A Precious Metals Toll Bridge
A royalty-like play on precious metals and other critical materials.
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Value Situations is NOT investment advice and the author is not an investment advisor.
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“The best business is a royalty on the growth of others, requiring little capital itself.”
“I have said in an inflationary world that a toll bridge would be a great thing to own.”
Warren Buffett.
Gold’s recent surge to a record high above ~$2,400/oz in tandem with silver also reaching a three year high of $29+ (and within touching distance of a ~9 year high of $30+) has prompted renewed investor interest in both precious metals, which are among the best performing assets this year, with gold and silver appreciating ~16%+ and +14%+ respectively YTD:
With respect to gold, there are a number of reasons for the surge in prices this year:
“Safe haven” demand for gold amid growing concerns of a major conflict in the Middle East between Israel and Iran;
Investors seeking an inflation hedge supported by an expectation of falling real interest rates in the United States later this year if/when the Federal Reserve cuts interest rates;
Continued, near-record purchasing of gold bullion by central banks, particularly in China, India and Turkey, following strong buying last year and after record purchases in 2022;
A weakening US dollar during Q1 also contributed to gold buying, making it relatively cheaper for buyers in other currencies given that gold is denominated in USD (although the dollar has started to strengthen again recently).
The second factor above regarding real interest rates is particularly interesting and is perhaps the most significant driver of recent gold price action.
Currently the US economy is performing strongly as indicated by the latest economic data. The US labour department reported that employers added 303,000 jobs in March, or ~50% more than the 200,000 estimated for the period, while US Census Bureau data indicated “blowout” retail sales in March, with sales rising +0.7% vs. an expected increase of +0.3%. Perhaps not surprisingly against this backdrop, the latest US inflation data indicates a rising inflationary trend again, with the CPI reading for March running at +3.5% YoY, compared with +3.2% in February and +3.1% in January.
Also adding further fuel to inflationary concerns in recent weeks has been a rising oil price in response to the Middle East conflict and supply concerns, with oil up ~16% YTD (as at the time of writing). Furthermore, a range of other commodity markets have shown renewed strength this year, notably copper and other industrial metals, supported by favourable supply/demand dynamics with improving demand vs. tight supplies.
This combination of economic strength combined with supply/demand imbalances therefore suggests further inflation, or even a more severe “second wave” of inflation, lies ahead (something I’ve discussed before, here, here and here).
Despite this apparent inflationary uptrend, the Federal Reserve is still expected to cut interest rates later this year, even after last week’s more hawkish comments from Fed chairman Jay Powell in response to the latest inflation data. The consensus prior to Powell’s latest comments was for three cuts of 25 bps between now and year-end, which has now been re-set to one or two cuts towards the back-end of this year.
Further complicating the rates outlook is the US Presidential election and President Biden’s “prediction” of rate cuts this year, interpreted by some as a sign of political pressure on the Fed to reduce rates to reduce the debt burden on US voters, homeowners and small businesses.
Tying these various threads together, the recent price action in gold reflects the perceived risk that the Fed may be forced (for a number of reasons) to start cutting interest rates later this year just as a second wave of inflation hits the economy, leading to lower or even negative real rates. This would justify the investment case for gold as a both a store of value/inflation hedge and given that gold itself does not pay a yield, its cost becomes relatively cheaper in a low or negative real rate (yield) environment.
The chart below shows the relationship between the price of gold and real yields over the past 20 years, with the real yield calculated as the difference between the 10 year US treasury yield (at constant maturity) and the 10 year expected inflation rate, as represented by the 10-Year US Breakeven Inflation Rate:
Source: Longtermtrends.net.
It is important to emphasise here that it is the expectation of higher inflation rather than the actual current inflation rate itself that drives real yields and therefore gold prices.
In the chart above, real yields are presented on an inverted basis in black (right hand scale). The chart shows how real yields have recently started to reverse downwards from a ~15 year high of ~2.5% reached in Oct-23, and since that apparent reversal in real yields in Oct-23 the price of gold has risen ~20% from ~$2,000/oz to its recent highs around ~$2,400/oz.
Based on the chart, the last time real yields reversed back in a similar fashion was ~15 years ago in Oct-08, when real rates declined from a previous peak of ~3.1% to 0% and then turned negative over the subsequent ~3 years to Sept-11 during the post-GFC period. Over that same period, the price of gold appreciated from ~$693/oz in Oct-08 to ~$1,896/oz by Sept-2011, or ~2.7x over ~3 years. Applying a move of similar magnitude to the price of gold when real yields most recently peaked at 2.5% in Oct-23 and then reversed downwards would imply a new peak price for gold this cycle of ~$5,400+ over the next 3 years!
To clarify, this is not intended as a prediction, but to illustrate the inflationary/real yield expectations that may be driving the recent rise in gold prices based on market history, the latest inflation evidence, and given the clear parallels in terms of real yields peaking and then reversing from broadly similar levels (~2.5% - 3%) in Oct-08 and Oct-23.
Currently, real yields are at ~2.2%, reflecting a 10 year treasury yield of 4.6% and a longer-term breakeven (i.e. expected) inflation rate of 2.4%. If a second wave of inflation were to take hold following (or perhaps even assisted by) Fed rate cuts later this year, this gap could close very quickly as inflation expectations re-set to a higher level, driving real rates lower and thus supporting an even higher gold price.
With regard to silver, similar to gold it tends to have an inverse relationship with interest rates and real yields and is also regarded as an inflation hedge. Silver prices usually move in tandem with gold (as the YTD performance illustrates), although often with a lag and it has a clear and strong positive correlation with gold over time as the below chart shows:
Unlike gold however, silver is also an industrial metal, being used in a range of industrial applications including auto manufacturing, solar panels, and electronics and as such its performance is more tied to the broader economic and business cycles than gold.
Silver’s recent strong price performance ahead of gold is likely attributable to dual drivers of increased industrial demand as well as its safe haven / inflation hedge qualities. Indeed, silver is increasingly regarded as an electrical metal, with ~300,000 oz or approximately one third of global silver supply now used in solar panel manufacturing. Additionally, the silver market has been in a supply deficit for the past three years and the Silver Institute forecasts that the market will be in deficit again this year, with demand of ~1.2 billion oz vs. supply of ~1 billion oz. Furthermore, increasing demand for silver from the solar industry is likely to be a structural demand driver in the years ahead that is unlikely to be matched by an increase in supply due to increasing scarcity, with depletion of existing silver mines, mine suspensions and various delays and constraints (political, environmental, financial) in bringing new mines online.
Reflecting on all of the above, I believe the recent price action in gold and silver is possibly signalling a new inflection point for precious metals, which has prompted me to look for potentially mispriced plays on this theme.
My friend Harris Kupperman, aka Kuppy, recently presented A-Mark Precious Metals (AMRK) as his preferred play on the gold/precious metals theme. AMRK is an intermediary business, being a precious metals wholesaler and and direct-to-consumer trading business that buys and sells gold and other precious metals products. As such, it essentially functions like an exchange or a commodity trading house, making its profit margin on transaction volumes and the spread between buying and selling prices. Such businesses benefit not simply from the underlying commodity price, but from volatility, such as occurs during bull markets. Kuppy’s recent tweet below also conveys an important aspect of his thesis for AMRK:
A well known adage is that during a gold rush, the surest way to profits is to be a picks-and-shovels provider rather than a gold miner, given the risks involved in mining as well as the capital investment required without any guarantee of striking gold.
As Kuppy alludes to in his tweet above, in the case of precious metals markets today the picks-and-shovels plays are the intermediaries such as brokers and exchange-like businesses that can provide exposure to spikes in the underlying commodity’s price without the operational, jurisdictional and other risks faced by miners themselves. AMRK as an exchange-like business clearly fits this mould.
[Note: For those interested in Kuppy’s AMRK thesis, I’d highly recommend reading his recent write-up on it and listening to his discussion of it on the the Market Huddle podcast here].
Royalty and streaming companies are often regarded as the highest-quality way to play the gold/precious metals theme without assuming the operational and other risks. Names such as Franco Nevada Corporation (FNV) and Wheaton Precious Metals (WPM) are viewed as the best players in this regard. However these royalty companies typically trade at very high valuations (reflecting their perceived quality and advantaged business models as capital-light, high margin businesses with no operating risk) - FNV currently trades at ~22x LTM EBITDA, while WPM trades at ~32x. At such high entry valuations, these names are just not an attractive way to play the precious metals theme today in my view.
However, after digging further I believe I have found another royalty-like precious metals name that fits the picks-and-shovels/intermediary model, and which is essentially a “toll bridge” for capital flows into precious metals. If and when a bull market for these metals materialises this name should do very well and without assuming the risks implicit in mining and royalty names.
This stock is …