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Adam Hamilton

Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Gold Juniors’ Q1’17 Fundamentals

The junior gold miners’ stocks suffered a serious thrashing between mid-April and early May. Relentless heavy selling blasted many back down near deep mid-December lows, leaving sentiment in tatters. But traders distracted by weak technicals need to keep their eyes on the fundamental ball. The gold juniors just finished their Q1 earnings season, which was solid. Their low stock prices are disconnected from reality.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports. These are generally due by 45 days after quarter-ends in the US and Canada. They offer true and clear snapshots of what’s really going on operationally, shattering the misconceptions bred by the ever-shifting winds of sentiment. There’s no junior-gold-miner data that is more highly anticipated.

Until later last year, the definitive list of elite junior gold stocks to analyze came from the world’s most-popular junior-gold-stock investment vehicle. The GDXJ VanEck Vectors Junior Gold Miners ETF was born in November 2009, and is the second-largest gold-stock ETF after its big brother GDX which tracks the larger major gold miners. Investors love junior gold miners’ stellar potential, so GDXJ has been very popular.

Unfortunately this fame has recently created major problems severely hobbling the usefulness of GDXJ. This sector ETF has shifted from being beneficial for junior gold miners to outright harming them. GDXJ is literally advertised as a “Junior Gold Miners ETF”. Investors only buy GDXJ shares because they think this ETF gives them direct exposure to junior gold miners’ stocks. But that’s increasingly becoming less true.

When capital flows into GDXJ as a proxy for owning junior gold miners, this ETF should be shunting that buying directly into junior gold miners’ stocks. But GDXJ is no longer fully doing that. Instead some of these capital inflows are now stealthily diverted into larger gold miners’ stocks, which is troubling. Investors who actually wanted to own majors would buy GDX rather than GDXJ. This junior ETF is failing its mission.

With capital explicitly intended by investors to buy juniors instead redirected into majors, the junior gold miners’ stocks are being starved of capital inflows. Strong investment buying that should be propelling the juniors much higher isn’t reaching them, which is quite frankly an outrage. That’s not only hurting their present prices, but future potential too since buying begets buying. GDXJ is sabotaging the junior sector.

How did GDXJ go so wrong since the middle of last year? Ironically it’s the victim of its own success. This leading junior-gold-miners ETF tracks an index called the MVIS Global Junior Gold Miners Index. MV Index Solutions is the indexing arm of VanEck, and its analysts have done a good job constructing their junior index for GDXJ to replicate. It contains most of the world’s best junior gold miners and explorers.

The inclusion criteria are pretty simple. Companies need to have market caps over $150m, which is tiny. They must have average daily trading volume of $1m, also small. And they have to generate at least 50% of their revenues from gold or silver mining. As of this week, this index underlying GDXJ has 48 component companies. Many are great choices, though some are operating at mid-tier instead of junior scales.

Before mid-2016, GDXJ’s composition was able to track this index as claimed. But in the first half of last year as gold surged 30% higher in its first new bull market in years, investors flooded into GDXJ to chase the soaring junior gold miners’ stocks. This small ETF mirroring a small sector enjoyed massive capital inflows. GDXJ’s net assets exploded from $1b to over $5b in that span, exceedingly large relative to its sector!

GDXJ attempted to shunt that capital into its underlying junior gold stocks as normal, which is the way ETFs are supposed to work. That’s why ETF-share buying directly bids up underlying stocks. But GDXJ ran into multiple problems. This ETF’s footprint in some component junior gold miners was so large that its ownership stakes approached 20%, a threshold that must not be crossed under Canadian securities law.

GDXJ is dominated by Canadian companies because that’s where the great majority of the world’s junior gold miners list and trade. This week Canadian companies accounted for nearly 2/3rds of GDXJ’s net assets. In Canada once any investor including an ETF goes over 20% ownership, it is deemed to be a takeover offer which must then be automatically extended to all remaining shareholders on the same terms!

As a passive investor on behalf of its shareholders, GDXJ can’t be acquiring and running gold miners. So this leading junior-gold-miners ETF had to simply stop investing in Canadian juniors nearing that 20% threshold! Instead GDXJ’s managers started diverting the torrents of capital inflows into investments in larger gold miners that weren’t a part of its mission or underlying index. That even included adding GDX.

Every quarter I analyze the latest results from major gold miners, junior gold miners, and silver miners using their respective leading ETFs’ component lists. Sometime between Q2’16 and Q3’16, GDXJ’s managers started buying GDX shares. GDX showed up as the third-largest component of GDXJ in both Q3’16 and Q4’16, so I railed about it in both analyses. It was false advertising, GDXJ investors wanted juniors.

GDXJ’s managers diverted capital intended for junior miners into other much-larger gold miners. Just this week for example, after GDX at GDXJ’s second-biggest weighting the third-and fourth-largest are bigger mid-tier gold miners not even included in GDXJ’s underlying index. So even right now with juniors not popular at all, at least 1/8th of the capital flowing into GDXJ for junior exposure isn’t going to juniors!

That was much worse later last year, and GDXJ has other problems too. It has struggled periodically to comply with IRS diversification regulations in order to keep preferential tax treatment as a regulated investment company. GDXJ’s underlying index is also what JNUG uses, that 3x leveraged ETF on junior gold miners. So vast quantities of GDXJ shares are often tied up as hedges underlying the crazy-volatile JNUG.

So GDXJ is really a mess, and is no longer the “Junior Gold Miners ETF” investors think they are buying. GDXJ’s solution is troubling too, although it may be the only option. It will soon change the composition of its underlying index to include much-larger gold miners, well into the mid-tier realm. I generally define juniors as less than 300k ounces of annual gold production, mid-tiers from 300k to 1 million, and majors over 1 million.

So in terms of weightings, going forward GDXJ is going to be dominated by mid-tier gold miners instead of juniors! Thus investors who really want exposure to junior gold miners are going to have to go back to directly buying shares in these individual companies. That’s ultimately better, as junior gold miners with superior fundamentals will see stock-price upside dwarfing that of the ETFs overdiversified with laggards.

Sadly GDXJ is increasingly no longer what it advertises itself as and what investors think it is. GDXJ will continue to contain the world’s best juniors, but their collective weightings will be smaller which means this ETF won’t track their prices well. GDXJ will be more of a mid-tier gold miners ETF, with performance closer to the major-dominated GDX. Investors looking for junior exposure need to understand what’s happening.

I’ll absolutely continue my quarterly studies of gold miners’ operating fundamentals, as this knowledge is essential to fuel our own trades outlined in our newsletters. But in future quarters I might have to lump all the GDX and GDXJ gold miners together, and then manually divide them out into major, mid-tier, and junior categories based on quarterly gold production of 250k+ ounces, 75k to 250k, and less than 75k.

But for the just-reported Q1’17, I’m sticking with my usual approach of looking at the top 34 “juniors” that are included in GDXJ. That number is arbitrary, it simply fits neatly into the tables below. Out of GDXJ’s 56 component companies this week, 8 more than its underlying index, the top 34 command a dominant 85.6% of its total weighting. That GDX filler is ignored, but I wrote an essay on its miners’ Q1 results last week.

Every quarter I wade through a ton of data from these elite gold juniors’ quarterly reports, and dump it into a big spreadsheet for analysis. Some made it into these tables. If a field is blank, it usually means a company didn’t report that data for Q1’17 as of this Wednesday. Some percentage changes are also left blank if that data went from positive to negative or vice versa. That actually happened quite a bit in Q1.

In these tables the first couple columns show each GDXJ component’s symbol and weighting within this ETF as of this week. Only half these stocks are normally listed to trade in the US. So if you can’t find a symbol, it’s a listing from a company’s primary foreign stock exchange usually in Canada or Australia. That’s followed by each GDXJ component’s Q1’17 gold production in ounces, mostly in pure-gold terms.

Most gold miners also produce byproduct metals like silver and copper. These are valuable, as they are sold to offset some of the considerable costs of gold mining. Some companies report their quarterly gold production including silver, a construct called gold-equivalent ounces. I only included GEOs if no pure-gold numbers were available. Financial and operational reporting varies greatly from company to company.

That’s followed by the quarter-on-quarter change, the absolute percentage difference between Q4’16 and Q1’17. This offers a more-granular read on gold miners’ ongoing performance trends than year-over-year comparisons. QoQ changes are also listed for the rest of this data, which includes cash costs per ounce of gold mined, all-in sustaining costs per ounce, operating cash flows generated, and GAAP accounting profits.

After spending lots of time digesting these elite gold juniors’ latest quarterly results, it’s fully apparent their stocks’ recent sharp selloff wasn’t fundamentally-righteous at all! Gold-stock traders got scared because gold was sliding after gold-futures shorting attacks. That excessive herd fear pummeled this sector back down to fundamentally-absurd levels relative to prevailing gold prices, spawning incredible bargains.

Let’s start with the top 34 GDXJ component miners’ gold production in Q1’17, since everything else from profits to stock prices ultimately depend on it. These elite juniors collectively mined 2.1m ounces of gold in the first quarter. Interestingly GDXJ’s 4 largest component miners not including GDX are also top-34 components of the latter major-gold-miners ETF. This brings up another longstanding frustration with GDXJ.

VanEck owns and manages GDX, GDXJ, and that MVIS indexing company that decides exactly which gold stocks are included in each. With one company in total control, GDX and GDXJ should have zero overlap in underlying companies! GDX or GDXJ inclusion should be mutually-exclusive based on the size of individual miners. That would make both GDX and GDXJ much more targeted and useful for investors.

The top 34 GDXJ gold miners’ Q1 production actually fell a sharp 6.4% QoQ from Q4, which seems like an ominous omen. If the leading junior gold miners can’t grow their production, that is bearish for their collective fundamentals. But interestingly, the world’s gold miners have long seen sharp drops in gold production from Q4s to Q1s. I explained the reasons why in last week’s analysis of GDX miners’ Q1’17 results.

In a nutshell, gold miners often choose to target lower-grade ores in first quarters before moving back to better stuff in the second and third quarters. Early in new years, miners have fresh capital budgets to target expansions which often require digging through lower-grade ores. Managements are also keen to set up scenarios where they exceed expectations later in the years, maximizing their stock compensation.

So the leading GDXJ junior gold miners will likely see sharp rebounds in their collective gold production in coming quarters this year. That gold-mining seasonality is well-established, production sliding in Q1s before bouncing back strongly in Q2s and Q3s. Of 27 of these top 34 GDXJ juniors reporting production in Q1’17, fully 20 had QoQ declines averaging 11.8%! That has major implications for gold-mining costs.

Lower gold production directly leads to higher per-ounce mining costs. Gold miners blast and haul big chunks of gold-bearing ore to mills. These are essentially giant rock grinders that break ore into smaller pieces, vastly increasing the surface area for chemicals to later leach the gold out. Mill capacity is fixed, with limits on ore tonnage throughput. So the same quarterly tonnage of lower-grade ore leads to fewer ounces.

But the costs of running mills, electricity, employees, and maintenance, are the same regardless of how rich the ore being run though. Lower-grade ore yields fewer ounces to spread these big fixed costs across, jacking up per-ounce costs. So a 6% drop in quarterly gold production should lead to a 6% rise in per-ounce costs, inversely proportional. And that’s indeed what the top GDXJ juniors reported in Q1.

There are two major ways to measure gold-mining costs, classic cash costs per ounce and the superior all-in sustaining costs per ounce. Both are useful metrics. Cash costs are the acid test of gold-miner survivability in lower-gold-price environments, revealing the worst-case gold levels necessary to keep the mines running. All-in sustaining costs show where gold needs to trade to maintain current mining tempos indefinitely.

Cash costs naturally encompass all cash expenses necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses. In Q1’17, these top 34 GDXJ-component gold miners that reported cash costs averaged $647 per ounce. That was 5.1% higher than Q4’16’s $615, actually better than the QoQ production drop.

This was really quite impressive, as the junior gold miners’ cash costs were only slightly higher than the GDX majors’ $623. That’s despite the juniors each operating fewer gold mines and thus having far less opportunities to realize cost efficiencies. Traders must recognize the junior gold miners are in zero fundamental peril as long as prevailing gold prices remain well above cash costs. And $650 gold ain’t happening!

Way more important than cash costs are the far-superior all-in sustaining costs. They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it really costs to maintain a gold mine as an ongoing concern. AISC include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current gold-production levels.

These additional expenses include exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation. They also include the corporate-level administration expenses necessary to oversee gold mines. All-in sustaining costs are the most-important gold-mining cost metric by far for investors, revealing gold miners’ true operating profitability.

In Q1’17, these top 34 GDXJ components reporting AISC averaged just $924 per ounce. While that was up 8.1% QoQ which is roughly inversely proportional to the production decline, it’s still way under today’s gold prices. Despite the irrational fears plaguing this sector, the junior gold miners are quite profitable at Q1’s average gold price of $1220. AISC of $924 still yield solid per-ounce profits of $296, for nice 24% margins.

Naturally Q1’s high all-in sustaining costs will mean revert lower in coming quarters as gold production rebounds, spreading high fixed costs across more ounces of gold. But even if $924 persisted, the junior gold miners are still seeing much-better profitability so far in Q2. Quarter-to-date, the average gold price of $1256 is 2.9% higher. That implies junior gold miners’ profits are surging 12.0% higher to $332 per ounce!

Some of these elite gold juniors gave full-year-2017 AISC guidance, and it averaged $879 for the 14 of these top 34 GDXJ components offering it. Thus the gold miners themselves see lower all-in sustaining costs going forward. And managements tend to intentionally inflate their cost forecasts early in years, which gives them more room to beat and exceed expectations later in years. So juniors’ AISC are heading lower.

Even that $924 in Q1 was anomalously high, driven by a single company. Klondex Mines reported a crazy-high AISC of $1719 per ounce! Without that extreme outlier, these top GDXJ components’ Q1 average would’ve been just $884. That’s right in line with the GDX majors’ $878 last quarter! KLDX is forecasting its full-year AISC at $1100, attributing Q1’s anomaly to major development costs at one gold mine.

With production down it’s not surprising the top 34 GDXJ components’ aggregate cash flows generated from operations also fell. They came in at $575m in Q1, 32.5% under Q4’s levels. But as production ramps back up in Q2, OCF will bounce back sharply as well. As long as the junior gold miners’ operations are able to keep producing lots more cash than they cost to run, this sector’s fundamental outlook remains fine.

As the juniors’ relatively-low all-in sustaining costs compared to prevailing gold prices imply, these miners should be quite profitable. That indeed proved true in Q1, with these top 34 GDXJ components reporting real hard GAAP earnings totaling $100m. That’s a whopping 44x greater than their collective profits in Q4! Despite all the irrational fear in junior gold stocks since mid-April, even $1220 gold yields solid fundamentals.

If the despised junior gold miners could fare so well in Q1’17 when gold was relatively low, imagine how they will look as gold continues mean reverting higher in coming quarters. In early May many of these stocks fell to levels near or even under where they were in mid-December, when gold was blasted down to $1128 and everyone assumed it was heading much lower. Even at worst in May, gold was still $91 higher!

Make no mistake, the junior gold miners’ stock prices today are truly fundamentally absurd. The sharp selloff between mid-April and early May was based purely on excessively-bearish sentiment, high fear levels that aren’t sustainable. Sooner or later investors will realize the folly of fleeing this sector and flood back in with a vengeance. That will catapult these irrationally-beaten-down junior gold miners far higher.

Given GDXJ’s serious problems, leading to diverting far too much of its capital into larger gold miners that definitely aren’t juniors, you won’t find sufficient junior-gold exposure in this troubled ETF. Instead traders should prudently deploy capital in the better individual junior gold miners’ stocks with superior fundamentals. Their upside is vast, and would trounce GDXJ’s even if that ETF was still working properly.

The bottom line is the elite gold juniors’ fundamentals in just-reported Q1’17 remained quite strong and bullish. Despite relatively-low gold prices and the usual sharp first-quarter production drop, the juniors’ costs stayed low enough to yield solid profitability. That will soar as gold itself mean reverts higher, due to the junior gold miners’ high inherent profits leverage to gold. The recent major selloff was totally unjustified.

That makes this battered sector a screaming buy right now fundamentally. Exceptional junior-gold-stock bargains abound as excessive and irrational fear still taints this small contrarian sector. But with GDXJ’s growing diversion into larger mid-tier gold miners, it should be totally avoided by investors really seeking junior exposure. Directly buy the superior junior gold miners’ stocks, and watch them soar on capital inflows.

By Adam Hamilton for Safehaven.com

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