Gold's Nuclear Winter Has Ended

Tom Bodrovics, a host of Palisades Gold Radio, welcomes returning guest John Hathaway, a Portfolio Manager of Sprott Hathaway Special Situations Strategy and Co-Portfolio Manager of the Sprott Gold Equity Fund

Hathaway discusses traditional portfolio weightings and why they no longer work. Bonds today are return-free risk, which opens the door for gold since something has to replace bonds. Some large pension fund advisors are considering gold as a risk mitigator. John explains how relatively small gold price moves can have an outsized impact on gold producers' profit margins. These stocks remain quite undervalued when considering their free cash flow yield.

Talking Points From This Episode:

  • Bonds and return-free risk
  • Debt and GDP
  • U.S. dollar is likely to decline
  • Mines and profits in a rising gold price environment



Tom Bodrovics: Welcome to Palisades Gold Radio. I'm your host, Tom Bodrovics. Joining me today is John Hathaway. He is a Managing Director and Senior Portfolio Manager with Sprott and brings 50 years of investing experience to the table. How are you today, John?

John Hathaway: Good, thank you.

Bodrovics: John, we saw the attitude towards gold really shift around the Powell pivot, and you were speaking about this before in another interview when the Fed changed from tightening their balance sheet to re-implementing QE (Quantitative Easing) infinity. What other macro factors play a role in propelling the price of gold higher right now?

Hathaway: The biggest one, and you hear some talk about it, but not enough, in my opinion, is very low interest rates. The reason that's important is that bonds really cannot function as a portfolio risk mitigator the way they've done traditionally. [I mean] the traditional 60/40 configuration (60 percent equities, 40 percent bonds), where if stocks were going to discount a recession, interest rates would decline and that would offset the decline in equities. Bonds would rise, equities would decline.


That doesn't work anymore because basically bonds represent return-free risk. They're basically correlated 100 percent to equities. This opens the door for gold, which has a proven history of mitigating risk. We are beginning to see some large pension fund advisors consider allocating to gold as a risk mitigator. As long as 10-year Treasury rates stay in the 1-1.5% area, something's got to replace bonds and that something is most likely gold.

Bodrovics: Excellent. I know you were talking about the sovereign negative-yielding debt being a huge risk. Can you explain why this is such a big risk and when interest rates go up, what the consequences of that could be?

Hathaway: If interest rates go up — which I don't think they will, certainly not by design — you have a world economy that is heavily levered, both private and public sector, and the bankruptcy risk, the disruption to the economy from even a 50 basis point rise on interest rates across the yield curve would slow down the economy. It would create credit risks that are sort of beneath the surface. It is tough to imagine that anybody would like to see even a small rise in interest rates. What we have talked about in our previous conversation has only become worse. The fragility of the system has increased since we last spoke.

Bodrovics: I think one thing that has exacerbated the situation and added to that fragility is the U.S. debt-to-GDP [gross domestic product] ratio. How have we seen that metric grow this year with the COVID-19 lockdowns? What are the effects and are we going to see it continue to grow?

Hathaway: Under a Biden administration, I don't think there's any secret that he's all for more stimulus, at least another couple of trillion dollars. There's no way that there's a market for it outside of what the Fed is going to do. The foreign buying has disappeared, private sector buying, maybe the banks will add to their position. The supply of U.S. debt is just too great to be absorbed outside of the Federal Reserve [the "Fed"], and therefore debt-to-GDP (we're now at 137%) could easily increase to 150% or 160% within the next couple of years.

Bodrovics: What do these factors mean for the U.S. dollar going forward? We know that there's a couple of theories out there around the consequences of these policies, and I wanted to get your thoughts on which camp you fall into.

Hathaway: I fall into the camp that the U.S. dollar is very likely to decline from here, and that's always been friendly for gold. Frankly, I would say that dollar weakness is probably the strongest pillar in the argument for gold right now.

Bodrovics: Excellent. John, on a Real Vision interview from a year ago, you made a call that the political environment was paving the way for a more radical populist, left-leaning administration, which ended up being spot on. What factors need to be taken into consideration with Biden as President?

Hathaway: To be honest, it's very constructive, although I never thought that Trump was much different. I mean, he was a populist. They're Tweedle Dee and Tweedle Dum. I assume we're going to have a Biden administration. There will be all kinds of spending initiatives. If they raise taxes, that's going to kill the economy. Certainly, at the corporate level, we have to see whether that's going to transpire. Higher taxes will hurt the economy and widen the deficit picture we've just been talking about.

Bodrovics: If they do all kinds of infrastructure spending and stuff like that, the taxes are more important and weighing on the economy heavier than any type of stimulus they would provide like that?

Hathaway: Deficit spending right now, which is basically so-called stimulus, is keeping the consumer alive. If spending is for infrastructure, who knows whether it's productive or not. But there will be a lot of money spent. If there is a silver lining in any of this, a successful virus vaccine could create some optimism and give a jolt to the economy. But I don't know if that's enough to offset deficit spending that would take place to get the economy back to pre-COVID levels. I would say it's a long shot that we get back there within the next couple of years.

Getting back to the deficit's size, the reasons for the spending, I don't think it makes much difference because we are in a period where the economy is underperforming. I think that it will last for at least another year. If that's the case, we're going to have huge deficits, a substantial debt-to-GDP ratio and ever greater fragility, and exposure to even a small rise in interest rates.

Bodrovics: John, with all these factors pointing towards the nuclear winter, as you called it, for gold being over, do we need any other fundamental tailwinds for gold to start changing the psychology and attitudes towards it?

Hathaway: We have so many things that are favorable. I would say that the big thing is that interest rates must remain low. Bonds can no longer do the job of offsetting equity risk. Large pools of capital will need to look elsewhere and that is gold. And we talked about the weaker U.S. dollar earlier.

The Fed doesn't want a strong dollar. Nobody wants a strong dollar. I'm just waiting to see further downside. Many very elite investors are calling for a 30% decline in the dollar from here. That would be dramatic and extremely bullish for gold. To me, the two strong things are interest rates have to stay low. Our fiscal situation is that we're basically in a position where we can't do anything about it and are unlikely to do anything about it. Therefore, the dollar will weaken and gold will find its way into institutional portfolios in a way that it hasn't historically.

Bodrovics: You've said in the past that physical buying of metal doesn't necessarily drive the gold price, so why does the leveraged money need to start moving into this space to really make it move?

Hathaway: I would say that it doesn't have to. Leveraged money, hedge fund money, quant money, that kind of thing, that'll come and go again if that's what you mean by leverage money. And that's really opportunity seeking capital.

The bigger story is that gold represents such a small percentage of $100 trillion of assets under management. Let's assume that there is $100 trillion of institutional money under management of all kinds, including pension funds, mutual funds, private wealth, all categories, sovereign wealth, etc. If just 1% were to move into gold over the next couple of years, that would equal $1 trillion. One trillion of demand for gold would be about six years of new mine supply. In my mind, there's no way that you could clear the market at current prices if $1 trillion were to move into the physical metal.

It doesn't take leverage; it just takes the reality of low interest rates. Capital needs a place to go to protect equity risk and gold is going to fill that vacuum. Using that math, you could easily see gold at five times the current price.

Bodrovics: Excellent, John. I'd like to talk about mining stocks. Obviously, they have been so out of favor for the last several years. I'd like you to explain to listeners who don't necessarily understand the dynamic of how a relatively small move in gold prices can massively affect the value of gold miners and how their profit margins can go up exponentially.

Hathaway: Just more basic math. It costs $1,000 an ounce to produce an ounce of gold, which is pretty much the global number. If the gold price averages, which it did last year, something like $1,500-$1,600, that means the profit margin on producing an ounce of gold was, let's call it, $500. This year, the average price of gold I will guess is likely to be about $1,800. That represents a 60% increase in the profit margin of producing an ounce of gold for the industry worldwide, and you've seen numbers that are just staggering in terms of profitability, based on reported third-quarter results. There has been a positive reaction, but to me, mining stocks are still ridiculously inexpensive. Free cash flow yields for many of the larger mining companies like Newmont, Barrick and Agnico1 are mid-to-high single digits. And there are many other mid-cap smaller companies that are producing gold that are generating free cash flow yields. That's free cash flow over a denominator of enterprise value of approximately 20%.

Unless you don't think the gold price can stay here, which I counter that it will move higher, this means incredibly positive valuation prospects for gold mining stocks. What we're seeing are dividend increases right across the board. We're seeing debt pay downs so that this industry is no longer financially leveraged. I think the industry is in very good condition financially. Mining companies are piling up cash even with all of this. The outlook is for cash generation, dividend increases and strong year-over-year earnings comparisons. You couldn't write a better scenario for an equity thesis than where gold miners are positioned right now.

Bodrovics: As we're speaking about the finances of these companies, have we seen capital become easier to get? How has it changed things in this space? Are we starting to see companies that don't necessarily deserve capital starting to pop up yet?

Hathaway: Actually, they don't need capital as they are generating so much by themselves that you're not seeing a shortage of capital. I'm sure the investment banking industry would love to do a bunch of deals, but the industry doesn't need the capital. I would say that we're in a very different place than we were ten years ago.

Bodrovics: John, what are some of the most leveraged ways, in your opinion, to speculate in this space? Would you favor M&A targets close to the top of that list?

Hathaway: There have been a lot of takeovers, but many of them have been mergers of equals, and so not at a huge premium; I can think of three or four in the last three months that were closer to being mergers of equals. There is not a lot of deal-related upside, but that could change. Right now, I don't see that taking place.

The best leverage is if you buy a large-cap company like Newmont or Barrick, and they continue to crank out all this cash flow; that's plenty of leverage because the stocks are still so undervalued. You don't have to hypothesize a big increase in free cash flow yields from, for example, 8-9% down to 2-3% to easily get doubles and triples in many mining stocks.

If you want to be more leveraged, you can go down the pecking order to mid- and smaller-cap stocks that are discounted for various reasons. But still, if you have a company that's trading at an 18-20% free cash flow yield and it goes to 10%, that's a double and it's still cheap. I don't think you need to stretch too much these days. I think you focus on quality stocks. You don't have to invest in many of the junior names — which we own and like — but they don't produce cash, at least yet. They will, in many cases, but they're riskier just because they don't produce cash.

If I were to allocate money to the space, I would own large-cap stocks and a good selection of mid- to smaller-cap companies that are actually producing.

Bodrovics: John, when you're talking about how you're valuing those larger-cap stocks, what kind of metrics are you using to really try and understand how they're undervalued at this time?

Hathaway: It comes down to what I've been talking about, cash generation and free cash flow yields. The companies can't spend the money they're generating. It's a great situation to be in. I mean, I could give you other things. You could look at price-to-net asset value. You could look at price-earnings ratios, very traditional things, price-to-cash flow, enterprise value (EV) to EBITDA.2 But I mean, one thing that we talked about recently is that EV to EBITDA for the industry generally is around 8x, which is not bad. Compare that to the S&P 500,3 it's about 18x. Again, you could just look at a straightforward metric like EV to EBITDA. The gold mining group is half as expensive as the standard variety component of the S&P 500 (see Figure 7, Gold, the Simple Math).

Bodrovics: Perfect. When we're looking at the smaller- and middle-tier companies, I'd like to get your thoughts about a single asset company and the reasons the market might possibly discount those.

Hathaway: Typically, that's because those companies would be located in jurisdictions where there's significant headline risk. I'll give you a name, just as an example. You take something like Torex [Gold Resources]1, which we like and own. They are located in a part of Mexico that's had some social license issues. Torex does a great job of this, but they're still hurt by the headline risk of being located there. If Torex were part of a larger company like Newmont or Agnico Eagle, that headline risk would go away.

In my mind, the single asset discount, which is real and it's not just for Mexico, you could talk about companies that are located in Canada. Another name that comes to mind is Pretium Resources.1 There's always a magnification of every little glitch for a single asset company that you don't get with an Agnico, Barrick or Newmont.

Bodrovics: John, are there any other assets that you're looking at besides gold and silver that make for a very asymmetrical bet right now?

Hathaway: The answer is no. I'd like to sound more open minded about it, but the setup for gold is so incredible. It's the best I've seen it in my 20 plus years of gold investing, if you think that the thesis on gold is correct and that the price moves higher over the next 3-5 years given that interest rates can't go up, the dollar is going to weaken. You don't have to talk about inflation or end of the world stuff to get excited about the gold space. I can't think of another time in the gold space when the setup has been as compelling as it is right now for owning gold mining equities.

Bodrovics: It is not a bad thing to be focused on one thing. I'd like to get your thoughts, John, on why you don't think that Bitcoin is a threat to gold.

Hathaway: People who like Bitcoin, people who like gold, are coming from the same place. They don't trust central banking; they don't trust paper currency. I just feel like it's like a losing proposition to get into a battle with people who like Bitcoin and simply say gold is better, or for them to say Bitcoin is better than gold. I just don't see the point of chasing your tail about that. I think they both have merit. I saw where Stan Druckenmiller just came out and gave a thumbs up to Bitcoin. I can see Bitcoin doing well. Not for everybody. It's more for people who are millennials, tech-oriented, Silicon Valley, etc. But it's not going to displace gold. It's much smaller.

Gold has a four-thousand-year history of protecting capital. Bitcoin is new. It may also protect capital and may have a lot to recommend it. But again, I just shy away from getting too caught up in the gold versus Bitcoin argument.

Bodrovics: Is there anything that we haven't touched on that you think is very important for our audience of gold investors, gold bugs to understand?

Hathaway: Gold is so under owned and it's still hated. It's not mainstream. You're fighting city hall. Nobody wants to get on board with it. It represents career risk for somebody in a straightforward investment firm, so it is considered a fringe investment strategy. From time to time, it's going to get knocked down a peg or two as we saw recently with the announcement that Pfizer has come up with a vaccine, which is great. I mean, who doesn't want a vaccine? So the quants just jumped all over that because it's a pairs trade.4

Time will tell. But to me, the possibility of a COVID vaccine does not change anything of what we've talked about in terms of low-interest rates, negative-interest rates, a weaker U.S. dollar, the fiscal picture being dire for the U.S. and other Western democracies. Just remember that gold, for a long time, has been considered a fringe strategy that is in some ways unfriendly to the orthodox thinking of mainstream investors.

For those of us who are supportive of gold, you're going to be fighting city hall all the way from $800 to $5,000. And I don't mind doing that. I've been doing it for a long time. But just remember that you won't get a lot of agreement from the consensus on the opportunities that gold represents.

Bodrovics: Excellent. In doing research for today's discussion with you, I came across you saying something about basically identifying your time and your ability to write your newsletter relative to where we are in the gold market. Are you still able to write it, or are you too busy to be able to do it right now?

Hathaway: No, I'm never too busy to spout off. I try to write four times a year, maybe more if necessary. I am basically trying to explain it and convey the investment rationale for investing in gold. You know others do it very well, but I think it just goes with the turf. You have to explain yourself all the time because gold is such an out-of-favor investment idea.

Bodrovics: Is there somewhere that our listeners can be able to read that?

Hathaway: Sure, all you have to do is go to the Sprott website, which includes everything I have said recently.

Bodrovics: Excellent. We really appreciate your time today, John, and look forward to reading your newsletter. Thank you very much.

Hathaway: Tom, thank you.

This podcast is published with the permission of Palisades Gold Radio. This podcast is for general informational purposes only, nothing on this podcast should be taken as investment advice. Guests on this show are not compensated for their appearance. Listeners are urged to educate themselves and make their own decisions, do not base any investment decisions on the information contained.

1 John Hathaway is Senior Portfolio Manager of Sprott Gold Equity Fund (SGDLX). In this podcast, he mentions gold mining companies Newmont, Agnico Eagle, Barrick Gold, Torex Gold Resources and Pretium Resources. As of 9/30/2020, these companies represented 2.58%, 1.28%, 3.17%, 2.73% and 1.36%, respectively, of the total net assets of Sprott Gold Equity Fund (SGDLX). Portfolio holdings are subject to change and should not be considered a recommendation to buy or sell individual securities. 
2 The EV/EBITDA ratio is a popular metric used as a valuation tool to compare the value of a company, debt included, to the company's cash earnings less non-cash expenses.
3 The S&P 500 Index is an index of stocks issued by the 500 largest U.S. companies. You cannot invest directly in an index.
4 A pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement.

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Past performance is not a guarantee of future results.  All data is in U.S. dollars unless otherwise noted. Sprott Gold Equity Fund invests in gold and other precious metals, which involves additional and special risks, such as the possibility for substantial price fluctuations over a short period of time; the market for gold/precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. The Fund may also invest in foreign securities, which are subject to special risks including: differences in accounting methods; the value of foreign currencies may decline relative to the U.S. dollar; a foreign government may expropriate the Fund’s assets; and political, social or economic instability in a foreign country in which the Fund invests may cause the value of the Fund’s investments to decline. The Fund is non-diversified, meaning it may concentrate its assets in fewer individual holdings than a diversified fund. Therefore, the Fund is more exposed to individual stock volatility than a diversified fund.


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John Hathaway
John Hathaway, CFA
Managing Partner, Sprott Inc.; Senior Portfolio Manager, Sprott Asset Management USA
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