Portfolio Review: Barrick Gold

“Inflation is always and everywhere a monetary phenomenon” — Milton Friedman

I don’t like being dogmatic about my investments. Many investors (including many value managers) have taken to buying gold in large quantities in the sure belief that currency debasement by countries around the world will erode the value of paper money. The standard paradigms of monetary theory which are the basis for this belief have been pretty fluid lately (see: St. Louis Fed thoughts on Money Velocity), but the threat of money losing its value certainly remains given the unprecedented rises in money supply. I can’t help but hear Milton Friedman’s “inflation is always and everywhere a monetary phenomenon” in the back of my mind.

Commodities are a bad investment for the long term. Commodities don;t produce anything, so you are just betting that a the supply and demand relationship will change over time and the price will rise. In fact you have to bet that the price will go up fast enough to offset the cost of holding a commodity in storage. Gold is no exception, despite its stellar performance over the last 10+ years (Performance looks difference if you look back to the early 80s).

It was with all this in mind that I made an investment in Barrick Gold (NYSE: ABX) on September of last year for $18.28 per share. The stock is down about 10% since then, having traded in a relatively narrow band all year. It is still well below its previous highs of $50+ (when the gold price was topping new highs).

On the one hand, it is hard to escape the fact that investing in a gold miner is inherently a bet on the price of Gold. What I like about it however, is that by investing in a mining business (vs. investing in the commodity directly), you get the optionality that comes along with backing a dynamic business that will adapt to the circumstances. In the short term, there is not denying the impact of the spot price on the Company, but in the long term, Barrick Gold (like most good business interests) will adapt to the environment in which it operates and adjust its operations accordingly. After all, almost no business has complete insulation from the pricing environment of the good they produce.

If the spot price rises dramatically, the Company might race to develop new assets and increase production (like it did in 2012-13), even if that means a rising cost per ounce mined. Conversely in a less favorable pricing environment (like today), the Company will be more cautious, dial back production and focus on its most cost effective assets. The halted development of the Pascua-Lima mine is a case in point.

I was looking for a good way to illustrate and visualize this, and I came up with the concept of “All-in Sustaining Profits” (or “AISP”) for a given level of gold price realized. I don’t pretend that this little model is predictive of near term results, but I think it is indicative of the long term profit potential of the current stock of mining assets.  The idea is based on the Company’s published All-In Sustaining Costs (“AISC”) for its gold core mining assets, and it simply assumes that in the long run mines that can be operated as AISC below the realized gold price (i.e. “profitable mines”) will operate at production capacity, while those which would not be run profitably will not be run at all.  AISC takes into account sustaining capex, and therefore my estimate of total AISP is roughly corresponding to EBIT.

The table below outlines the key statistics provided by the Company for its key assets for the last 3 years (2014 = midpoint of the Company’s “2014 outlook”) and shows the calculation of AISP based on realized gold prices for the respective years:

Source: Company Filings.
Source: Company Filings.

I think it is worth emphasizing again, that this is a rough and indicative measure. There are lots of issues with it, including: AISC may rise and fall over time, the Company may be able to realize lower AISC at lower production levels (i.e. my “binary” assumption of whether a mine is run or not is poor) and mines that have received heavy investment might have cash costs that are low enough to keep operating them, even if the total AISC might categorize them as unprofitable—just to name a few. Notice that despite my comment above comparing my AISP to EBIT, looking at 2013 and 2012 at the Company’s average realized gold price for those periods it represents 85% of EBIT (2013 EBIT: 4,703m) and 75% of EBIT (2012 EBIT: 6,606m) respectively.

The chart below shows AISP and production levels based on the Company’s 2014 outlook at various levels of the Gold price. If anything, I think it is helpful to note that even at very low price levels, the Company would likely still be able to run profitably in the long run, even if that means being a smaller concern, exploiting a smaller set of assets

"All-In Sustaining Profit" and assumed production at various level of gold price.
“All-In Sustaining Profit” and assumed production at various level of gold price.

Value

In many ways the “value play” in this investment has a lot more to do with the original point regarding currency debasement. If this will prove to be a great investments, then some part of that thesis will be correct. The other face of the argument is ultimately more about downside protection and safeguarding against loss (a very important factor!).

Assuming 10x long term sustainable EBIT multiple (i.e. AISP in my example), The Company would retain its full current value even if Gold prices settled around $1,000 per ounce. Again, this is not to say that if the gold price dropped to $1,000 tomorrow and stayed there the Company’s stock would not go lower, but rather to imply that if that were a long term scenario, the chances of at least breaking even on the investment would be good. If I further assume that AISP should be “grossed up” to EBIT based on it representing 85% of it (again, a very rough assumption), then the gold price level at which the long term value of ABX remains attractive is even lower.

1994

Read “Risk in Today’s Markets” by Howard Marks. It reads like it could have been published this week, but it was published on February 7, 1994. The market took a hit a few weeks later (prompting Marks to publish”Risk in Today’s Markets: Revisited“) and it was generally mixed for most of 1994. But who remembers 1994? It certainly doesn’t evoke the images of overpriced markets and subsequent busts that we associate with ‘2007‘ or ‘1999‘.

Part of the reason is the end of 1994 was the beginning of the 5-year long bull market that led to the 1999 tech bubble, with PEs expanding for around 15-20x (well within historical norms) to more than 30x (a level never before seen). Stock market valuation multiples expanded at a rate of over 10% per year for the subsequent 5 years–earnings and the macro-economy can do whatever they want and you will still be in the black with that kind of tail wind.

Does having 5 years of incredible, irrational multiple expansion justify paying elevated prices today? Seems like a classic case of ‘greater fool’ theory, or what little kids call a game of hot potato. It seems easy to answer ‘No’, but that begs the questions of what is one to do at a time like 1994. There are great benefits to staying invested over the long term; continuing to own stakes in good businesses will generate a return, even if it is a moderate one, while holding cash will not. Staying out of the market between 1994 and the bottom of the tech bubble (i.e. “waiting for valuations to come back to a reasonable level”) would have been a big mistake. If you bought a broad index in 1994 and sold it at the worst possible time at the bottom of the market in mid-2002, you would have made an 89% return. It would have been a wild rollercoaster ride, but that is actually a pretty decent return! Sustained periods of both overvaluation and earnings growth like the 1990s really accentuate this issue.

Another easy answer is to say we should only invest in undervalued assets, even if the broad market is overvalued. There is certainly some truth to that, but as it turns out, that is easier said than done. It is especially hard, given that a generally overvalued market has a tendency to push up all prices in unison and reduce the dispersion of valuations. See chart below:

 

Multiple Dispersion (Source: Business Insider)
Multiple Dispersion (Source: Business Insider)

While the tech bubble was an exception (high overall market value was mainly driven by astronomical valuations in the tech sector), generally elevated pricing environments tend to exhibit lower dispersion in valuations. This is certainly the case today, with valuation dispersion at their lowest point in over 20 years. A difficult task becomes harder.

So what is a prudent investor to do in a time like this? I try to maintain some discipline with the following goals in mind:

  • Buy securities that are fairly priced: You may not find absolute bargains out there, but if you buy the securities of companies with a solid business at a price where you feel comfortable you can earn a decent return over a long horizon,  then you protect yourself on the downside.
  • Stay invested: I struggle with this, but a little struggle can be a healthy thing. If you can avoid taking excessive risks, then making sure you earn some return on your capital will pay off in the long term. As Albert Einstein said “Compound interest is the eighth wonder of the world”.
  • Know where you stand: Just because we can’t predict where the market will go next, doesn’t mean we should pretend like all times are the same. There are times to be cautious and there are times to be courageous–It is usually best to do the opposite of what everyone else is doing (yet another difficult task!).

Let me book-end this post with one more Howard Marks memo, as he has some great comments on the very last point I made:You can’t predict, you can prepare, published on November, 2001.

More on Absolute Valuations

I felt pretty good after writing the post on Absolute Valuations a few days ago. It felt like a nugget of useful insight that had come out of forcing myself to write down my thoughts–exactly why I was hoping would come out of this exercise. It has been on my mind a lot since and while I still believe the idea has value, I am coming to think it may be overly biased by the current state of the market.

I am relatively young, and I did not experience what it was like to invest in the 70s and 80s, when long term rates were 10% or higher. The idea of getting a 10% risk-free return is completely foreign to me. Granted, inflation was a much more significant factor then, but event account for that, real rates were significantly higher than than anything I have seen in my investing career. Here is a helpful chart from a Paul Krugman post:

Real Rates since 1959

So when I say to myself that any investment must meet a basic level of absolute return for me to consider it interesting, I am inadvertently comparing it to what might be the “prevailing market rate of return”. The more interesting thing however–and what I think led me to write the original post–is that the prevailing market rate of return is so close to zero today. And zero is a special number because cash earns a return of zero. I may say I am unwilling to make an investment unless I am comfortable I will get a minimum return of 5%–that 5% is my absolute floor. But if I could get 5% risk free by buying government bonds, wouldn’t that be a silly floor to have?

There is merit in having an absolute floor, especially when valuations are high and prospective returns at historical lows. I admit, however, that as overall returns become more attractive, engaging in a more selective comparative process has a lot of merit.

Absolute Valuations

I have heard money managers I respect talk about investing as a ‘comparative process’, meaning that you should look at the whole universe of opportunities and select the most attractive ones. While there is obviously merit to this, it is ultimately not how I go about things. For one I like the time and resources of an industrial money management operation to ‘consider the whole universe’, but I also think there is a powerful aspect of risk management in limiting yourself to investments which you see as attractively priced on an absolute basis.

Portfolio Review

I think one’s “cost basis” is one of the biggest biases affecting most investors. The way professional investors are remunerated perpetuates this, but it affects personal investors just the same. With that in mind, I want to review the holdings in my portfolio and make an assessment about the initial investment thesis and whether it still holds. Hopefully this can be a periodic exercise, and hopefully it can be done independent of the entry price/cost basis of each holding.

Purpose

I have taken an active role in managing my investments for some time now. I try to be structured and thoughtful about each decision, but have not kept detailed records of my thinking so far. I often write e-mails to friends and family outlining my thinking–I know these are of little interest to them, and ultimately I do it mostly for my own benefit. It is a nice thing about investing that you can openly shares your thoughts and ideas without jeopardizing any personal value they may have for you. It is with all that in mind that I opened this account.