Hurts So Good

Near the later stages of a market cycle, if I don’t feel stupid and my portfolio doesn’t hurt, I’m probably not positioned appropriately. With short-term interest rates rising considerably over the past year, my patient positioning is beginning to feel a little too comfortable. At this stage of the cycle, I should be suffering more. As such, I recently reintroduced a painful position to my absolute return portfolio – a precious metal miner.

For asset managers who are currently experiencing shiny-happy performance and congratulatory client meetings, a beaten-down miner may be just the thing needed to scratch that contrarian itch. From a personal perspective, I’ve found a good time to make uncomfortable changes to a portfolio is often when performance looks best. And there’s nothing like a precious metal miner to create the right amount of angst and discomfort!

For most of the current market cycle, the only thing more painful than holding cash has been the precious metal miners. I held several miners in 2014-mid 2016. The pain was excruciating. At one point, the miners I owned were down -30%+ after they had already declined 50-60% at the time of purchase! It was the most challenging and controversial position I’ve ever taken. Frankly, I hated it. But value is value. And as many seasoned investors will attest, the best values are rarely presented as beautiful bouquets.

I wouldn’t be human if I didn’t feel reluctant to readminister the pain. To help me cope, I started with a small weight and plan to add to the position slowly as the price declines and discount to value increases. My slow and steady approach to positioning is based on experience. Historically, once I’ve determined commodity stocks are cheap, they typically become much cheaper! Picking the bottom in commodity stocks is extremely difficult – at least for me – so I prefer buying small positions and averaging down.

Another thing I’ve learned about commodity stocks is investors love or hate them – rarely do they remain near their valuation equilibrium. With such wishy-washy investor psychology, one can expect volatility and violent booms and busts. While the commodity prices themselves are partially responsible, I believe popular valuation techniques also contribute to volatility.

Many analysts use cash flow metrics to value commodity businesses, such as EBITDAX. Although cash flow is important, when attempting to value a commodity business with a high degree of confidence, I’ve found future EBITDAX to be too uncertain and volatile.

Early in my career I decided to part ways with EBITDA valuations. Capitalizing depreciation or depletion has never made sense to me, especially for commodity businesses (reserves must be replaced to stay in business). Instead of cash flow, I prefer using a less volatile valuation technique for asset-heavy commodity businesses. Specifically, I use replacement cost. In effect, my goal is to buy a dollar of reserves (oil, natural gas, gold, timber, etc) at a discount to the cost required to replace those reserves.

For example, if it costs $300 to find and develop an ounce of gold and I can buy a proven and developed ounce for $150 in the equity market, I’m interested. Focusing on developed mines with a sufficient history in production and operating costs can also reduce risk. Accumulating reserves by building a new mine often comes with uncertain production, operating costs, and financing. In effect, instead of taking the risk of building a new mine, I’d rather buy the reserves of a developed and operationally efficient mine selling at a discount. And that’s what I’m finding today in the mining sector. Proven and funded mines that are selling below the cost to find and develop their reserves.

To be clear, commodity businesses, such as miners, are very risky and carry tremendous operating risks. As such, I focus on commodity businesses with strong balance sheets that I believe can survive a prolonged period of depressed commodity prices. It doesn’t matter if you can buy an asset-heavy business at a large discount if the company doesn’t have the balance sheet required to survive the cycle. I’ve seen many commodity companies worth much more than their stock price go bankrupt in commodity bear markets. They simply ran out of time and liquidity. Ideally, I prefer commodity stocks and miners with no debt, but they’re almost as rare as the metals themselves!

With extreme pain and discomfort, I’m back in the precious metal miners (or I should say miner). Similar to past experiences with commodity stocks, I’m assuming the miners will continue to fall and I will not be able to time their bottom perfectly. My plan is to gradually add to the position during the decline, but will not exceed my pain threshold (during the last miner bear market the weight in the absolute return portfolio peaked between 10%-15%). In addition to my pain threshold, my weight will likely be limited by the number of small cap miners that pass my balance sheet requirements and other guidelines (mine locations, all-in costs, reserve life, etc.).

While the introduction of miners will likely hurt in the near-term, given my patient positioning, I like the idea of owning asset-heavy businesses selling at a discount. In effect, I view my recent miner purchase as an investment and a hedge. A hedge against the Fed falling behind the curve (before the cycle ends) and a hedge against future central bank asset purchases (after the cycle ends).