So I woke up this morning thinking about gold producer price to NAV5% discounts/premiums. I’ve struggled to understand the intuition behind being priced at a premium to NAV5% as this implies that the appropriate discount rate for the stream of cash flows is less than 5%. How can this be given that gold mining is inherently risky. Arguably more so than the typical business in the S&P 500.
Well there are a couple of explanations for this pricing behavior:
- Analyst NAV assessments underestimate the future
stream of cash flows
- This is possible but I doubt this is the answer as any future resource conversion is going to occur so far in to the future that it would be discounted to oblivion
- Analysts use a flat price deck when creating the
- You could make the case that a nominal price deck should be used but this change would be offset by the use of a nominal discount rate; probably not the answer.
- NAV5% is not the correct discount rate to be
used for specific gold producers.
- I think this is the underlying logic driving the price to NAV logic.
In the gold space, small companies typically trade at a discount to their NAV. Generally, discount to NAV is negatively correlated with size; smaller company, larger discount. The intuition behind this equilibrium makes sense as larger companies are more diversified (operationally and jurisdictionally). Senior producers generally trade at a premium to NAV and streaming companies trade at an even higher premium.
Being priced at a premium is a challenging concept to understand. At the extreme, this can imply that the purchase of the security will provide cash flows that are less than the purchase price. This is very similar to negative interest rates. Unlike negative interest rates, however, the pricing of these securities is not manipulated by quantitative easing and central banks. The “rational” investor is doing the pricing.
So how can a discount rate of zero (or negative) be justified. The capital asset pricing model states that the equity risk premium is the risk free rate + beta * equity risk premium. The current T-bill rate is around 1% so this implies that the beta of these investments must be zero or slightly negative. This train of thought led me to start looking into beta and the correlation of gold to the broader economy.
So what is beta? I like to think of it as a leverage factor for stock returns. A beta of 1.25 means that the stock will move 125% of the move of the general market. Beta can also be thought of as “risk” factor. A high beta implies high risk -higher volatility- and investors will require a higher rate of return for an investment in the security.
If we look at the beta of monthly returns from 1973 to the end of 2018 we see that gold has exhibited a negative beta with respect to the S&P500. Conversely, copper, oil, and silver have positive betas. These relationships make sense as these other commodities are more related to economic growth and, in turn, the S&P500.
The beta values are misleading as they understate gold’s performance
Because, as you’ll see in this chart, gold generally hovers around a beta of zero during periods of relative calm and spikes in other occasions (2008).
This chart that gold acts as insurance during calamity, increasing in value by more than the S&P falls.