Disclaimer: I own, through a company I control, 10000 shares of MML and intend to likely increase this position in the future. This article is for educational purposes only, please do your own diligence, as this does not constitute investment advice. Full disclaimer can be found HERE.
This article is part 1/3. Here are the links to Part 2 and Part 3.
It sometimes happens in the life of a value investor to find what looks like a truly abnormally good opportunity. A gold mining stock with stable and growing earnings, no debt on the balance sheet, good and improving macro perspective for gold in general.
So far nothing exceptional, with gold rising the last few years, all gold miner had growing earning and most of them have paid down some debt. So what made me call this abnormal?
I started the normal due diligences on the company. The P/E is also below 4, oscillating between 2.5-3.5 most of the time. And the balance sheet is actually so flushed with cash that the net debt cover 50% of the whole market capitalization. And every quarter, the company adds to its cash account another 12% of its market cap. So should the same results persist, it will accumulate to its cash account the entirety of its current market cap in just 2 years.
Despite all that, the stock stays stubbornly low and its price is largely flat, although with some volatility. Even after the company started to distribute dividends. Even when good news keeps coming. This is despite gold and inflation being the topic of heated debates for months now.
When such stock and company appears on your radar, the more you learn about it the more puzzled you get. I am not at all a believer in the efficient market theory (that's pretty incompatible with being a value investor), but still... How can I be the only one to see this? What am I missing? What's the catch?
To be honest, with this one I became really paranoid. And so I read more into it. Does the accounting seem honest? How long has the company been operating? Are they under threat of massive litigation? Are there hidden liabilities? Who is the management team?
And so on and so on. Ultimately, the question is "Does the jurisdiction really justify such low multiples?"
Just as a reminder, multiples means the ratio given by market to the company. Is the company worth 4 times, 10 times or 35 times its earnings. Depending of the market opinion on that, a stock price can fluctuate widely without the company fundamentals varying. Generally, low multiples, like a P/E of 4 (instead of the more reasonable 10-15) means that the market expect the company or the whole sector to be in trouble any time soon.
But the more the responses come back positive or at worst, okay, the more perplexing the case became. And exciting. Could this actually be real? Is it just a case of the market being overly pessimistic?
At last I had to admit, this looked like a tremendous opportunity. And so I felt I should share it with you. I also hope that by sparking some interest into that company, I can get feedback from fellow investors and analysts who might point out me to something I am actually missing. Because I so far failed to find a justification for the low multiple compared to its industry peers. But considering how strong the difference between its current market capitalization and its financials, I will really, even more than usual, strongly recommend my readers to do their own research.
But first, credit where credit is due, I have to thank Tim Staerose for pointing out this company to me, in this article. If you are looking for truly unconventional value investing in emerging markets, Tim is a gold mine (pun intended) of interesting ideas.
So the company I was talking about is Medusa Mining Limited (MML), trading in the Australian Securities Exchange. This is a gold miner operating in the Philippines.
I will write in a follow up post a detailed analysis of the company's financials, but here are a few highlights to show you why I am interested.
Market capitalization: US$126 million
Cash on the balance sheet: US$79 million
Total assests: US$103 million
All liabilities: US$29 million
Estimated duration of the mine (at current production rate, with proven and estimated reserves): 16-26 years
Net profit after tax: US$40 million
P/E ratio: 2.62
AISC (All-In-Sustainable-Costs): $1250/ounce of gold
So the company is quite literally minting money every month, and will keep doing so as long as gold price stays above $1250. It has a lot of cash, and its net debt is covering more than half of its current market capitalization.
If it keeps going on the trajectory it has had during last quarter, the net debt will reach the current market cap in only 1-3 years. So the company might become very soon a net-net, I would say around 2022-23. Most value investors will tell you that net-net companies have become so rare as to be virtually extinct since the time of Ben Graham. I am not so sure myself after reading MML reports. In fact, I lately keep finding quasi net-net companies in emerging markets.
So even without being a gold bug, you might be interested in looking at it simply for its extraordinary balance sheet, good earnings and cheap price.
But lets just go back a little, and give a look at the macro environment. Medusa (MML), being a gold miner, is highly dependent on gold price. This is especially true as MML is an unhedged miner, so it sells its products at the daily market price, instead of long term contracts. This is good if gold goes up, but bad if it goes down. Hence the importance to judge how likely is gold to, at the very least, maintain its current price.
Ultimately, gold is an insurance against currency devaluation or destruction. It does generally well in periods where central banks print more money. As I am sure you know, the Fed have been quite busy lately. To the point the last data points start to look a little bit too vertical for my taste. Other central banks are more or less doing the same, so it is not just an American problem.
Just look at the graph below. To simplify it, it mostly mean the amount of money in circulation (you can learn more on Investopedia HERE). It started to increase slowly in the 70s, accelerated in 2000, but was still growing at relatively stable rate. In 2020, not some much, with stimulus spending sending the money stock almost vertical...
Granted, gold is not always a perfect hedge for inflation, but considering the recent 1.9 trillion stimulus bill, probably followed by another 2 trillions in an infrastructure bill, and I assume some other stimulus in a form or another, this all adds up. And it comes on top of good old-fashioned deficit spending that are partially monetized too. At some point, these extra dollars will start entering the real economy and create some sort of inflation. And after all, this is what the Fed publicly announced it wants to achieve and is not worried it might get out of control.
In practice, the strongest correlation is between gold and real interest rates. For more details and explanation of the link between gold and real rates, I warmly recommend the work of Jesse Felder, from which I have personally learned a lot.
Gold has reacted just as expected to the last large balance sheet extension, from 2000 to 2011, to then retract to a higher plateau. I would not be surprised to see a very volatile gold price over the next few years, with a new plateau around the $1700-$2200. Even if gold price crashes, I could see it stabilizing around the $1300-$1400 range, but hardly going back to pre-2009 levels. At least not with almost every government on Earth busy increasing the monetary volume and doing more stimulus.
Obviously, if you think that gold is just a useless metal with no monetary value or no quality as an inflation hedge, you will not be interested in a gold miner. But you might be looking at adding to your portfolio an asset that does not correlate much with anything else over the long term. Or you are worried that the currency of your country is going down, even if the dollar will hold on, and gold exposure is a way to hedge against that risk. Recently the citizens of Venezuela or Turkey have rediscovered the virtue of gold for capital protection when currency is aggressively devaluated.
Overall, I think a little bit of gold in a portfolio is a good way to reduce volatility and get some optionality in case of inflation. But why a miner instead of the metal itself? Well basically, miners are a levered bet on the commodities they produce. This is due to the way the miners make money. Let me resume it in a simple example.
A miner produces an ounce of gold at a cost of $1200. I usually use, if available, the AISC (All-In-Sustainable-Costs) to have an approximate measure of the real cost of production. When gold sells at $1400, the miner makes $200/ounce produced.
Production cost 1200 1200 1200 sell price 1400 1600 2000 profit 200 400 800 profit increase 100% 400%
If the price increases by $200, only a relatively small 16% increase, the profit per ounce doubles. If the price increase by $600, a 50% increase, the profit quadruples. Obviously the same goes the other way, if the price of gold stays below the production cost for too long, the company will not only lose money but go bankrupt and take all your money with it.
This mechanic is why a small allocation of the portfolio can bring strong results with miners. With a miner, you have a downside risk of 100% (bankruptcy), but an unlimited upside potential. In addition, when a commodity price has been changing strongly for a while, the miners valuation multiples tend to grow too, compounding this effect.
So MML is ultimately a bet on gold price. More precisely the bet is that gold will at least stay at a stable price above $1600-$1700. With the current stock price, even if gold goes sideways for the next 10 years, MML is going to produce a lot of cash flow.
If gold skyrockets, obviously, I will be very happy and able to congratulate myself for my cleverness.
The only circumstance where MML could be a bad bet in regards to gold price, is if gold crashes and stays for years at $1300/ounce or lower. Then the leverage effect of miner margins will likely mean a large loss of capital for its investors. The current cash on the balance sheet means the losses would likely not be total, but they still could easily go up to 50-70% in that scenario.
So before going deeper into MML itself, it is important you decide what do you are worried about. Are deficit spending, inflation and massive stimulus your concerns? Or do you think that deflation is at the horizon? And do you already have a portfolio with hedges against inflation?
Depending of your responses, you might want to look at underpriced miners, especially gold miners, or stay away from them. I will continue the analysis of MML in part 2.
As always, it's up to you to decide, I only write for fun and to exchange ideas with fellow analysts. See a more complete disclaimer HERE.