Learn Where Gold Stocks Will Potentially Outperform as Margins Expand

• Q2 2024 reporting for gold companies may show significant margin expansion due to high prices and moderated input costs.
• This margin expansion could attract generalist investors to gold stocks, potentially closing the valuation gap between gold equities and the gold price.
• The conversation discusses how to position investments across different tiers of gold companies to benefit from this trend potentially.
• The speakers highlight companies they believe are well-positioned, including AngloGold Ashanti and Aris Mining.
• The discussion emphasizes the importance of timing and positioning in junior gold companies before potential price movements.

As the second quarter of 2024 approaches, investors in the gold sector anticipate a potentially significant shift in the market dynamics. Combining sustained high gold prices and moderated input costs could lead to substantial margin expansion for gold producers. This article summarizes a conversation between Derek MacPherson and Sam Pelaez, executives at Olive Resource Capital, discussing the potential implications of this scenario for investors and how they might position themselves to benefit from these market conditions.

The Potential for Margin Expansion

The discussion opens with an analysis of the current gold market conditions. Gold prices have been trading at record highs, pushing $2,400 per ounce as of the recording date, and have remained elevated throughout most of Q2 2024.

This situation is unique because, unlike previous periods of high gold prices, key input costs for producers have moderated. These input costs include labor, energy, and other commodities used in gold production. Pelaez explains, "What's happened over the last six months is that we've had a leap [in gold prices], the kind of leap that can create a significant margin expansion overnight, and as MacPherson said, the inflationary pressures haven't kept up with it." This scenario allows gold producers to increase their profit margins significantly.

Historical Context and Market Behavior

To provide context for their expectations, the speakers reference similar periods in the past, particularly 2016 and 2018, when sudden increases in gold prices led to margin expansion for producers. They suggest that studying these periods can provide insights into how the current situation might unfold. An important observation is that gold equities have not yet fully reflected the increase in gold prices.

Pelaez notes, "For the last six month to eight months, the gold price is up 33%, and the large caps, measured by the GDX over that period, are up about 44%."

While this indicates some outperformance by gold stocks, it falls short of historical patterns where a 30% move in gold prices has led to 60% to 100% moves in large-cap gold equities. This discrepancy suggests there may be room for further appreciation in gold stocks, particularly if Q2 reports confirm significant margin expansion.

The Role of Generalist Investors

A key theme in the discussion is the potential for these improved financial results to attract generalist investors to the gold sector. MacPherson explains that for large-cap gold stocks, the marginal buyer is often not specialist resource funds but generalist funds looking for growth and profitability.

Pelaez elaborates on this point: "When you're looking at the large caps, their comparable universe is other large caps in other sectors, and there are two things that generalist investors are willing to pay for: one is growth, and two is profitability."

The expected margin expansion could make gold stocks more attractive on both these metrics, potentially leading to increased investment from generalist funds.

This influx of generalist money could be a significant driver of stock performance. As Pelaez notes, "That can drive significant billions of dollars into the space."Investment Strategies Across the Gold SectorThe speakers discuss how investors might position themselves to benefit from this potential trend. They outline a typical pattern of money flow in a gold bull market:

1. Large-cap producers: These are typically the first to move, attracting generalist investors.
2. Mid-tier producers and large-scale developers: These often follow, with a lag.
3. Junior producers and developers: These may see significant moves later in the cycle.
4. Exploration companies: These typically move last but can see explosive growth.

MacPherson emphasizes the importance of timing and positioning, particularly for smaller companies: "When you start looking at developers and explore cos on the lower end of the scale where you have a lot less liquidity, even for a smaller fund like ours to build a position requires patience, time, and you can't get in later. You will wake up tomorrow, and it will be 100% higher than where you thought it was an attractive valuation."

This observation underscores the potential risks and rewards of investing in junior gold companies. While these companies can offer significant returns, they have higher risks and less liquidity.

Specific Company Examples

The speakers highlight several companies they believe are well-positioned in the current market:

AngloGold Ashanti

AngloGold Ashanti is described as a "fantastic operator" with a new management team that has been in place for about two and a half years. The company has made strategic moves, including deals with Goldfields in Africa, acquisitions in Nevada, and moving its headquarters to the US. They've also been active in buying stakes in some junior companies. Both speakers view AngloGold Ashanti positively, citing its potential for substantial production growth over the next few years. While it's not currently the company with the highest margins, the expected margin expansion could significantly improve its economics. This combination of growth potential and improving profitability could make it attractive to generalist investors.

Aris Mining

Aris Mining operates the Segovia mine in Colombia, producing over 200,000 ounces of gold annually. The company has a clear path to nearly 500,000 ounces of annual production through the expansion at Segovia and the construction of Marmato. It's described as funded for this growth. Both speakers see Aris as well-positioned to benefit from margin expansion. While Segovia has higher cash costs due to being a deep underground mine, it could benefit more from rising gold prices. The company's growth profile and potential for improved margins make it an interesting prospect, especially given its current valuation gap compared to mid-tier peers.

OMAI Gold Mines

OMAI is described as more of a developer than a producer. It has "ounces in the ground," and there's significant M&A activity nearby. Both speakers view OMAI as a junior company with significant potential. They note that its stock price has already appreciated over 100% since they started taking a position, but they suggest there could be more upside, particularly if you consider the recent takeout of Reunion Gold nearby. This illustrates the potential for sudden, significant moves in junior gold stocks.

Aurion Resources

Aurion is exploring in Finland. While it doesn't have its resource estimate yet, the speakers note that it's in an area of interest, particularly given the expansion of Rupert Resources' nearby project.: Both speakers see Orion as another junior company with significant potential. They suggest it's "in the center of the M&A conversation" and that it's "only a matter of time" until its potential is proven. However, they also note that it's very sensitive to news flow, highlighting the volatility often associated with junior explorers.

K92 Mining

While not discussed in detail, K92 is mentioned as an example of a first quartile (lowest) cash cost producer that the fund owns. Both speakers noted that while K92 won't benefit as much from margin expansion due to its already low costs, they own it because of its "funded production growth." This illustrates how investors might balance different attributes (low costs and growth potential) when selecting gold mining stocks. Both speakers' comments on these companies illustrate their investment strategy across different tiers of the gold mining sector.

They balance positions in larger, more established companies like AngloGold Ashanti with investments in smaller, growth-oriented companies like Aris Mining and more speculative plays like OMAI and Orion. This approach allows them to benefit from margin expansion across the sector while positioning for potentially outsized returns from successful junior companies. However, it's important to note that smaller, less established companies typically carry higher risks.

Portfolio Construction Considerations

The speakers provide insights into how they structure their portfolios to balance potential returns with risk management. They aim for a mix of approximately:

• 40% in liquid, large-cap names
• 30% of junior public companies
• The remainder in private investments

This structure allows for exposure to potential outsized returns from junior companies while maintaining liquidity through larger cap holdings.

Challenges and Risks

While the overall tone of the discussion is optimistic, the speakers do highlight some challenges and risks:

1. Timing: While they anticipate a move in gold equities, the exact timing is uncertain.
2. Liquidity: Particularly for junior companies, a lack of liquidity can make it difficult to enter or exit positions at desired prices.
3. Volatility: Junior gold stocks can be highly volatile, with the potential for significant gains and substantial losses.
4. Execution risk: The speakers emphasize the importance of management quality and project execution, particularly for developing companies.

The upcoming Q2 2024 reporting season for gold companies could potentially serve as a catalyst for significant moves in gold equities. The combination of high gold prices and moderated input costs may lead to margin expansion that attracts generalist investors to the sector. While this presents opportunities across the gold mining sector, from major producers to junior explorers, it also comes with risks that investors must consider carefully.

Investment Proposition for Gold Equities

• Consider increasing exposure to gold equities, as they may be poised for outperformance relative to gold prices.
• Look for companies that benefit most from margin expansion, such as those with moderate (not lowest) cash costs.
• Consider a mix of investments across the sector, from large producers to junior developers, to balance potential returns with liquidity and risk.
• Pay attention to upcoming Q2 reports for confirmation of margin expansion trends.
• For junior companies, consider establishing positions early, as price moves can be sudden and significant.
• Look for companies with clear paths to production growth, which is attractive to generalist investors.
• Consider the geopolitical risks of a company's projects when making investment decisions.
• Monitor for increased interest from generalist investors, which could drive further price appreciation.
• Be prepared for volatility, particularly in junior gold stocks.
• Regularly reassess your portfolio allocation as market conditions evolve.

The gold mining sector may be entering a period of significant margin expansion due to high gold prices and moderated input costs. This could attract generalist investors and drive outperformance in gold equities relative to gold prices. While this presents opportunities across the sector, from major producers to junior explorers, investors must carefully consider timing, liquidity, and company-specific risks. A balanced approach, incorporating exposure to different tiers of gold companies, may offer the best opportunity to benefit from potential sector-wide appreciation while managing risk.