SA Interview: Investing In The Gold And Silver Sector With SomaBull

Summary

• SomaBull has been investing in the gold and silver sector for almost 20 years, has maintained a strong track record of outperformance, and currently is a research consultant for high-net-worth clients investing in the precious metals market.
• Why we’re in the early stages of a multi-year bull market for gold, why Bitcoin and Gold can co-exist without disrupting the other’s path and how to gain an investing edge are topics discussed.
• SomaBull shares a long thesis on OceanaGold.

Feature interview

SomaBull has been investing in the gold and silver sector for almost 20 years, has maintained a strong track record of outperformance, and currently is a research consultant for high-net-worth clients investing in the precious metals market. He believes the gold mining stocks are on the verge of a substantial move higher. Join The Gold Edge to learn more about the incredible opportunity in the sector. We discussed the differences between development stage vs producing miners and red flags to look out for in mining projects.

Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?

SomaBull: My investment strategy is simple: Identify undervalued companies, sectors, and asset classes with exceptional fundamentals, and then buy aggressively.

The idea is to minimize risk, but not reward.

Specific stocks or entire sectors can become undervalued (sometimes significantly) due to the periodic inefficiency of the market. Scour for those opportunities, and then invest accordingly.

Anyone that deploys that strategy is bound for long-term success in the market because fundamentals are the ultimate driver of prices.

I don’t believe in drastically overpaying for growth. That works in a bull/bubble market like we are in today, but when the tide goes out these stocks eventually revert to fair value or below. Fundamentals don’t currently support most valuations in the market.

I’m heavily focused on the gold and silver mining sector because there are incredible opportunities in these stocks.

SA: You believe we’re in the early stages of a multi-year bull market for gold – what are the drivers behind this and what are the best ways to play it? What is your outlook for silver?

SomaBull: My bullish investment thesis on gold is based on the fact that:

1. U.S. (and global) M2 is increasing exponentially, and gold will keep pace with this growth rate, and

2. The negative real interest rate environment will continue.

If the Fed raises rates, the interest on the national debt will increase. Not subtly either. The U.S. government projects interest on its debt will surge from ~$300 billion annually this year to over $900 billion per year by 2031, and that’s assuming a slow and steady rise from 1.6% to 3.5% on 10-year Treasury yields over the next decade. Or, to put it another way, that assumes the average interest rate on the debt will move gradually from 1.7% to 2.7% from 2021 to 2031.

What happens if that uptrend in rates isn’t gradual? What if the average interest rate on the debt increase to over 6%, which is where it was twenty years ago? How does the Fed raise rates without causing the deficit and debt to grow out of control? You have to ask these questions in this environment when inflation is running well above targets.

The Fed will need to let inflation run hot and the money supply rampant to keep devaluing the dollar, which means negative real interest rates are here to stay. Gold thrives in this environment as its purpose is to protect purchasing power.

Buying physical gold is the safest way to play this bull market, but the gold mining stocks offer the best risk/reward by far.

My outlook for silver is even more bullish than gold, as silver is being driven not only by investment demand but also by increased industrial demand.

SA: Can Bitcoin be considered a “digital gold”? Why or why not?

SomaBull: No, Bitcoin can’t be considered “digital gold.”

Gold is a $12+ trillion market, has been considered a form of money for thousands of years, and is a proven inflation protector.

Bitcoin is an $800 billion market (one could argue that’s a bubble valuation as well), is still immature and hasn’t been tested over centuries and centuries, and so far, we don’t know whether it’s a true hedge against inflation.

Those suggesting to others that they should buy Bitcoin often add the caveat to only invest what one can afford to lose. When have you heard anyone say that about gold? Major U.S. brokerage firms consider Bitcoin a highly speculative asset class that is extremely risky and should only be traded outside a long-term investment portfolio. I believe that answers the question right there. If Bitcoin were truly digital gold, it wouldn’t have all of these warnings attached to it.

Having said that, I think too many investors are turning this into a competition (Bitcoin vs. Gold), which isn’t necessary. Both can co-exist without disrupting the other’s path.

I look at Bitcoin as another asset class that investors can use for diversification, not something that’s replacing gold. Think about the relationship between silver and gold. Many investors in the sector own both metals and don’t look at the two as competing against each other. It’s the same idea with gold and Bitcoin.

SA: Can you discuss how your extensive knowledge and experience provides an edge and helps you identify opportunities/catalysts before most other investors? Can you give an example of an idea you found this way that worked out?

SomaBull: If a storm is coming your way, you know the likely outcome even though that storm hasn’t hit. That’s because you are looking forward, anticipating the result, not backward at where the storm has already been. With investing, it’s a similar concept.

It’s about interpreting the data, and there is a wealth of it at everyone’s fingertips. Anyone can gain an edge over “the average investor” if they put in the time and effort. Ambition is the differentiator. I’m trying to get to the core of these companies, breaking them down, analyzing them piece by piece, stress-testing the thesis to make sure the model can hold up under pressure and determining what could break it. Most importantly, I’m taking all of that data and looking ahead to project what’s coming, not behind at what’s already occurred, in order to determine if it’s a sunny outlook or a gloomy one.

I’m not doing anything others can’t do themselves, but obviously, when it comes to the mining sector, extensive knowledge and experience certainly help one to better sort through all of the information and pick out what’s important and what isn’t.

One example was my bearish outlook for Kirkland Lake Gold (KL) in 2019-2020. The company’s Fosterville mine has been the flagship operation and generated the majority of cash flow over the last several years. Investors were valuing KL as if Fosterville had 10+ years of ultra high-grade reserves, but the reality was that the high-grade reserves were dwindling and only supported 3-4 more years of ~600,000 ounces of gold production. Exploration drilling wasn’t turning up anything of substance either. The writing was on the wall, and I warned that production from 2022 and onward would fall off a cliff. As expected, Kirkland’s updated 3-year guidance calls for a dramatic decline in Fosterville, but they decided to reduce output this year to smooth out the drop. The stock substantially underperformed the sector since I made the call as the bearish thesis played out.

SA: What are the differences in analyzing development stage vs already producing miners in terms of valuation, financial modeling, etc.? Under what market conditions or outlook is it better to invest in a certain type of miner (such as development) and why?

SomaBull: Development stage companies are still either proving up their project(s) or on the verge of construction. Both of which have considerably more risks than a company that is in production and generating cash flow. Therefore, developers should always trade at a discount to their NPV. How much of a discount depends on several factors, including the level of the most current technical study and whether there are reserves or only resources.

A company in the PEA stage with only inferred resources should trade at a deeper discount to a miner with proven and probable reserves on their project and a bankable Feasibility Study. Derisking a project brings more value.

Determining valuation also depends on the level of exploration success. Many of these developers are still actively exploring in and around their projects, and a sizable increase in the resource could greatly impact the NPV and overall valuation of the company. Drill results do give strong hints of whether the resource will grow and by potentially how much.

Developers are generally more volatile, and in an environment where liquidity isn’t flowing normally, are prone to underperform producers. Developers need the capital markets to keep moving projects forward. If you cut off those sources of funds, stock prices can drastically underperform as the advancement of projects grinds to a halt.

For producers, modeling is different as they generate cash flow and should be valued at least at the NPV of their assets, and above NPV if there is exploration success. They are also typically better insulated during downturns; how much so depends on margins.

All boats float in upturns.

SA: Are there any common denominators in terms of successful management teams or mining projects? What are red flags to watch out for?

SomaBull: I will answer the last question first.

For management teams, it’s simple: watch out for those that consistently overpromise and underdeliver. They are the bane of the mining sector and serial destroyers of investors’ capital.

Mining is a tough business, but successful management teams always know how to address and overcome problems and typically will appropriately set expectations. It comes down to operators vs. promoters. Watch out for the promoters, as they promise the sky but rarely deliver.

For mining projects, there are a host of red flags to be on the lookout for. For example, jurisdictional risks, potential grade variability, low-grade deposits being promoted by companies even though they will never see the light of day, the same goes for high Capex/low return projects, potential issues with recoveries due to the metallurgy, environmental risks (which are more important than ever at this time) that could prevent a project from being built, to name a few.

SA: A recurring question in this interview series is about the mispricings created by the coronavirus and its short and long-term impact – can you weigh in on this?

SomaBull: Mispricings work in both directions. I believe companies are adjusting to this new normal and learning how to adapt to a world where COVID-19 could be a permanent fixture. As Ray Dalio stated, the pandemic has created new opportunities that didn’t exist before and is leading to innovation, including how people work and interact. Profits are returning as businesses adjust, and I don’t see the level of undervaluation in certain sectors of the market (e.g., retail, restaurants, etc.) like last year.

But this economic revolution is still evolving, so businesses will need to keep pace to remain successful. I see investors mispricing more to the upside, especially companies that have been some of the biggest beneficiaries of the pandemic. The transformation of the economy is occurring rapidly, which is the greatest risk to every company.

SA: What’s one of your highest conviction ideas right now?

SomaBull: If I had a dart and put my 10-15 favorite gold mining stocks up on the board, I would have a high conviction on any company that dart hit. That’s how extraordinary the value is in the sector at this time.

But one at the very top of my conviction list is OceanaGold (OTCPK:OCANF). OCANF has been one of the worst-performing gold stocks over the last several years, as the Philippine government didn’t renew the mining license for the company’s Didipio gold/copper mine back in 2019. I warned at the time that this event wasn’t priced into OCANF, and the stock was a sell. The company was also struggling with its Haile gold mine in the U.S., putting even more pressure on the stock.

However, back in July of this year, the Philippines renewed the mining license for Didipio, and the operation is ramping back up. Didipio is a very high-margin gold mine thanks to its copper credits, and it’s expected to produce 120,000 ounces of gold annually at an incredibly low AISC of $200-$300 per ounce.

Jurisdictional risks might appear high with OCANF, but its other producing mines are in the U.S. and New Zealand. It’s also unlikely the Philippines will suddenly reverse its decision on Didipio.

Haile is still a work in progress and is the greatest risk to the bullish thesis, but the company just brought in the former GM of the Detour Lake mine to be the new GM of Haile, which I think sets up the operation for more success in the future. If that assumption is incorrect, Didipio back online more than offsets any future disappointment at Haile.

The market is also not pricing in the stellar exploration results at the company’s WKP discovery just 10 km north of the processing plant at its Waihi mine in New Zealand. OCANF has reported exceptionally wide, high-grade drill holes at WKP.

The Martha Underground mine at Waihi is also ramping up.

Cash flow is coming, as Didipio ramps up, as does Martha Underground. Again, we are looking forward, not backward.

Didipio alone is worth the price of admission, as the market cap of the company is only US$1.25 billion. I expect a sharp rerating over the next 6-12 months.

I think OCANF is likely an acquisition target by many companies in the sector.

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Thanks to SomaBull for the interview.

SomaBull is long OCANF.