.
So, what’s the best way to play it?
The most obvious way to play the gold trade is through the metal itself, and I remain long gold from $1,450/oz and may look to add to my position if we head back below $1,700/oz. However, my favorite way to play the trade is Kirkland Lake Gold. The company is a mid-cap gold producer with operations in Australia and Canada, and it’s down more than 45% from its all-time highs even though it has the highest all-in sustaining cost margins in the sector, enjoying margins of close to $950/oz, given that it’s getting gold out of the ground for ~$800/oz. This suggests that the stock should have corrected less than its peers, but a transformative acquisition that the market doesn’t fully appreciate and anxiety about the acquisition have provided an opportunity, with the stock seeing its second largest correction in years.
While many miners are trading at 12-15x earnings and offering reasonable value, Kirkland Lake Gold is trading at less than 9x FY2021 earnings estimates of $3.70 at a share price of $35.50 after subtracting out $3.50 in cash. Currently, the company has $3.50 in cash ($800MM) and no debt, is on track to generate $1.2BB in free cash flow in FY2021, yet trades at an enterprise value of just $8.6BB. This means that investors are getting an astounding 14% free cash flow yield for a more than 50% margin producer in safe jurisdictions, as well as a current dividend yield of more than 2.20%.
(Source: YCharts.com, Author’s Chart)
It’s quite rare to see sales like these in the market, but occasionally they arise when a previous leader has fallen out of favor, and the prevailing sentiment is that there’s something wrong with the company. Based on FY2022 annual EPS estimates of $3.95 and what I believe to be a fair earnings multiple of 14, I see a fair value for the stock closer to $55.00, representing nearly 60% upside from current levels. So, while gold could return to $2,000/oz before year-end, Kirkland Lake Gold looks to be a much better play on the metal given the leverage, the yield, and the ability to buy the former leader in the sector at a discount.
The current belief among many market participants is that gold’s best days are over, Bitcoin is the new champion, and there’s no point in owning miners or gold. While Bitcoin could take gold’s place, this argument fits perfectly with sentiment, and assets often are crowned “King” when they’re up 400% on a trailing-eighteen-month basis. This is exactly the time when I believe it’s best to be cautious and look to buy more out of favor assets, not the ones that everyone is touting and suggesting will easily double from current levels. Therefore, I see the current violent correction in miners like Kirkland Lake Gold as a low-risk buying opportunity, and I would view any pullbacks below $1,700/oz as having a high likelihood of being false breakdowns; and buying opportunities.
Disclosure: I am long 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.
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