Look Away I’m Hideous

One of my favorite Seinfeld scenes starts with Kramer walking into Jerry’s apartment and asks Jerry to join his smoking club.

Kramer: “Hey buddy, you should come over, it’s pipe night.”

Jerry [in disgust]: “Look at your face. It looks like an old catcher’s mitt.”

Kramer [looks at his reflection]:  “My face is all craggily, it’s crinkly.”

Jerry: “It’s from all that smoke. You experienced a lifetime’s worth of smoking in 72 hours. What did you expect?”

Kramer: “Emphysema, birth defects, cancer, but not this. My face is my livelihood. Everything I have I owe to this face. It’s my allure, my twinkle.”

Jerry: “Your teeth, your teeth are all brown.”

Kramer [in horror]: “Look away, I’m hideous.”

Have you ever owned an asset so contrarian that conventional wisdom would classify it as hideous? Ideally we all want our portfolios to be beautiful – filled with investments that feel good to own and are admired by others. For me and for many investors, that’s high-quality businesses with consistent free cash flows and strong balance sheets. Companies that are growing and can be valued with a high degree of confidence. These are the type of stocks we’re all taught to know and love. Unfortunately, the market doesn’t always price great businesses at levels that allow for adequate absolute returns. As I discussed in past posts, I believe high-quality stocks remain very expensive and very risky.

In order to generate attractive absolute returns over a market cycle, there are times when it’s necessary to step out of our comfort zones. Opportunities do not always reside in our list of investment favorites. After QE3 many of the high-quality stocks I purchased earlier in the cycle began to exceed what I considered to be fair value. Instead of riding the momentum wave, I remained disciplined and reluctantly sold some of my favorite high-quality holdings. During this time, there were also certain areas of the market that were declining and out of favor. Specifically, asset heavy commodity businesses.

While there were some opportunities in natural gas producers, I was particularly interested in the carnage within the precious metal mining industry. After thoroughly researching, I determined several precious metal miners were selling at a discount to my calculated valuations. I began to buy miners that passed my financial strength criteria. My purchases accelerated in 2013 and I continued to buy (mainly to maintain positions) in 2014 through early 2016. After initially suffering losses, the miners eventually spiked higher this year causing me to sell. It was a volatile trip, but worth the ride.

From the time I purchased to the time I sold, owning the miners was one of the most challenging positions I’ve ever taken. I’ve owned many out of favor stocks in the past — investing in a contrarian manner wasn’t new to me. Why were the miners so difficult and different than other contrarian positions I’ve taken? Besides the fact that it felt like they went down daily for three years, the difficulty of investing in the miners was compounded by the isolation I felt by owning them – they were very lonely investments. No matter how low their prices dropped, few in the investment management industry or the financial media came to their defense. They were left for dead. It is difficult to explain, but there is something about miners that creates a certain emotion with many investors. It’s located somewhere between disgust and hatred.

I’m not going to try to convince anyone precious metal mining is a great business – it’s not. It’s extremely cyclical, capital intensive, and carries above average operating risks (too many to list here). From an early age, portfolio managers are beaten over the head with “miners are bad investments” in business school and in their professional lives. By the time professional investors are given the keys to a portfolio, they have been conditioned to believe mining is an awful business and should be avoided. I was taught and told the same thing. Then why in the world have I owned miners in the past and continue to have several on my possible buy list?

After researching many miners thoroughly, I discovered that yes, mining is a difficult business. However, developed mines can generate meaningful cash flow over a cycle and can be attractive investments if priced properly. There are many mines that have very long lives with the majority of exploration and development costs behind them. Developed mines are very difficult to replace. From the initial discovery, it can take a decade or more to have a large mine up and running. Grey Poupon investors clamoring for a moat should attempt to open a precious metal mine. It’s extremely difficult and extremely expensive. When precious metal prices spike, it’s impossible to flip a switch and build a mine to participate in the boom. There are times during each cycle when developed low-cost mines become extremely valuable.

I’ve also found that the cash flows of many miners are no more volatile than other commodity businesses. As a portfolio manager, why is it acceptable to own energy producers but not miners? Both industries have recently gone through severe recessions and both suffered extreme losses and bankruptcies. Both are capital intensive and both have extremely volatile cash flows. Both industries have weak and strong competitors – some survive and some don’t.  There are of course differences, but on average I believe the pros and cons of each industry average out making it difficult to claim one industry is better or worse than the other. Nevertheless, the stigma of owning miners remains, while investing in energy seems to get a pass.

I don’t have an answer to why some commodity businesses are acceptable to own by professional investors and others are disallowed. As with many things in investing and crowd psychology, it may have more to do with perception than anything else. Owning a precious metal miner suggests that you believe their end products have a use – that they’re valuable. You may be labeled a gold bug. Heaven forbid! Such a “crazy” label could cause clients to leave and reduce assets under management. For the record, I’m one of the crazies who believe precious metals have a purpose as a store of value and currency. If you dispute this try the following test. Buy 20 gold eagle coins and throw them into a crowd. It’s similar to throwing a loaf of bread into a flock of hungry seagulls.

Whenever the conventional view of hideousness prevails, I’ve found there is often value and opportunity. With the VanEck Vectors Gold Miners ETF (GDX) up 53% YTD, miners are not exactly hurting this year. However, the trend appears to have reversed (GDX was up 120% YTD in August) and my interest is beginning to perk up again. I currently have a 0% position in the miners and may require prices to fall further before purchasing, but I’m currently performing my due diligence on several. I’m very fortunate to have sold my miner position a few months ago and feel even more fortunate that I may have another chance of repurchasing. It’s one of the wonderful things about the miners and other cyclical businesses – second chances are common.

What is causing the most recent decline in the miners? Gold and silver prices fell sharply last week after the presidential election. Some investors believe a Trump presidency will stimulate the economy, increase interest rates, and strengthen the dollar. Last week Stanley Druckenmiller announced that he sold all of his gold once the election results became known. He stated all of the reasons he owned gold may be ending. He’s a very smart investor and he may be right. But with every seller, there’s a buyer. I suspect buyers disagree with Mr. Druckenmiller and would argue economic stimulus will not come free, requiring fiscal deficits, debt monetization, and higher inflation.

When buying miners, or any commodity business, I attempt to avoid making commodity price and cash flow predictions. It’s simply too difficult to get it precisely right. In my opinion, valuations based on commodity prices and cash flows are too unreliable. Instead of attempting to predict the unpredictable, I prefer to focus on the balance sheets of asset heavy companies. In effect, I want to buy their net assets at a discount to replacement value. If I can buy natural gas reserves for $1/mcf and it cost $2/mcf to find and develop that mcf, I’m interested. As it relates to miners, if I can buy a new developed low-cost mine for $500 million and it costs $1 billion to replace, that’s also something I’d be very interested in.

During periods of depressed commodity prices, commodity companies go bankrupt. It’s simply how the world works. This is why it’s extremely important to only buy commodity businesses with strong balance sheets that enable the commodity producer to survive the trough of the cycle. As an equity holder, it doesn’t matter how cheap an asset becomes if it ends up in bankruptcy court. My rule of thumb is only buying commodity businesses with debt below 3x discretionary trough cash flow. Ideally they have little to no debt, but occasionally I’ll buy commodity businesses with some debt if they have low-cost production assets that are capable of generating positive cash flow even in industry recessions.

In conclusion, the recent decline in the precious metal stocks has once again grabbed my attention. While they’re not as inexpensive as they were earlier in the year, several are again selling near my calculated valuations and are worthy of researching further. Investing in precious metal miners isn’t for everyone. They’re highly volatile businesses and stocks. The commonly held belief that precious metal miners are bad businesses and are uninvestable makes them lonely and uncomfortable investments. However, such extreme conformity and distaste can create opportunity. While it may appear hideous to outsiders, it’s often the most hated, misunderstood, and painful investments that turn out to be the most beautiful.