Gold Miners Index GDX
December 24, 2008 - 8:29am EST by
2008 2009
Price: 30.70 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,380 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Thesis:  We believe that gold will appreciate by 2-3x over the next 2 years to ~$2k/oz. An index of gold miners (GDX) will increase by 4-5x over the same time period assuming $2k gold as you are creating many companies in this index at ~3x FCF. We are comfortable with these targets because:

·        We are on the verge of one of the biggest monetary debasements in the history of the western world.

·        Demand for gold is likely to outstrip supply in a significant way as the major savers of the world (emerging countries) are dramatically underweight gold and overweight the $. 

·        Gold mine production is declining at a rate of ~3% at the same time as the physical market for gold is extremely tight.

·        The total market cap of gold held as an investment outside central banks as a % of total global financial assets is currently ~1%. A 3% reallocation to gold would significantly overwhelm the current stock.

·        The value of gold miners relative to the underlying commodity is at a multi-decade low

Key Points: 

Our country suffers from an unprecedented debt burden and the only way out is significant inflation while also keeping nominal interest rates low.   The ultimate pressure point will be the $. The US currently has a debt/gdp ratio of 350% which is ~2x the levels experienced in the late 1920s. In the early 1930s’, we saw gdp contract by ~45% which caused debt/gdp to increase to ~300%, still far below current levels. Household debt service was ~8% of GDP in the late 20s and today we are at over 10%. If we see anything like the deflation we saw during the Great Depression, the real cost of the debt burden will crush the country. When FDR temporarily took the US off the gold standard in 1933, we went from -5 to -10% deflation to +4% inflation. We can create inflation with a printing press and Bernanke is prepared to do this as recent data points indicate.  

      The Fed’s balance sheet has exploded from ~$1T to 3T+ (includes recently announced initiatives) in just the past few months. The Fed has announced that they will buy GSE debt which is the first purchase of unsecured debt and a step towards significant quantitative easing. The Fed is also buying ABS, MBS and even CDOs. By paying interest on bank reserves, the Fed has effectively put a floor on the fed funds rate which allows them to expand their balance sheet and the money supply aggressively. We expect this debasement to accelerate in the next 12 months as we see a federal budget deficit of $2T+ that will likely require treasury monetization by the Fed.  

      Foreigners hold ~50-60% of the $5T+ of US treasuries and ~40% of that debt has a duration of under 2yrs which poses significant refinancing risk for the US. Total US gross external liabilities are ~100% of GDP. If foreigners continue to focus their resources on creating internal demand at the same time that a massive amount of treasuries are rolling over and new treasury issuance is hitting the market, the supply is likely to outweigh the demand. The govt wont let interest rates increase given the significant debt burden so the Fed will be forced to monetize treasuries and potentially other high quality corporate bonds in order to keep nominal rates artificially low. 

      In creating inflation, the govt has to choose between two side affects: 1) higher interest rates or 2) a weak dollar. The govt showed its hand recently when it decided to offer $600b+ of $ denominated currency swap lines to foreigners looking to service their USD denominated debt. Caught in the unwind of the USD carry trade, these investors would have been forced to liquidate US securities to raise $ liquidity which would have put upwards pressure on interest rates. Instead, we are creating a significant risk of a run on the dollar as a world already over-exposed to $s (66% of global FX reserves) is flooded with new $s to avoid a credit lead deflationary bust in the US. Gold is the ultimate paper/fiat currency hedge and will benefit from these actions. Even if we are wrong about inflation, gold has done extremely well in deflationary environments over the past 100-200yrs. 

      In addition, if you look back to the early 1930s and mid 1970s, two periods that share many similar macroeconomic characteristics with today, gold performed extremely well and gold mining stocks were multi-baggers over a several year period.

Gold is under-owned by the world’s biggest savers and this is starting to change. The US and many Western European countries have 50-70% of their FX reserves allocated to gold while many EM countries have less than 3%. China has ~$2T in FX reserves with only a 1% allocation to gold. Recent press reports indicate that China is interested in increasing its allocation to gold from 600 tons to 4k tons. This demand alone would be equivalent to 1year’s supply of gold and would increase China’s allocation to gold to only 6%. We believe it is likely to go much higher as China reallocates away from $s.

      As debasement continues in the US and elsewhere, gold will become a natural asset class for all investors. This demand will overwhelm the annual supply of gold as well as the stock of gold that sits in investment accounts globally. There is currently ~160k tons of gold above ground and 50% of that is in the form of jewelry, 20% is held by central banks and 30% is held by other investors. Annual mine supply is ~2.5k tons which means the total stock of gold is growing by only 1.5%. The market value of gold held by investors outside central banks is only 1% of global financial assets so if we were to see investors increase their allocation to gold by 2-3%, that would overwhelm the current stock. This is already starting to happen as investor demand for gold increased by 50%+ YoY in 3Q 08 and our research indicates that the physical market for gold is extremely tight. Investors are paying 10-15% premiums for gold coins and treasury mints around the world are running backlogs as they try to keep up with investor demand. We believe that mutual fund managers and financial wealth managers may start advising clients to have a % of their portfolio allocated to gold which could cause a massive increase in demand.

Gold is currently valued at ~50% of its inflation adjusted peak in the late 70s. and at ~1/7th of its peak relative to the Dow Jones. The market cap of the above ground stock of gold held as investment outside central bank hands is currently 3-4% of the market value of total US financial assets vs 17% in the early 30s and 20% in the mid/late 70s. The price of gold is currently ~20x the price of oil vs 36x in the early 30s and 30x in the early/mid 70s. As we mentioned above, a small reallocation of financial assets towards gold, can have a very significant impact on the price of gold. Based on these metrics, it is not hard to see how gold could increase by 2-3x to $2k.
      The index of gold miners (GDX) is currently trading at the cheapest valuation that it has in several decades relative to the underlying commodity. The ratio of the price of the GDX relative to the gold price is currently 50% below the 30yr historical average and 1/3 of historical peak levels. At $2k gold, you are creating the gold miners at ~3x fcf when they have traded at over 15x historically.   In addition, as the price of gold increases, the P&P reserves for several of the miners also increase as more reserves become economic. We don’t take this into account in our fcf estimate so this is additional upside.
Note: since the GDX hasn’t been around for that long, we use the XAU gold index as a proxy to get the ratio of the gold miners/gold going back to the early 80s. 

Bull/Bear Debate:

Bear: Due to global deleveraging, demand for gold jewelry will decline substantially causing over-supply.

Response: ~60% of annual demand comes from jewelers, 10% comes from industrial/dental and 30% comes from investment demand. This is pretty much irrelevant as we believe there could be a global reallocation of wealth towards gold that would overwhelm the 50k tons of above ground gold held as investment and the 3.6k tons of annual gold supply.

 If you are wrong and we don’t see a global reallocation to gold, the downside could be significant.

      Response: Recent signposts indicate the probability of an explosion in the price of gold is increasing. In addition, mine production is decreasing at a run rate of 3% per year even at current gold prices. At the same time, we are seeing extremely strong physical demand for gold (30% of demand), stable industrial/dental demand (10% of demand) and strong jewelry demand from the EM countries which make up over 60% of jewelry demand (ie 35%+ of total demand).   The one area where demand has been very weak is in the US/UK/Western Europe jewelry demand category makes up under 10% of total demand which means we can see a 50% fall in this demand and the market will still be in balance. Based on industry cost curves, approximately 20% of current production would come off-line if gold fell below $500/oz for any sustained period of time.

 We are going into a massive deflationary environment due to credit contraction and gold only does well as an inflation hedge.

      Response: The easiest way out of this problem is inflation and Bernanke knows this more than anyone else. Inflation is possible with a printing press as we saw in 1933/4 when FDR took the US off the gold standard and debased the $ by 45% (relative to gold). Gold is the ultimate fiat currency hedge and a great store of value. As the US and many other countries continue to competitively debase, there will be a global mistrust in fiat currencies that will likely lead to an increased allocation to the only currency that cant be debased – gold. Gold does well in deflation as well.

 What happens if we just go into a slow, muddle through type of environment?

      Response: It’s hard to believe how we go into a slow, muddle through like we saw in Japan with the Fed/Treasury acting as aggressively as they are and with the Obama team coming into office in the next few months. But even if we do, the downside to gold and the gold miners seems limited and the upside is huge.


dollar deleveraging turns into dollare debasement,

the fed balance sheet explodes to $5T+ as they monetize treasuries and other assets,

the US runs a $2T+ budget deficit,

China and other EM countries reallocate savings away from USD and into gold
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