Going Deep in the Name of Due Diligence

Matt Scherer, CFA
August 15, 2018

Stabilization of the U.S. dollar, progress on trade agreements and signs of a recovery in the emerging markets all contributed to solid returns for the month.

The MSCI All Country World ex USA stock index was up 2.4% in July, but remains down 1.5% for the year. Stabilization of the U.S. dollar, progress on trade agreements and signs of a recovery in the emerging markets all contributed to solid returns for the month. International markets continue to lag domestic markets, but the gap closed some in July as easing headwinds and attractive valuations enticed investment.

During the month of July I traveled to Vancouver, Canada, to visit with one of our portfolio holdings and a few other prospective investments. Canada is a well-known natural resources market and the trip included a visit to an underground gold mine in northern British Columbia. The trip got me thinking about precious metal investing and our due diligence process.

Gold prices at month-end stood at $1,234 per oz., which compares to all-time highs above $1,800/oz. in 2011 and down roughly 10% over the last five years. Historically, strategists considered gold an important part of any asset allocation, but precious metals and commodities have gradually fallen out of favor while short-term trends appear to be accelerating with significant flows out of gold ETFs in recent weeks.

Bears, or detractors, argue that gold has little intrinsic value, that the diversification benefits have diminished, or that we are now in an inflation-less economy. On the other hand, those with a more bullish outlook argue the asset class is not correlated to equities and bonds, will protect wealth should inflation spike and is a scarce resource. Predicting commodity prices is notoriously difficult, but for the “gold bugs” among you, I have always felt that owning the equity of gold miners has merits relative to investing in a gold ETF.

Gold miners typically purchase or discover a reserve and are specialists in removing the ore and bringing it to market. This is no easy task as I learned on my trip–many commercial ore bodies are located in difficult-to-reach parts of the world, and this ore body was no different. From Vancouver, I flew about two hours to Northern British Colombia where the Alaskan panhandle reaches into Canada. We landed on a gravel runway, high in the mountains where the pilots frequently abort if the cloud cover does not provide enough visibility (or in some cases if moose or bear are in the way). From there, we took helicopters to the mountaintop, about 1,400 meters above sea level and the tree line. The mine site was first located in the 1960s, but as is often the case, only started producing commercial quantities of gold this year.

Upon arriving, the group of analysts I was traveling with met with senior management, engineers and operators (some of the 300+ people on site) who explained the mine and took us through an extensive safety check. From there we boarded small trucks and entered an underground mineshaft measuring roughly 15’ x 15’. As we snaked our way down the dark and damp corridor, we made several stops along the way to see the mining operation in action. We visited areas where explosions would break the rock, points where rock was being taken to the surface, large mining equipment, and, of course, gold.

It was shocking to think we were 950km north of Vancouver, over 1,400m up in the mountains, hundreds of feet underground, and the visible gold was no larger than the nail of my pinky. Being in the mine also made me realize the cost and effort that goes into mining enough gold to make even something as simple as a wedding band. This mine could be a world-class mine yet it extracts only 14.1 oz. of gold for every ton of rock they take to the surface to process. A ton of crushed rock fits in the back of a large pick-up truck, and from all that rock, a single ounce of gold is recovered, enough to make four rings.

Upon exiting the mine we visited the rest of the facility. As rock is brought out of the mine it is placed on conveyer belts where it moves through the facility. First, it goes into a series of huge cylinders with bowling ball-sized balls that crush the rock into gravel. The processed rock then moves to an automated sifter where the shaking motion separates the majority of the gold from the rock. The collected gold is then melted and poured into “dore” bars for transportation. Nothing is wasted: even the rock the slurry is reprocessed to ensure all the gold is recovered. Finally, the excess rock is safely disposed back into the mine or an appropriate location.

I am not a geologist, so visiting a mine like this will not tell me if there is more or less gold in the mine than the 8.7m oz. the company’s feasibility suggests (approximately $10 billion worth of gold in the ground at current gold prices).

Having invested in commodities for clients for many years, I know that owning gold mining stocks affords investors several unique advantages. For example, gold mining companies have gold in the ground, so the stock prices are highly correlated with gold prices. However, they also are producing a product and typically generating a cash flow stream. More importantly, they are run by management teams who have the operating experience to lower costs and maximize returns. These managers are more experienced in gold economics and know better when to ramp up or pull back on production. Yet, there are investors who will argue that these managers do not, in fact, have this ability, which is the main reason we travel to see companies before we invest: to assess the quality of the management teams and the operators, to understand the mining process and to gain comfort that the management team is aligned with shareholders.

At the end of the day, mining has historically been a difficult industry to invest in given our quality growth approach. As I mentioned, miners discovered this mine in the 1960s and likely have spent more than $1 billion since then to get it to production. Even when the investment does not fit for our portfolio, we always find due diligence trips useful. We learn about the process, competitors to our portfolio holdings and the value chain; additionally, our portfolio companies are often customers or suppliers.

There are many ways to invest clients’ money. For us, fundamental research is core to our investment process. We think it is important to understand the businesses we own and more importantly the managers guiding those companies. You can’t always do that from a desk—sometimes you have to get on a plane and do your due diligence in person.

Matt Scherer is a portfolio manager and equities analyst for CIBC Private Wealth Management with more than 20 years of industry experience.