Best stock investments – Friday File: Tech Happy, Gold, Uranium and Insurance Sad

Best stock investments

Well, we finish out the week with yet another dramatic performance from the market-dominating tech stocks. Alphabet (GOOG) did better than expected and popped a bit, climbing further through the day, almost as much as the gains Microsoft (MSFT) made on a more dramatic ‘beat’ of expectations (though analysts have always been better at estimating Microsoft’s numbers than Alphabet’s)… and Amazon (AMZN) beat on revenues, even after accounting for Whole Foods, and perhaps beat on earnings (it’s always hard to tell, they did “beat” but they had also dramatically lowered expectations last time out… and it seems no one really cares what Amazon’s actual profits are as long as the revenue keeps growing).

All that comes despite their Amazon’s creepy “let us into your house” delivery offering announced this week. Good news for those three tech giants is good news for pretty much everyone, given the huge sway they hold over the broader markets (Facebook jumped half as much as Alphabet in sympathy, thanks to “if ads are good to Google, they’ll probably be good to Facebook, too” reasoning, which will either be confirmed or not on Thursday when FB reports). Amazon’s revenue growth continues to be one of the most overwhelming things I’ve ever seen — as is the investor enthusiasm for the shares while Amazon invests all of their cash flow and their considerable cloud services profits into further market dominance in e-commerce. It’s Jeff Bezos’ world, the rest of us just live in it… hopefully he’ll be a benevolent overlord.

And Apple (AAPL) didn’t release earnings this week, their report will come out on Thursday, but they did something more important — they finally released the “new” new iPhone the iPhone X, so we can finally start freaking out about deliveries and timetables and, in about a week, get our hands on one so we can cut it open and see what chips are inside and see which suppliers “won” (OK, we won’t do that — but all the teardown services will).

That release has spurred some optimism in iPhone suppliers over the past few days as rumors about when the production bottleneck might clear and what the total iPhone sales will be like have swirled, and now we’ve had, at least, confirmation that there’s strong demand for the iPhone X as the limited number available for the first day sold out immediately and the delivery window quickly got pushed out to mid-December. Apple has been a little weak of late because of tepid sales for the iPhone 8 and rumors about “catastrophic” problems with the iPhone X and some of its parts, but that’s partly just because it’s a wildly over-followed and over-analyzed company and every rumor makes headlines. I suspect Apple will come out fine and be higher in six months, though it may be bumpy if the first few iPhone X customers have trouble with their face recognition or other problems emerge and deliveries slow — similar issues happen every couple years with Apple, and they are more able to handle them than any other company, so I think the risk is low.

That said, I’m not buying more. I have a plenty large position, and actually took some profits earlier this year (right around this price) to reduce exposure as Apple becomes ever more iPhone-dependent and struggles with beating their own past performance with each upgrade cycle. There’s a decent chance that the next six months could be their strongest sales cycle ever if the iPhone X is enthusiastically received, but it’s also quite possible that they’ll stagnate because the iPhone 7 and 8 are also pretty incredible and more than adequate for most users. Stagnating on the top line, which I think is the biggest “high probability” risk, is OK at 13X earnings with a growing dividend and a huge cash pile for buybacks, particularly if there’s a repatriation tax break that brings back a lot of cash and Apple uses that to pay large dividends or do even more aggressive buybacks (though they’v borrowed a lot to do some of that already), but it means Apple might not be able to grow as quickly as some would like, and Apple has at times traded at much lower valuations than it carries now… so it could certainly fall a bit if sentiment shifts. Investors adore growth, so if it slows they often wander off to find the next shiny thing. I’m perfectly happy to keep holding Apple, the greatest consumer products company in the world, and I’ll let you know if my perspective changes after earnings are released (or after I get my iPhone X, which will be a while — I do want to try it out, but I’m not willing to wake up at 3am to order a phone).


*****

Giant uranium miner Cameco (CCJ) released earnings today as well — Cameco is not really an earnings story, but I do have a long-term speculative call option position as a sort of placeholder for “uranium should go up someday” in my portfolio, and it’s interesting to hear the commentary about uranium prices. It wasn’t great, and there was little said about the sunrise peaking out above the horizon when it comes to uranium pricing — the note that struck me in the press release was this:

“Ultimately, our goal is to remain competitive and position the company to ensure we have the ability to be among the first to respond when the market calls for more uranium.”

So that’s why CCJ is the blue chip in uranium — they’re managing well, they still have positive cash flow, they’re still selling uranium on long-term contracts, and prices are still falling (their realized prices were down 25% year over year in this quarter), but they’re also producing far less (production for the first nine months this year was about half of the year-ago total, though sales volume was similar because Cameco has plenty of inventory they can use). They are very much hunkering down, producing the minimum, trying to be conservative, and waiting for the market to turn — and if they don’t see it turning yet, you can be pretty sure it’s not turning. The long-term contract price is now down to $30/pound, so as Cameco’s long-term contracts roll over there will be a real push-pull on signing new ones — $30 is below their average cost of production right now, so it seems unlikely they’ll plan to lose money.

Maybe we’re approaching that turn in the uranium market that every natural resources newsletter has predicted for three or four years now, but I wouldn’t hold your breath… and as the bear market in uranium persists, my sentiment shifts further toward Cameco and away from the juniors — when the standard-bearer, with huge production capacity and inventory, is trading at less than book value and managing the low price environment well, with the ability to be ready for when prices turn, it’s hard to convince yourself to bet on a uranium explorer that might require capital before the market turns.

*****

Markel (MKL) released its important post-hurricane earnings on Wednesday, which brought the year-to-date to a substantial underwriting loss — as expected. They report a total expense for the Hurricanes and the Mexican earthquakes in this quarter of roughly $500 million, which drove the combined ratio for the quarter up to 134% (anything over 100 means you’re losing money on the insurance side of the business), and noted that the fourth quarter will also have considerable claims volume because of the earthquakes and the California fires.

The investment portfolio did pretty well (market indices rose anywhere from 3-6% in the third quarter and bonds didn’t lose money, so they had few investing headwinds), so the total loss for the quarter on the income statement was only about $20 million, and the book value dropped to $641.20 per share, still an increase on the year but a (trivial) decline for the quarter (it was $642.19 in June). That reassures about the strength of the company, lots of insurance companies have reported (or will report) substantial drops in book value as a result of these hurricanes (AXS, for one, had a book value drop of almost 10% in the quarter), so we’re reminded that the ability of the investment portfolio and Markel Ventures to make up for a bad insurance quarter or year is wonderful, but it doesn’t do much to support the high valuation Markel trades at today (at $1090 or so, MKL is trading at well over 1.7X book value). They may be among the best insurance companies out there, but they’re valued like one of the best and their book value growth has slowed over the years

Markel shareholders usually have to see something pretty bad before they’re willing to sell a lot of shares, the last time the stock got really cheap was when their last major acquisition was announced, so I’d love to see the stock drift back down to a cheaper price so I could load up with some more shares… but for now it looks like it’s just going to continue trading at post-financial-crisis high valuations, like most other large and admired insurance companies, so I’ll just hold and watch. There’s a lot to like about Markel, I just don’t want to overpay when there isn’t a huge amount of growth… if you like overpaying for stability, which is not the worst idea in the world, it’s certainly a nice company to own. This is what co-CEO Tom Gayner said on the conference call:

“I am proud of our organization that we can create the win-win situation of providing $500 million of support and payments to our policyholders and increase the net worth of the Markel Corporation at the same time. That is the design of Markel, and it is win-win. It is easy to say and hard to do, but we’ve done so.”

Sometimes it won’t be a win-win, and those are the times when there’s finally a break in sentiment and I’d hope to be able to load up on more shares… but not today. I feel like a broken record on this, having held Markel for a dozen years now and having stubbornly resisted buying more at what seemed to be inflated price/book ratios for several years, but that perspective comes from having sometimes overpaid for MKL shares in the past — there have always been times when the stock fell out of favor for a while, and I have to have some faith that those times will return. Maybe my faith in future calamity is misplaced, we’ll see.

And speaking of calamity, Axis (AXS), the newest insurance company position in my portfolio, also released earnings this week. They had a similar loss on the natural disasters, slightly lower at about $468 million, but Axis is also a much smaller company than Markel — and that’s reflected in the even larger impact on the combined ratio for the quarter, Axis reported a ratio of 152.9%.

Axis CEO Albert Benchimol said what every insurance company investor wants to hear: They think rates will rise now, finally, and that the market will “harden” … here are his words from the press release:

“We expect the market to react strongly to industry losses this quarter, which when combined with low interest rates and sustained multi-year pricing erosion, will drive adjustments to risk-based pricing.”

Yes, that translates into, “please let’s all charge higher rates, OK?”

The book value of Axis is now $55.03, which is down about 8% (it had previously been roughly flat over the past year). So AXS is no longer trading at a discount to book value, but it is trading right around book value. No real surprises here, but no great ray of sunshine and rainbows, either. They are not as conservative as Markel, and don’t have the massive portfolio to help cushion the blow, so the shares will probably be more volatile — but they’re well-managed, and if pricing turns they’ll do very well. This will remain a small position for me until I see how they do coming out of this record disaster year (or until they hit a stop loss trigger), so we’ll watch and see.

Berkshire Hathaway and Fairfax Financial are likely to have meaningful claims hits on the quarter as well, this year is getting close to being the largest in terms of insured losses for the industry (it’s in second place now, behind 2011, but there’s still a quarter to go)… but they don’t report until next week — neither one is in any danger of disastrous claims impact from the hurricanes, I expect, they’re too big and well-diversified for that, but you never know exactly what the numbers will be. Fairfax is still the insurer I would buy first today, thanks to the combination of good valuation and good investment management, but it’s also certainly more volatile than sort-of-peers Markel and Berkshire.

Incidentally, Markel’s view on the market is also that rate increases are coming, finally — that doesn’t guarantee improvement, not unless we stop seeing hedge fund money and institutional cash flooding into insurance and catastrophe bonds as an “uncorrelated asset class” (though big losses this quarter on those bonds might help to reduce the capital flow, which would be good for pricing). Here’s what Markel co-CEO Richard Whitt said about the state of the market in that regard:

“It feels like for the last several quarters I’ve been saying, the market remains competitive and not much new to report. Coming out of the third quarter, I have some new things to say. The property market is clearly in transition. By that, I mean, post the events of the third quarter, there is clearly momentum building for rate increases. Questions that remain are how much will rates increase and how broad-based will rate increases be. Our sense is the extent of rate increases will play out over the next several months, all the way into next year. As the actual losses from these events are realized by companies and as we get closer to the critically important January 1 renewals, the breadth and depth of rate increases in the property market and beyond will emerge.”

The drumbeats are increasing for a hardening market (meaning rising prices and less competition)… if that happens without the stock market crashing, all of these insurers will do well, and if interest rates get to rising at a steady pace, insurance company executives will do a happy dance at the prospect of both better portfolio returns and higher premiums (and then they’ll probably get too excited, forget about this $100+ billion catastrophe loss year, and go back to cutting rates again to take market share, turning the market “soft” again — all things move in cycles).

PCSB Financial (PCSB) released its quarterly earnings as well, and posted ten cents per share in earnings for the quarter, pretty much as expected (though there isn’t a lot of analyst coverage). This is the Westchester, NY mutual savings bank that did a stock conversion and went public earlier this year — the reason for buying was that it was fairly priced given the big boost to book value from the mutual conversion, and given that it is a solid local bank in a wealthy suburb and would be a likely takeover candidate three years after conversion (converted thrifts have to wait three years before they can be taken over). These investments tend to be solid and steady, with much higher probability of success than your average stock investment, but unless a big takeover does come they can easily underperform during a bull market (or, of course, if there are problems with financial stocks in general). I penciled this one in with a goal of 20% returns in three years with little downside risk, and we’re already just about there.

PCSB is still certainly reasonable, it trades at about 1.25x tangible book value (which is very close to reported book value — tangible book is $15.16 per share, book value $15.53), which is fairly average for a small bank but may not give them a lot of room for multiple expansion unless PCSB truly turns out to be an exceptional bank and is able to use its extra capital (the $100+ million in cash from the mutual conversion) to grow the business aggressively.

There’s no particular sign of that, but nor is there any indication that banking is suddenly going to become a worse business (interest rates appear likely to head in the right direction, at least, and the housing and commercial real estate markets are still healthy), so this one can just remain a quiet little hold for me. My base case assumption now is that they can keep adding to their book value at the current rate, roughly 3%/year, and that they therefore could have a book value per share of about $17 in three years. If they’re then still valued at about 1.25X book value, that would be a share price of close to $21… 1.4X book would be just under $24. It’s at $19 today, so that means the rational hope for the shares, assuming they don’t get taken out at a steep premium or turn into a faster grower (either is possible, of course), is a return of something between 10-25% over the next three years. The downside is likely to be limited to 15-20% or so unless there’s some company-specific scandal or crisis or the financial industry collapses completely, it’s a fairly simple local banking business and the bank is very well capitalized thanks to its extra equity. So you can make your own call on that. My inclination will probably be to take some profits off the table if the shares rise a bit further in the near term, but mostly just because I don’t see a high probability of the stock rising more than the market over the next few years — it still strikes me as quite safe and likely to quietly rise in value.

Retail Opportunity Investments Corp (ROIC) also released earnings — pretty much exactly in line, with forecast in line, a solid and predictable and steadily (but very slowly) improving business with roughly a 4% dividend yield, and they keep growing by issuing new equity to buy more shopping centers (and adding debt, though debt is only about 37% of total capitalization), so shareholders have about $1.3 million in “equity” in their real estate if you ignore the dividends paid to date — dividends are paid out of the cash flow, the FFO per share, and are quite reasonable based on that, but because of depreciation the dividends are substantially higher than net income, which means that dividend payments erode the equity on the balance sheet… a common refrain for REITs, though ROIC is, I think, an admirably conservative and well-run REIT.

Not lovable, but certainly likable… and how about that stop loss that we were so close to triggering last week? Retail Opportunity hit its stop loss trigger on Wednesday when it closed below $18.60, and after using that alert as a reason to investigate it more thoroughly I decided to allow that stop loss to work, and I sold my shares. This has been a long-held position, I’ve been letting my ROIC position compound since 2011 (and have added a few times along the way… and enjoyed a nice run from the warrants before then). I do like the company, but I looked through it with fresh eyes today and don’t find a 4% yield compelling enough given what I see as their limited ability to increase the dividend.

It’s not a bad stock, to be sure — management is excellent, and CEO Stuart Tanz probably knows more about buying West Coast shopping centers and increasing their value over time than anyone else alive, but dividend growth has been slowing (the last increase was about 4%, each increase has been lower than the last) and there are structural concerns about the industry in the changing retail environment. That doesn’t mean grocery stores and pharmacies are going to disappear overnight, which was the fear that sent ROIC falling earlier this year when Amazon bought Whole Foods and all the grocery stocks cratered (most of ROIC’s shopping centers are anchored by grocery stores), but it does mean there’s risk of more upheaval in that industry… which could keep a lid on rent increases and/or the customer traffic that keeps ancillary rents at shopping centers rising (like the rent for the dry cleaner next to your grocery store, etc.).

I expect ROIC will probably be fine, but the combination of rising interest rates (likely, but far from certain — the end of the bond bull market has been predicted dozens of times over the past decade, always incorrectly), some industry risk, an inability to meaningfully accelerate growth in FFO per share or dividends per share, and a mediocre current dividend of 4% are tepid enough for me to let the market tell me what to do and sell the shares at this stop loss level. I think the only likelihood for a real surge in ROIC is if interest rates fall markedly again and investors are suddenly willing to again accept a 3% yield from a slow grower, or if they get taken out by a larger REIT, which doesn’t seem all that likely to me (but is always possible — that’s how Tanz cemented his first fortune, by generating a lucrative buyout for his last REIT).

If a stock I think has better potential than the market thinks hits a stop loss because of investor overreaction, I may actually ignore that stop and buy more if I think it’s undervalued (or at least hold, as i did with MPW when it hit stop loss alerts a couple times over the past two years)… but in this case I think the market probably has ROIC pretty much right here, and I’ll take the wisdom of the crowds and sell my shares. We’ll see how it turns out. My guess is that we will not see dramatic downside or upside for ROIC over the next six months.

*****

Also in REIT-land…

QTS Realty (QTS) reported this week and came in mostly in-line, though their per-share guidance improved a bit, largely because they’re pushing off some of their capex to next year (because capex requires raising more money, which is usually roughly half equity and half debt, and thus they’ll be adding more shares when capex goes up). I took profits on about half of my options position, so even if the balance goes to zero, which remains possible (these are still out-of-the-money options we’re talking about), I’ll have booked a profit of about 40% on my initial speculation. They did not say anything particularly encouraging about ramping up dividend increases, which was part of my rationale for speculating on this data center REIT having a growth spurt over the winter, but they are growing capacity aggressively in some areas, particularly Northern Virginia, so there’s certainly some potential for a hike. Dividend increases in the past three years have averaged about 10%, so I expect that’s where the over/under line lies — if it rises faster, the stock should bump up; if it’s just another 8-10% hike (or interest rates rise), the shares could easily remain under my $60 strike price.

And CoreSite (COR), my largest REIT position, also reported earnings on Thursday morning, which also came in pretty much as expected — a slight beat, but nothing really meaningful. Perhaps more importantly, they did not raise their FFO forecast for the year, so there was no real reason for investor enthusiasm for what is already a pretty richly-valued data center REIT, and therefore the stock sold off by 2-3 percent.

With CoreSite, there’s no real reason here to make any adjustments — I’m leery of the high valuation but enjoying the ride for now… and that’s pretty much been how I’ve felt about CoreSite since it hit $60 or so, so I’ve generally been too conservative. There is still room in the FFO and cash flow for them to make a second dividend increase as we come to the end of the year. They increased the dividend by 12.5% to to 90 cents ($3.60 annualized) in June, shaking up their pattern with a surprise Spring dividend increase, but are likely to boost it again — their pattern has been to announce the dividend increase in early December, and the huge dividend increases, averaging something like 25-30% over the past six years, with a truly massive and shocking 50% last December, have been a big part of what has fueled this stock’s incredible rise. At this point they’ll be approaching a limit on what they can pay out unless FFO growth continues — a boost to a dollar per share in December, for example, would be a 90% payout of FFO, and that starts to get uncomfortably high unless the forecasts for FFO in 2018 grow considerably.

Right now, analyst estimates are for roughly 20% earnings growth per year for the next couple years, which should translate into a similar or slightly higher FFO growth, so there’s room to keep growing the dividend at double digits… though the expectation should probably be that dividend growth in the 15% neighborhood is reasonable, and 20% is on the high end of what one might hope for… it seems unlikely to me that we’ll see any more 50% dividend hikes like they announced last December.

But you never know, COR keeps surprising me on the upside, and investors keep surprising me in how much they’re willing to pay for that growth, so I’ll keep holding on and enjoying the ride. The current stop-loss trigger for COR is $97.12 per Tradestops (that’s an 18% stop loss, based on COR’s historic volatility), so that’s the downside to keep an eye out for… and look for that next dividend announcement and the early guidance for 2018, that will give us some indication whether COR can keep this nosebleed growth going or is more likely to plateau.

*****

Ventas (VTR) was getting fairly close to hitting its stop loss trigger of $59.59 yesterday, but positive earnings today have popped the stock back up. This diversified healthcare REIT beat expectations slightly, thanks partly to some asset sales as they continue to divest their way out of skilled nursing facilities, and showed continued growth in “same-store earnings” of 2-2.5% or so… and they upgraded their forecast for the year slightly, so everyone’s happy again and cheerfully pocketing that 5% dividend. Their forecast for 2017 is now for normalized FFO per share of between $4.13-4.16 (actual FFO will be a little lower thanks to a few cents of hurricane impact), so the current dividend of $3.10 should be easily supported by cash flow and will likely be increased with the December quarterly payout (the last dividend increase was by 6.5%). Ventas is focusing on building a life sciences business, with facilities leased to or affiliated with big research institutions, and they also are benefitting from the diversification in their portfolio across senior housing and medical office buildings. Steady as she goes, I don’t think it’s so opportunistically cheap that I’d pile in here but it remains my most stable and diversified healthcare REIT (the other two, Omega Healthcare with its large skilled nursing portfolio and Medical Properties Trust with its hospitals, both of which have much higher dividend yields and tend to be more volatile, report next week).

*****

Delphi Automotive (DLPH) is continuing to advance in self-driving technology and made news with a $450 million acquisition of NuTonomy this week. DLPH remains a strong play on both electric vehicles and self-driving technology, the two biggest trends in global automotive… which is why it still seems reasonably valued to me despite the recent softness in the shares. If Delphi were a startup just getting attention, and with as good a market position and potential in those two trends, it would be trading at a considerably higher valuation than the current-year PE of 15. If Google spins off Waymo, for example, it probably won’t be profitable and it will likely get a crazy-rich valuation.

Delphi is very much tied-in autonomous driving, and we’ll have the chance to see whether that “pure play” half of the business gets a real premium price when Delphi splits next year, so for now the NuTonomy acquisition is a good indication that they’re still focused on being leaders in this space… and the worries about an auto “top” mean they’re reasonably valued based on current earnings.

My sense is that Delphi carries a lot of baggage when it comes to investor perceptions, and the history of their past bankruptcy and their previous status as a captive parts supplier to GM… so despite all the asset sales and the improvements over the years, it doesn’t get enough credit for its transition to being a strong electric vehicle and self-driving vehicle parts marker, particularly given the reluctance of auto companies to rely on new parts suppliers. Auto parts are a different category than consumer electronics, with huge weight placed on reliability and sturdiness for a vehicle that should last ten years and spend most of that time outside, in all weather conditions, a very different set of criteria than those used for consumer electronics that might only last a year or two and aren’t generally life-threatening. Delphi is embedded with most of the major carmakers and should have an inside edge on the next generation electric drivetrains and, thanks in part to the NuTonomy acquisition, on self-driving car technologies. The first carmaker to have Google’s Waymo or another fresh face build something mission-critical is going to probably be a little worried, but they have Delphi build their drive trains and electronic “brains” every day.

The downside, and what keeps me from piling on to this position, is that we’re very likely to have a drop in auto sales — and that would hurt Delphi’s top line, one assumes, since not all of their parts are in solely hot-selling higher end or electric vehicles. Lots of them are in legacy vehicles that they were designed into years (sometimes decades) ago, so loss of sales volume could very well hurt at some point. I think there’s a good chance they make up for that over time by improving their “share” of the car, particularly in higher-end parts and systems, but that depends on design wins and, well, those aren’t always predictable, and if all the auto stocks drop because of increased pessimism about auto sales, Delphi will drop, too.

One reasonable way to play Delphi, then, could be hedging against broader auto industry decline with a short position in another industry participant like Visteon (VC) or Magna (MGA), or even one of the major automakers… but my position isn’t large enough that I’m worried about hedging, so for now I’ll just let this ride and see if they can be a relatively strong performer in an industry that is “due” for a headwind to hit sometime soon.

*****

What’s up with Trek Mining (TREK)? I just wrote some updated comments on this disappointing performer recently, but now those have been superseded by the news that Trek is now merging yet again (Trek itself is the outcome of two mergers that took place within the past year or so). Gold in general had a weak week, down sharply at times as the dollar strengthened on hopes of rising interest rates, but that wasn’t what Trek investors were thinking about — they’re wondering how to parse the details of this merger, and, if they’re like me, they’re trying to figure out if they end up holding something of greater or lesser value at the end.

With the merger they’ll also get another name change, assuming all the shareholder votes go through, so Trek Mining will become Equinox Gold (ticker will be EQX in Canada, LWLCF might remain the OTC symbol). Trek seems to be essentially the surviving entity here, despite the name change, but it’s a merger of near-equals with NewCastle Gold (NCA.TO, CTMQF), with a smaller sliver also owned by Anfield Gold (ANF.V).

On the surface, it appears that Trek Mining is yet further diluting the near-term impact of their most valuable near-production asset, the Aurizona mine in Brazil, so the question is, “Why?”

Ross Beaty appears to be the main answer — Beaty comes with Anfield Gold, which used to be Magellan Minerals, and is in permitting (with some dispute) to build the relatively small, high grade Coringa gold mine in Brazil… he owned 23% of that company, and leveraging that into an 11% stake in the new Equinox by also putting about $20 million into the new company puts him as the largest shareholder of Equinox, and Chairman of the Board, and it brings a real top-shelf name-brand investor and company-builder to the combined company.

Beaty has a big following because of his string of successes starting 25 years or so ago, particularly his founding of Pan American Silver (PAAS), and for a while he was often called the “broken slot machine” because he always paid out for investors. That bloom is perhaps off the rose a little bit now, following the long bear market in junior miners (and his enthusiasm for geothermal that wiped out some fortunes in 2011, though Alterra Power, the survivor of that geothermal boom and bust, has been recovering well more recently), but junior mining speculators certainly still watch him closely.

So is it worth it to essentially dilute away about half of Aurizona in exchange for the other larger near-term project that’s part of the deal, NewCastle’s Castle Mountain, plus Coringa and the Ross Beaty name and Chairman role, plus a financing package from Sprott to advance Aurizona, plus a few smaller doodads? (and we still have the legacy assets from Trek, those exploration-stage copper poryphyry properties in South America from J. David Lowell and little Elk Mountain in British Columbia).

That’s a pretty tough sell, frankly. Particularly because financing should have been available without the deal, too — Aurizona is not an expensive project, and Trek already had $75 million in cash, so they’re supplying most of the pro forma cash for this combined company. The financing is a good thing — they’re getting an $85 million credit facility from Sprott, plus a $200 million development and acquisition facility, so Aurizona effectively has the green light now in real terms — but it’s not enough to make the deal compelling.

So the cynic in me says that this doesn’t help the value of Aurizona much — other than to confirm what was already quite likely, that yes, they now have ample financing to build that mine. I thought Trek was was worth $300 million before, and that’s still true, but now Trek is 44% of the new Equinox. So is Equinox similarly undervalued? Is it worth $680 million, thereby keeping the same theoretical upside potential in place for Trek shareholders? The pro forma market cap will be somewhere in the C$400-450 million neighborhood, assuming the prices don’t drift much.

NewCastle Gold is the other major component — the Castle Mine, a past-producing mine on the California/Nevada border south of Las Vegas, is a pretty low-grade deposit but would probably be relatively cheap to operate (and it has an existing permit). It has the potential to be a much larger mine than Aurizona, but is earlier in the process of being explored, defined and developed. It has a four million ounce “measured and indicated” resource, and is seen as being a low-cost heap leach operation with the eventual potential of producing 300,000 ounces a year (maybe half of that in the earlier stages)… but those aren’t real feasibility or geologist numbers, those are “goals and strategy.”

They still have to turn their resources into reserves (meaning they begin to prove that they’re economically viable to produce), and that’s their goal for next year — they do have some initial drilling results that are compelling, including some high-grade intercepts, but it’s early. They did upgrade their resources in August with a new technical report that indicates, at a pretty low 0.2 grams/tonne cutoff, that there’s a total of more than 5.5 million ounces in the measured, indicated and inferred categories (about half measured) — though they use a lower number of 4.2 for indicated at a higher cutoff in their presentations. So that’s good that the deposit is growing larger as they study it more, but we’re still not talking “reserves” or “feasibility”. You can see their last pre-merger presentation about Castle Mountain here, from September.

NewCastle seems to have had quite a lot going for it, including the main federal permit in place and a plan for local construction permitting and water use that’s under way now (they’ve been drilling for water), so they could start up pretty quickly, as soon as late next year, by processing the backfill from the previous mine… but first we should see a feasibility study this Fall, and that will give a clearer picture (at least to me) of the value. This one looks like an appealing project that was under-funded, so the financing makes a big difference to them… and it also carries that risk of not yet having a feasibility study or reserves booked, but it does have good and experienced management. For a junior miner, it has had a very stable share price over the past year, so I’ll be a bit conservative and say that the project is worth what the market says this year, at a time when most of these stocks have been discount-priced, somewhere in the neighborhood of C$160 million, with the catalysts to come in the next several months including drilling results and feasibility studies — and with, like Aurizona, the potential to start mining unusually quickly, in part because it’s a past-producing mine. I could probably be talked into a higher valuation for NewCastle, but I’d rather wait to see the feasibility study first.

I’m not as sanguine about Anfield Gold (ANF.V) — their asset is the proposed Coringa mine, which is tiny (but high grade), here’s how they describe it in the prefeasibility study:

“The proposed 450 tonne/day mine will operate over an 4.8 year period with average annual gold production of 32 thousand ounces. Initial capital costs are estimated at US$28.8 million, with life-of-mine capital costs of US$27.7 million. At a gold price of US$1,250/oz the project generates an after tax net present value (NPV) at a 5% discount rate of US$30.5 million and an internal rate of return (IRR) of 30.1%.”

That’s a decent rate of return and a manageable up front investment, but a very small mine compared to the others. The project is in “legal action” right now because the government has sued to block the mining licenses they were granted, and they’re still preparing their environmental impact statement, so there’s at least a fairly large dose of uncertainty in this asset. Anfield seems to me, in retrospect (that’s the easiest kind of perspective, of course) to have been overvalued for much of the past two years, based on the value of Coringa, and is still pretty richly valued at C$45 million… whether that’s because there’s value in the Coringa area beyond that identified with the feasibility study, or because Ross Beaty is involved and therefore the stock got overpriced, I don’t know. I wouldn’t buy Ashfield now even with Ross Beaty involved, so I don’t assign any value to this.

So the value has to come to this new combined company either because the “sum of the assets” is greater than the whole, or because some of the less-defined assets are more valuable than we currently realize. The most likely to be rerated, I think, is the Warintza copper project that was part of Lowell Copper before this whole parade of mergers began. That was the key upside asset, I think, in the creation of JDL Gold, just because it’s a Lowell-identified copper porphyry in Ecuador that’s similar to past large mines he found… and when they were doing private placements to raise money for JDL Gold (which included the mill in Peru, another copper porphyry in Chile, and the high-grade but “no one has wanted to develop” Elk Gold mine in British Columbia), that combined company was getting a valuation of about $100 million. It didn’t hold that value for long (and they brought on Aurizona by merging further with Luna Gold not long after that), so that value has been kind of hidden for the past year… but I think it’s pretty safe to say, with copper prices up about 50% since those days, that that combination of projects, led by Warintza, should be worth at least $50 million. But though that gives copper exposure, it’s also already part of Trek, and part of the $300 million valuation I thought that company should have.

So essentially we’re talking about C$160 million for NewCastle, and US$300 million for Trek and Aurizona, so that’s a total of about C$545 million in what I can seriously consider those lead projects to be worth. Any extra value has to be created from the other projects, which are mostly quite small or extremely early in exploration and don’t appear particularly valuable for me, but could turn into something eventually… or from the financing package or the management team.

The Aurizona mine, frankly, continues to be the project that I like most, by far… but no one else seems to like it very much, so you might be wise to form your own opinion there. The picture seems to be of a company that for a year now has kept trying to add more earlier-stage projects to Aurizona to make it more valuable through diversification, but each time they do it seems to also add risk and dilute near-term value in terms of foreseeable cash flow. If it weren’t for Ross Beaty, frankly, this deal would stink a bit… unless you happen to really adore Castle Mountain, which is a decent-sized deposit under and around a past-producing open pit mine (and did have a PEA several years ago, though there must be a reason it’s not talked about now, that put the value at $350 million in a base-case $1,300 gold world).

With Ross Beaty? Is it worth holding now that the company will have a market cap of something like C$450 million? That means the company is trading at only a 20% discount to what I think a reasonable valuation might be… and we’ve added $285 million more in financing access (not cash, but liquidity to cover development and construction — and enough to go a long way toward getting both Aurizona and Castle producing). So they don’t have to go out and seek more money, which is a big deal if we go through another softer patch for mining finance.

So the question is really how much Ross Beaty is worth… and though my initial response to this news yesterday was “sell!”… I surprise myself by saying “Beaty’s worth quite a bit” in this circumstance, because I think there’s a pretty good chance that having Beaty at the helm of a near-production gold company that also has other prospective properties, and has a pathway to grow into almost a mid-tier size producer, is going to be catnip for mining investors (and newsletters), and as soon as there’s a modicum of excitement about gold developers there’s a good chance that we could see these shares pretty rapidly rise in value.

Of course, that might be in a couple years, or it might be in a few months… and if gold doesn’t go up, it might not happen at all (though since they’re well-financed now, a shorter-term decline in gold wouldn’t be catastrophic). A lot depends on animal spirits in the gold investment community (spirits that seem to be on loan to the cryptocurrency sector at the moment).

Equinox will be a very different company than Trek, mostly because of Ross Beaty’s presence and because of that second mine that could follow Aurizona by a year or two and have them producing a total of 250-300,000 ounces of gold a year in four or five years. So despite my initial misgivings, I’m giving Beaty the benefit of the doubt, particularly because he’s paying close-to-market prices for a big chunk of this company, and increasing my position in Trek/Equinox by about 50%. That brings it up to a substantial risk for me, and it means I don’t really have any more room for gold speculating in my portfolio unless I sell something… so we’ll see how that goes.

On the positive side, at least when it comes to diversification, the sale of Retail Opportunity Investments, a far larger position than Trek/Equinox, means that I’ve still reduced some of that effective “anti-dollar” and “benefits from low or falling interest rates” exposure — the REITs tend to travel with all other interest-rate sensitive stuff in the short term, which means that when interest rates rise and money comes to the US bonds seeking those higher rates of return, and the value of the dollar therefore rises (and gold falls — exacerbated by the fact that gold competes with bonds to some degree, and gold yields nothing), REITs also fall, and vice versa. That relationship doesn’t always stand, but it’s been tight for the past three years — you can see that in this chart of GLD vs. the Vanguard REIT Index ETF (VNQ).
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And what this Equinox deal does indisputably do, at least, is make Sandstorm Gold’s (SAND) royalty a bit more valuable by de-risking — Sandstorm was a major streaming partner on the Aurizona mine, and was crushed when that mine, by far their biggest revenue generator at the time, was taken offline because of Luna Gold’s development and financing problems several years ago, so they ended up converting that streaming deal to a royalty and getting some convertible debt and equity in Luna Gold, which later became Trek Mining. Ross Beaty is buying up a bunch of that convertible debt from Sandstorm, but they still have the royalty on both Aurizona and the surrounding exploration area, so that should be good for $5 million or so in annual royalties (at current prices) to Sandstorm once Aurizona hits commercial production in a couple years — and Aurizona will now be a safer bet because development will be fully funded.

Five million doesn’t sound like a lot, but the royalty companies routinely trade at huge multiples to sales because their sales have such a huge profit margin (remember, they don’t do any of the mining, and they have few employees and low overhead, they just collect their share of the ounces). At Sandstorm’s price/sales of about 10, among the lowest in the sector, that means this anticipated $5 million in annual revenue is responsible for perhaps $50 million of their market cap, about 6% of the company’s valuation… or $100 million if Sandstorm ever gets to have a truly rich valuation like Franco-Nevada at 20X sales.

So the royalty gets less risky, and Sandstorm gets to sell off part of their convertible debt position in Trek/Equinox (they’ll maintain some exposure, they’re not selling it all and they remain a substantial Equinox shareholder, holding about 6% of the company), which helps their balance sheet flexibility as they focus on selling down non-core assets. That’s a good end result for Sandstorm, and it means their initial Aurizona financing deal, one of Sandstorm’s very first deals, will more likely end up being OK… if not nearly as good as originally expected back in 2010. Aurizona has also probably consumed far more of Sandstorm CEO Nolan Watson’s psychic energy over the past decade than it ended up deserving, so perhaps they’re relieved to have some of this monkey off their back, and will look forward to the resumption of cash flow from Aurizona in a couple years. (For what it’s worth, Sandstorm also has a royalty on Coringa… the one I’m not holding my breath on. Franco-Nevada (FNV), which is far larger and also in my portfolio, has a 3%+ royalty on Castle Mountain).

So yes, in case you’re curious, Sandstorm Gold would still be my first bet if I were building some exposure to gold into a portfolio today… and it will certainly be a heckuva lot less risky than Equinox.

*****

In other gold news, First Mining Finance (FF.TO, FFMGF) got a bit more detailed with their discussion of the Springpole project, which was the focus of the teaser campaign promoting the stock earlier this year (and is First Mining’s most valuable project, at least for now). No real big news there, but they did lay out their permitting timeline — so the earliest they could go from the current PEA, which I updated my thoughts about here, to starting construction is about four years (two years for environmental permitting, a year and a half for construction permitting). Mining projects pretty much never happen on the optimistic schedules proposed by miners, but they are at least talking about moving the project forward.

And interestingly, First Mining has been spending quite a bit of money drilling and doing pre-development work on a couple of its projects this year — to the extent that this latest press release contained a phrase I don’t think I’ve heard First Mining use before…

“First Mining is a mineral property company that is evolving from a holder of mineral assets to a project developer.”

That “project developer” sounds like a slight change in tack, those are folks who build mines, not folks who explore or aggregate properties when prices are low and sell them off to more spending-happy miners during hot times, which was First Mining’s original intent… though perhaps it’s just semantics — they do still call themselves a “mineral bank,” and it’s not very likely that they’ll be the full owner of Springpole for the next five years as it advances through the permitting and feasibility studies. If they do develop Springpole by themselevs, it will suck up quite a bit of cash. Makes me think that perhaps they’re falling in love with Springpole just a bit, which can take away some of that “banker” mentality, but I could just be projecting.

*****

And I noted in passing earlier this week that I had laid on some more speculative options positions on JD.com (JD), so those are also in the Real Money Portfolio now… though that speculative end of my portfolio, much of it China-related, took a beating this week when lots of growth stocks and China stocks dropped sharply (and recovered slightly when Amazon and Microsoft and Alphabet made us think that all’s right with the world again).

So there you have it… a heaping dose of blatheration as we head into Halloween weekend, enjoy yourselves, and please keep sending in your questions or suggestions for what you’d like covered in future Friday Files… thanks!

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