Why Gold Mining Companies Habitually Destroy Capital (w/ James Rasteh)

Why Gold Mining Companies Habitually Destroy Capital (w/ James Rasteh)


JAMES RASTEH: I’m James Rasteh from Coast
Capital Management in New York. We are fund that takes a private equity approach
to investing in public companies. And what that means is we look for and invest
in companies that have important positions in fundamentally profitable industries, but
that have very low valuations on depressed earnings. We then work with the very best managers and
experts on that company, and sometimes on the industry that we’re investing in, to put
together a turnaround plan and a value creation plan for the company that we invest in. We make long term investments. And we create consensus around our plans among
our fellow investors. I started looking at the sector from a personal
perspective. I was interested in having some exposure to
a financial instrument that would protect me from a likely bought of inflation at some
point down the road. We’re quite agnostic on the price of gold
and not a gold bug at all. But I’ve been struck by the prevalence of
bad management and onerous cost structures imposed upon the gold mining companies that
we look at. We’ve been fascinated with the gold mining
sector in that, basically, that the mid-cap miners, if you will, seem to trade at an extraordinarily
large discount to their larger cap peers. And that’s on earnings that are depressed
because of a long history, and a protracted and continued history of capital misallocation
toward exploration projects, overly generous management compensation structures, very large
and unnecessary and overly compensated board members and board structures as well. So when we look at the sector, it seems to
us as though there’s been a breakdown in discipline in how many companies in the sector are managed. And we think that there is room for an actively
engaged investor to come in and invest in companies that most benefit from a rationalization
of their cost structure, a sale of non-core assets, or perhaps a sale of the overall company. Very difficult for a bottom up fund manager
like myself to formulate a conclusive view on the macro trends affecting the sort of
ebbs and flows into specific industries. But, certainly very cognizant of the fact
that a lot of historical investors in gold seem to have allocated capital to cryptocurrencies
and to Bitcoin over the past few years. That’s really been the preferred instrument
for a lot of investors to bet against potential inflation or an erosion of the value of Fiat
currencies. These gold mining companies happen to be,
in large part, headquartered in Canada. And a lot of capital that would have historically
flown toward gold mining companies seems to have flown into sectors that have garnered
much greater interest in Canada. Cannabis companies, believe it or not, being
a case in point. And, in general, I would say that the management
teams in the gold mining sector have given investors every reason not to invest in their
companies. Right? Management teams in this sector have an extraordinary
track record of destroying capital. And that capital is being destroyed basically
through terrible investments in exploration projects, but also really destructive M&A
over the past few years. So by way of example, the whole sector right
now has about $225 billion in market value. And most of the companies in the sector are
publicly quoted. So for about $225 billion, you could buy every
single gold mine in the world just about. Right? But the top 20 players in the sector alone
have destroyed $157 billion worth of capital just only over the past 10 years. This extraordinary mismanagement track record
is the biggest reason I can think of why investors have shunned this sector and why they will
likely continue to shun the sector unless important changes are made. And we’re investing in the sector to affect
and to bring about change. Investors have allocated to the sector with
on average pretty terrible results historically. Right? Since 2006, I think the price of gold has
almost double, right? And the average company has lost 50% of its
equity value. So investors would have been right to avoid
the sector. And that’s what’s gotten us to a point where
valuations are near all-time lows. The price to cash flow that this sector is
trading at, particularly among the mid-level miners that we look at, valuations are currently
at 30% on a price to cash flow basis of what they have been on average over the past 20
years. Why now, you ask? Here are two reasons. One is in 2020, starting in 2020, almost every
major gold miner in the world will have entered a period of declining reserves and productions. Right? And so you think, all right, well, maybe they
can offset this declining reserve and production through new discoveries. Well, here’s fact number two. We’re not finding new gold. OK? Last year, we spent three times as much CapEx
looking for new gold reserves around the world as we had spent in ’95, three times as much. We found only 5% of the gold that we found
in 1995. And the quality of the gold that we found
was 50% measured in grams per ton of what it was in ’95. So the majors are running out of gold. They’re not discovering any new gold. The only way for them to replace those reserves
is through consolidation. And by the way, there is an extraordinarily
powerful economic rationale for consolidation. In fact, there are many. But here’s one of the most powerful. As a major gold miner, you are trading at
twice the multiples on price to net asset value, price to cash flow, whatever metric
you want to look at. On average, you trade at a 100% premium to
the smaller players in the space. And so, financially speaking, it certainly
makes all the sense in the world to consolidate the sector. And then when you think about the fact the
smaller miners have lower margins because they’re encumbered with onerous and unnecessary
cost structures, all of which at the GNA level can be done away with upon consolidation,
you look at an extraordinarily powerful rationale for consolidation. And we think that consolidation has to happen
and has to begin to happen before 2020 lest the majors in this space continue to decrease
in size. There are many companies in the sector that
spend over, almost, and in some cases over 100% of EBIT on GNA. Right? And they trade at half the multiples of the
major players in this sector. Right? You remove GNA and many of these companies,
you’d double profits. If you look at the number of gold mining companies
in any given market cap range, say, maybe $1 to $5 billion, the gold mining sector has
three times as many companies than any given market cap range as producers of other metals
in the world, some of which have bigger end markets in terms of yearly sales. Right? And so this is a sector that, it seems to
us, particularly in the mid-cap range of this space should have a third of the companies
that it currently does. So you’re looking at many, many dozens of
transactions that need to happen. Just over the past 10 years, the top 20 companies
in the sector have destroyed $157 billion worth of capital. Over the same frame, they’ve made almost $130
billion worth of cash. Now we’re looking at pretty stratospheric
numbers. And the way that that capital has been destroyed
is by investing in new and Greenfield projects that have yielded very little and, in fact,
have yielded zero return on capital. OK? And then, here’s another big problem with
the sector, which I think is maybe the root problem, is that the management teams in the
sector have very low ownerships of the companies that they lead. Right? Average insider ownership rate– management,
and top managers, founders, what have you– is about 0.4%. That’s a fifth of the next lowest insider
owned industry that we’re aware of, which happens to be in the natural resources space
as well. So these management teams really aren’t incentivized
based on share price performance. But their yearly cash bonuses– which tend
to be very generous– are calculated based on how large the reserves of the companies
are, and how large the production is, and how large the production profile is. So what happens is when the price of gold
goes up, the share price of the company might go up, the cash flow certainly go up, the
bankers throw a lot of capital at these companies. They use their share price and their cash
flow and that capital that’s newly available to them to buy the biggest gold mine that
they’ve been looking at buying and that they’d be interested in buying and adding to their
collection of assets. And for maybe a year, they make a much higher
compensation. But when the price of gold then goes down,
their cash flows dry out, their share prices decline. And now they have leverage to contend with. And they could potentially face liquidity
problems, right? And so they sell the very asset that they
had bought often for pennies on the dollar. And you rinse and repeat this process over
a cycle, you end up with an industry that– even though fundamentally, very profitable
at the operational level– will, through an extraordinarily nonjudicious allocation of
capital and business development, destroy the kinds of capital that this industry has
destroyed over time. We take a long-term perspective to investing
in this sector. And our investment time horizon will be anywhere
from two to five years. If you’re looking to invest in a company with
a view to improve the management and the performance of the company, you have to really give it
time to work. And very often– and this is the bane of my
existence– things go against you before they start to go in your favor. Right? So I think it’s really primordially important
to give the average company that we’re looking at at least two years to work out. We are not operators. And ultimately, when you buy into a company,
you’re buying into an operation. And how that operation performs will determine
how well you do as an investor. So we work with the very best operators and
the very best managers in the sectors that we invest in to vet the quality of the assets
that we’re buying into. In the case of gold mining companies– which
happens, obviously, to be an area of interest for us– we use the greatest management teams
in the sector and the greatest geologists that these managers have a long history of
working with to vet the quality of the operations that we’re buying into. Certainly the safety of jurisdiction ends
up being a primordially concern. But then we will also have a very specific
and well-defined perspective on what could and should be done differently with the company
to create value for investors. What are the non-core assets that this company
has been plunking good capital into that will, for the company itself, earn zero return on
that capital over time? And, therefore, what are the assets that should
be sold? Should the company itself be sold? Who are the likely buyers? Why? How? What is the rationale? How do we go about putting all of that into
place? We find that the sector experts that we work
with help us develop an incomparably richer perspective on the companies that we invest
in than we could ourselves alone by just only studying the financial data available to investors. I think that investors in the sector on average
are pretty keen for change. I think investors understand that consolidation
needs to happen. I think investors understand that capital
needs to be spent a lot more judiciously. I think investors understand that there is
a lack of sophistication in the financial decisions that have been made and that continue
to be made by the companies in the sector. So our work is to aggregate the thoughts of
the most competent leaders in the sector and the greatest, I would say, experts on the
very companies that we’re investing in, put together a detailed value creation plan for
the company at hand, and create consensus among our fellow investors around our plan. And to the extent that we invest in great
companies that are badly managed and have very low valuations on depressed earnings,
usually we find that our fellow investors share our frustration and share our desire
to see productive change and will be very interested in engaging with us in pushing
for some of these changes. The compensation that these CEOs work toward
and work for has very little to do with the share price performance and with value creation
and return on capital. And it has a lot more to do with the growth
and the reserves and the assets that the company has and the production rates that the company
has. And so over time, there’s been a tendency
to focus on acquiring assets when the markets are buoyant. The gold price is going up. The cash flows are strong. The share prices are strong. Acquire assets. Market then reverses. Gold price goes down. Their share prices go down. The cash flows go down. They sell the very assets that had bought
for pennies on the dollar. And this process has, as mentioned, destroyed
a lot of value. And we’ve, over the past three years that
we’ve studied this sector, put together an advisory board that gathers well over six
of the leading CEOs in the space. These are individuals who have a clear and
exemplary track record of creating value for the investors and their companies. They’re wonderful world class advisors. They have wonderful geologists that they’ve
surrounded themselves with. They have a very developed understanding of
what are the most attractive assets to buy into and how to trade around attractive assets
whose performance has been masked by subpar management, be it financially or operationally,
and most often both. So we work with our advisors in putting together
turnaround plans for the companies that most need them. We’re very excited about the process of bringing
about change to these companies, particularly in light of the extraordinary amount of capital
that these companies have destroyed and probably, left to their own devices, will continue to
destroy. I’m not at all advocating that investors invest
in gold mining stocks period. I’m not a gold bug. We have no view on the price of gold. But we have a very large number of gold mining
companies where there’s room for extraordinary returns to be generated for investors specifically. And we aren’t quite yet at a point where those
changes are beginning to occur. And unfortunately, there aren’t enough companies
that are going from bad to better or changing their practice. The sector basically has sort of three buckets
in which you can place a company. Right? There are the majors. There are the juniors and maybe venture stage
companies. And in the middle, there’s mid-cap players,
from my perspective, that actually have cash flow, attractive operations in many instances. But the middle of the market is where the
greatest opportunities are. There’s like a company for everyone. If you like growth companies with world class
management teams and maybe above par valuation, there are companies like Randgold which is
a wonderful, very well-managed company in the sector, probably the most competent management
team. And we greatly admire them. If you like companies with very sustainable
and attractive cash flow profiles, there’s a lot of coal mining royalty companies that
we certainly think very well of. The folks at Osisko and have spent a fair
bit of time getting to know them and their operations and their perspective of the world. And we’re very intrigued and impressed with
what they’ve done. In that SSR in Canada is really in a way Canada’s
answer to Randgold. Great management team, wonderful assets, neatly
managed, focused on operations, much more importantly from my perspective an extraordinarily
pragmatic and value focused M&A strategy. But we really get much more excited about
the wonderful assets that are fundamentally very productive and cash flow generative,
but whose output and whose cash flow and whose value is being masked by consistent destruction
of capital and consistent mismanagement financially and operationally. And in that category we think Detour certainly
is one that investors should look at. And it’s a company that I think investors
should absolutely put up for sale lest they see and they continue to allow the credit
and extraordinarily incompetent management and board continue to destroy value for investors. But we think of the fact that the management
team of that company in a recent and very feeble attempt to try to defray investors’
demands and not comply with investors’ demands that the company appointed a brand new slate
of board directors with a view to put the company up for sale. They’ve proposed three new board members who–
by the way, look reasonably competent and have great backgrounds, and who should have
been appointed all along, and who would have probably not allowed the current CEO’s quote
unquote CEO’s antics to continue. They would have probably put an end to status
quo quite a long time ago. And so we think that Detour is a very interesting
case of a company that clearly should be sold. We think that Torex in Mexico, which has a
very attractive and productive mind, but has recently dealt with some labor issues that
I think have been resolved very satisfactorily. But the share price doesn’t reflect that yet. I think that that’s a very, very neat company
and certainly every timely one to look into as well. There are companies like Yamana Gold, again,
assets across the Americas, but really mostly in Latin America. A number of assets that don’t necessarily
jurisdictionally belong together. The only company in this sector whose chairman
also happens to be the CEO and has quite unchecked powers over the company saddled with an unnecessarily
onerous cost structure, and a board that’s rubber stamped management’s decisions consistently. And management’s decisions have been not always
very productive from investors’ perspective. If you look at the company, they’re starting
to really pay lip service to the idea of change and to the separation of powers and there
being checks and balances on the chairman and CEO. And the company is talking a lot more about
a focus on cash flow and return on capital, which is quite extraordinary for them. I’m not sure that has led to changes in operational
practice quite as much as it could and should. But there is evidence of burgeoning change,
which we think over time will be quite valuable and, frankly, productive. We think that the process needs to be accelerated,
not only in the case of Yamana, but for many companies across the sector. If you look at mining companies in Australia,
incomparably better managed, focus on operations, focus on cash flow generation. And any company in Australia in the same market
cap range will trade and add premium to their Canadian counterpart. Right? And the premium based on price to reserves,
to EBITDA, price to net asset value, price to book value, price to cash flows. Australian companies trade at a meaningful
premium, because they’re just operationally focused, focused on operations not M&A. They do a much better job. And their cash flow profiles are much more
attractive. And we think with that kind of discipline,
focus on operating performance, would do the Canadians a world of good. I expect that a lot of the Australians should
and, therefore, are looking at acquiring their way into Canada and bring some of that discipline
across the Pacific Ocean. That’s a very important question, particularly
when you think, again, about the fact that over the past 10 years, we’ve seen almost
doubling in the price of gold and the average companies lost 50% of its market value. Right? So these are companies that destroy capital
on that share price declines, even in an environment when the price of gold goes up. Right? And the environment that we’ve seen over the
past few months where gold prices declined from well over $1,300 to now less than $1,200
an ounce. Very difficult for a lot of these companies. The sector is fundamentally very profitable
operationally, right? The average company has $950 in all in sustaining
costs to produce an ounce of gold. Gold is still being sold for just about $1,200
an ounce, $1,180 or whatever it happens to be today. So these companies are earning a pretty good
profit on an EBIT basis for every ounce of gold produced. You then have to look at– I think that the
answer to your question really depends on the company. It depends on the amount of leverage at the
company at hand. It depends on their own sustaining costs. It depends on their CapEx needs. But our view would be that a lower gold price,
while presenting a lot of these companies with difficult if not unfathomable challenges,
I think over time to the extent that it pushes for consolidation might serve the industry
very well. If I think about the fact that the major gold
miners would trade at twice the multiples of the medium and smaller cap players in the
sector are entering into an ad infinitum period of declining reserves and production. And if I think about the fact that there’s
no new gold being discovered. OK? We had a theory of peak gold in ’07, ’06,
’07, ’09– I apologize peak oil in ’06, ’07, ’08. Nobody’s talking about peak gold. But in terms of discovery, I think that the
argument in favor of peak gold right now is much more important than the argument was
back then in favor of the concept of peak oil. So majors have twice the valuations, are running
out of reserves. And they need to, presumably, maintain, if
not increase their production to continue to warrant the multiples that they trade at. They cannot do that through discovery, which
is what they’ve done historically. The only path available to them, the only
path saving them from literal extinction, is consolidation. The reason why I think now’s the time to look
at consolidation is because we’re a year and three months away from a period in which the
majors see declining production. This is a sector that has an uncanny ability
to fail to do the right thing at the right time. And that’s why I think investors need to engage. That’s why I think the sector needs active
investors and active investments. And that’s why I think the advisory board
that we’ve put together and the process that we’ve put in place should help us create a
lot of value from companies that are currently hiding it through operational or financial
malpractice.

12 Comments

  1. My conclusion is the fiat monetary system is a failure.
    It's failed in the past, it will fail now and it will fail again in the future.
    The system is a ponzi scheme. It's fraudulent.
    It's too complex and it's discriminatory.
    And it hurts the lower classes.
    so why should people believe in a system created by Jews which only benefits the elites?
    I believe people should have abandon the us dollar and the federal banking system.

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  3. Ultimately, prodigious restructuring of production will not deliver a metal that’s not there. Hence, when the global financial debt bubble crashes resulting in a hyper-inflationary monetary crisis, gold’s meteoric response will likely boggle the imagination…it’s an even rarer commodity than most know.

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