<March 4, 2021>
One of the things we treasure most about our strategy is its flexibility. When we believe our opportunity set is expensive, we aren’t required to remain fully invested. As we like to say, “Why overpay if you don’t have to?” We also have flexibility when it comes to sector weights. When a sector is expensive, such as technology in 1999 or financials in 2006, we are not mandated to have exposure. Conversely, when a sector is out of favor, such as precious metal miners in 2015 and energy in 2020, we are not constrained by sector limits from taking an above average position.
In our November 2020 post “Locking It In”, we stated we felt low oil prices were unsustainable and that the industry’s response to depressed prices was setting the stage for a recovery. While we believed prices would eventually rebound, we didn’t anticipate the bounce would be so drastic and sudden, with oil spiking 68% from early November 2020 through February 2021.
The sharp rise in energy prices has been a blessing and a curse for us. As much as we’ve enjoyed watching energy stocks increase in value, energy was one of the few sectors in the market that remained attractively priced. In effect, it was an oasis of value, and that oasis is currently being overrun by anxious relative return investors and a newly minted inflation narrative.
While we continue to believe there is value in certain energy stocks, they are clearly not as inexpensive as they were only a few months ago. In our opinion, it may be time to reassess the valuations of energy stocks and look for the next out of favor sector in our small cap universe.
Small cap stocks have been on a wild ride over the past year. We’ve been managing small cap portfolios for nearly three decades, and frankly, we’ve never seen anything like it. After declining 40% from its early 2020 highs, the Russell 2000 has increased 130% from March 2020 to February 2021! Based on current valuations, we believe our opportunity set has never been more expensive and risks never this elevated. Therefore, finding value in the current small cap market has become extremely challenging.
Few sectors in the small cap market have been left behind. Even highly cyclical businesses, such as commodities, have risen sharply over the past several months. However, there has been one noticeable laggard—the precious metal miners. Since early November 2020, we’ve found the dispersion between energy and precious metal miners to be particularly noteworthy, with energy stocks up over 60% and precious metal miners declining approximately 20%. That’s quite a performance gap, especially in a period with so many investors searching for inflation hedges.
While we appreciate the fundamentals driving the increasingly popular inflation narrative, we’re puzzled by the market’s distaste for precious metal miners. Given record fiscal deficits, we believe the U.S. Treasury will continue to rely on the Federal Reserve to help fund government outlays. Furthermore, with the government’s cost of borrowing on the rise, we believe the Federal Reserve will eventually increase quantitative easing (QE) and attempt to manage the entire yield curve. In our opinion, rising inflation, record fiscal deficits, and potentially higher levels of debt monetization are near perfect conditions for precious metals and the precious metal miners.
In summary, the relative attractiveness of the commodity sector has changed since November 2020. At that time, we were finding considerable value in energy stocks and had minimal exposure to precious metal miners. Based on meaningful changes in valuations, we’ve recently shifted our research focus from energy stocks to precious metal miners.
Our search for miners will be similar to how we screened through beaten-down energy stocks. We’re focusing on precious metal miners with strong balance sheets that will allow the companies to survive a prolonged industry downturn. As was the case with energy, we do not want to own miners that are dependent on bankers or the credit market for capital, and as always, we want to avoid combining operating and financial risk. We are also searching for miners that sell at discounts to the replacement value of their long-lived assets. And finally, we prefer miners with proven developed mines that are in favorable geographies.
Owning precious metal miners is not for the faint of heart. They are extremely volatile and will do their best to shake out the most disciplined investors. And while we do not believe precious metal miners are as inexpensive as they were in their devastating bear market of 2015, we think the industry’s cash flows, balance sheets, and investment rationale have improved. In our opinion, it’s time to revisit the precious metals miners. We believe the sector is ideally positioned for a future of rising inflation, debt monetization, and a Federal Reserve with limited options.
Eric Cinnamond
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Definitions:
Russell 2000: The Russell 2000 index is an index measuring the performance of approximately 2,000 smallest-cap American companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. stocks. It is a market-cap weighted index.
Russell 3000 Energy Index: An index that measures the performance of the energy stocks within the Russell 3000.
Arca Gold Miners Index: An index of publicly-traded silver and gold mining companies comprising of common stocks in addition to depository receipts traded on the NYSE, NYSE MKT, NASDAQ, and the Toronto Stock Exchange.