by Travis Johnson, Stock Gumshoe | October 20, 2017 6:23 pm
So… what’s going on this week? The world watched Congress actually pass something last night, on the 30th anniversary of the 1987 stock market crash (they passed their spending framework bill for 2018, which is importantly mostly because it sets the stage for tax reform legislation to proceed in the coming months), so that made everyone feel pretty good this morning… it’s encouraging for investors to see that there’s a majority vote in Congress for something.
But was that enough to settle down the heartburn brought by the memory of that crash and the constant crash discussion in the financial press? Or enough to settle everyone’s worries about China’s slightly disappointing GDP growth? (Or the warning from the Peoples Bank of China that crashes are more dramatic following bubbles? Next update: if you throw a rock in the air, it might fall on your head!)
I don’t know… but so far, sure, the market is pretty happy — the S&P, as I type around midday on Friday, is still up a bit on the week (and gold is still down about 1.5% on the week, which may be an indicator that fears of inflation and crisis are lower… or, at least, that the dollar has strengthened slightly from recent lows). And Kim Jong Un and President Trump are continuing their war of words, but that doesn’t seem to make the market all that nervous anymore.
Any news on the stocks in the Real Money Portfolio? I thought I’d keep it pretty brief this week, but I want to answer some reader questions about two gold stocks that are performing poorly, USAU and TREK.V, and then I’ll wrap things up with a little China speculation update… let’s get right to it:
U.S. Gold Corp (USAU) stock is down sharply this year, perhaps because of a lack of understanding about where the company is in its development. This is a gold explorer, led by an experienced geologist who has found huge gold deposits before in formations that are similar to U.S. Gold’s Keystone property in Nevada, but they haven’t found anything material yet in their short existence — or in miner parlance, they haven’t yet made a discovery.
That was the case earlier this year when the company was really formed, and it’s the case today, and it could easily still be the case in six months — if there is a big deposit on U.S. Gold’s land akin to the nearby Carlin Trend monster gold deposits that have been mined for decades, and it is concentrated enough to make it worthwhile to build a mine, then U.S. Gold is worth hundreds of millions of dollars or more, most likely (possibly much more, though that depends on the size of the deposit). If there isn’t enough gold there, or they run out of money before they can find the gold, then U.S. Gold is functionally worthless (perhaps not totally worthless, since they also own a second property called Copper King, but that property isn’t nearly as exciting as their Nevada land holding and investors don’t care about Copper King at the moment, so “worthless” is a safer assumption).
U.S. Gold seemingly depressed its share price by raising some more money recently — that ended up raising not much more than $2 million, but the company is so small that that’s a roughly 10% “dilution,” and investors almost always have a knee-jerk negative reaction to companies raising money. That’s a little silly at this point, they had enough cash to finish their 2017 exploration before that but they will need a lot more cash to actually drill up to reserves, and they will likely end up selling a lot more shares to raise that cash along the way (hopefully at higher prices, if they do end up with some impressive drilling results). People don’t lend money to exploration companies, because they know they’re not getting that money back if the company doesn’t find anything, they buy stakes in them so they can at least participate in the huge upside potential in exchange for taking the risk of a 100% loss — that’s how explorers fund their work. So they will sell more shares in the future, you can pretty much depend on that.
And yes, the company has noted that they were already fully funded for their 2017 exploration campaign… but they also just last week expanded that drilling plan — so I guess that means they should have plenty of cash to get through this newly expanded drilling phase now… but if they do release good results at some time over the winter, I would expect them to sell more shares afterward to raise money for more drilling, they’re still on “scout holes” for the most part, trying to understand the potential deposits and narrow down where they should be drilling in the future, it will take lots more drilling to actually begin to identify resources or reserves (assuming, of course, that they do find something that has the potential to be the 1+ million ounce deposit they’re looking for).
It’s a long and hard business, and it often fails, so we’re really just waiting to see if they succeed — in a case like this, where you’re just waiting for a catalyst and it’s pretty much an “all or nothing” result (either there’s a meaningful gold discovery, or there isn’t — size matters, but the first real variable that matters at this point is whether there’s a discovery at all, and how long it takes to get to that awareness), it doesn’t really make much sense to use a stop loss. A stop loss in this case would just mean you’re trading on sentiment shifts when there’s no real potential for meaningful news from the company… and while “efficient market hypothesis” folks will say that the falling share price itself is an indication that they won’t find gold because “the market always knows”, that strikes me as hooey.
Yes or no, we don’t know, and we probably won’t know for a while — the yes is potentially huge, the no is terrible, and I’ll just sit and wait to see what the word might be. You might still wish to use a stop loss if you worry about capital preservation, but with little stocks like this (U.S. Gold’s reported market cap is below $20 million), the only real capital preservation technique is position sizing — the stock could have fallen 50% or more in a day because they said pessimistic things about their first round of drilling (instead of 50% in six months from just ennui and a lack of great news), and that could still happen tomorrow if they release bad news — but the current weakness strikes me as just a gradual “lack of great news” decline that perhaps is also hitting stop losses along the way… and there’s no predefined point at which we can know for sure that a definitive discovery will have been made or not made, so I’ll just wait. You go in with money you can afford to lose, you pays your money, and you takes your chances, and there’s no point in folding before you even know what your cards are.
And speaking of gold stocks that are down and looking somewhat ugly in the Real Money Portfolio, how about Trek Mining (TREK.V, LWLCF), formerly known as JDL Gold and Lowell Copper and, before that, Luna Gold? That stock has been suffering for quite a while, despite what I continue to believer is a very attractive, if smallish to midsized, mine in development.
Trek is redeveloping the old Aurizona mine, formerly operated by Luna Gold, and it’s an easy case to make in basic economic terms — the mine is partially done already, construction is underway to rebuild and restart the mine, they should be able to produce 165,000 ounces of gold a year for 6.5 years at low cost, and the company is valued at a discount to the net present value of those six years of gold production today, despite the likelihood of extending that mine life because of surrounding deposits that are just now being drilled and may be added to reserves in the near future. And, if you want a little sugar on top, there’s also the fact that they own several other copper and gold prospects in North and South America.
But it’s also a stock I clearly overpaid for, in retrospect, so there’s that.
The net present value, according to their latest feasibility study from earlier this year, is estimated at $197 million if you use a 5% discount rate (that’s for $1,250 gold … if you use $1.350 gold it’s $254 million), and the net cash flow is expected to be $65 million per year, resulting in payback of the relatively limited initial and sustaining capital ($182 million) in less than three years.
That’s a pretty easy “green light” project, particularly since they already have $75 million in cash so actually don’t need to borrow the full initial capital expenditure budget. I use that cash in my calculations and am therefore comfortable saying that Trek Mining, absent a collapse of the mining industry or a gold price dropping (and staying) below $1,100 or $1,200, should be worth about $300 million (at least $200 million for Aurizona because there is almost certainly substantial gold surrounding the already-defined deposit, plus some valuation for the other assets that recognizes that they are real and prospective, particularly the South American copper prospects brought to the deal by J. David Lowell, one of the most successful prospectors in history, plus $75 million in cash).
I think Trek is well-managed and has several strong shareholders, including Sandstorm Gold (SAND) (which got a substantial ownership stake in exchange for what had been a large streaming deal with Luna before Luna had to restructure), and it looks to me like that rare thing in gold mining land: A pretty good business. The share price might not go anywhere soon, that probably depends on their progress in construction, which should be starting in earnest about now, and what kind of additional reserves they book over the next few months thanks to their additional exploratory drilling (or whether their partner, Anglogold Ashanti, finds anything in their large greenfields exploration area next door).
But if we assume a reasonably stable gold price and a lack of critical problems with mine construction, I believe this stock should be twice the price it now trades at — which, frankly, is a lot closer to the price I paid last year in a feat of optimism. My optimism about the cash position and about Trek’s other assets appears to have been misplaced last year, investors don’t appear to care about those things now, but the Aurizona mine still looks like a great low-risk property and should reward shareholders in fairly short order (first pour is targeted for late next year, and that probably won’t happen because miners are pathological optimists — but even within two years is pretty quick for a mine startup, and there should be a steady diet of construction news to mollify shareholders).
I’m irritated that I overpaid in putting on a decent-sized position right when Lowell Copper and JDL Gold got together to form Trek Mining, partly because it would have been smarter to do what I usually try to do and ease into a position and give myself a chance to build my ownership during a more pessimistic time, but I will keep holding. The fundamentals have not deteriorated (they’ve gotten better, in fact, as construction begins and drilling continues to find more gold to extend the mine life), the gold price has not gotten worse, and the company remains well-capitalized and is in a good position to begin production in the foreseeable future, so the stock should improve at some point.
I won’t add to my position at this point, since it already represents more than 1% of the cost basis in my portfolio and that’s enough risk to take in one junior mining name, but I’m quite optimistic about Trek here and think it represents an above-average value in a near-production mine. There is always a decent chance, however, regardless of how I feel about the project and the management team, that a company in this sector can see its value go to zero or lose its valuable assets due to a massive decline in the commodity price, to severe problems at its flagship asset (like if Aurizona floods or has an earthquake or gets is permits revoked or whatever else you might imagine), or to financial distress in a broader market collapse, so betting much more than 1% of my capital on a single junior miner is too big a risk for me, but if I had started with a smaller position I’d be adding now.
If I didn’t have any gold exposure, though (and I do think every portfolio should have some gold in it), the first place I’d look today would be Sandstorm Gold (SAND), the midsize gold streaming and royalty company which remains my largest gold holding (a bit larger than Franco-Nevada, the gold royalty blue chip that has always traded at a much richer valuation than Sandstorm) — their business keeps humming along, and will be extraordinarily profitable with very strong earnings growth over the next five years if gold stays anywhere above $1,200… and they have almost no financial obligations and a nice, clean balance sheet, so they’re not at any risk of going out of business if gold hits another pothole (the stock price, of course, will fall sharply if gold falls hard again — it’s just that they won’t go bankrupt or close up shop like a lot of small miners might). Probably no rush on that one unless gold soars, it’s been relatively undervalued compared to its royalty and streaming peers for most of its life and it will take a few years for the biggest part of their revenue growth to hit, but you never know when animal spirits can light up that sector, and if they do Sandstorm should be a big upside participant in the next gold rally.
Shopify (SHOP) has not had any actual news, but they now have formally announced their earnings date — the quarterly announcement and the conference call will be on Halloween morning, 10/31, before the markets open. That conference call will be a must-listen for Shopify investors because management has promised a more detailed response to Citron’s short attack, so mark those calendars if you’re interested in this one. I’ll at least be watching to see if the growth in users and revenue keeps up, the biggest issue with Shopify is that it’s aggressively growing a business and is investing more aggressively in that growth each year, with tons of hiring and lots of splashy new offices, so they really need to make sure the revenue growth and operating margins keep investors and employees excited about the growth.
They don’t need to make money, but they can’t start to lose a ton of money on an operating basis, either — investing in growth is good, but losing much of the profit margin in the subscription business is not OK unless you see the potential for this to be a $100 billion business in the future, which is more than I can envision with my inadequate imagination (their margins are going to go down as they get more revenue from the lower-margin payment processing business, as opposed to the software subscription business, but hopefully they’ll break out that detail in their report so we can see how the core business is doing).
I haven’t had the guts to buy more SHOP in the Citron-caused dip, mostly because I have a hard time buying more when I own a growth stock that’s trading at nosebleed valuations, as SHOP has over the past year (even after falling 25%)… but I have been slightly tempted, and I reserve the right to change my mind. We’ll see what happens on Halloween.
And for those who are following Naspers (NPSNY) or Tencent (TCEHY), which I wrote about three weeks ago when I finally put Naspers on my watchlist in hopes of finding a better price or otherwise talking myself into buying the stock… I’ve been out of luck on that front, Naspers has since been closing the gap on Tencent, with a rise of about 10% as Tencent has risen “only” 2%. It’s still a considerable valuation gap, and I still find Naspers a bit more appealing than Tencent, but man, I’d really like to see a price dip that would make me feel better about buying a few shares. Is that too much to ask? (Apparently, the answer is “yes”).
In further China speculation news, I did take the opportunity of recent China pessimism (or what passes for it, anyway… maybe we should call it “mild concern”?) to speculate on a bounce-back in JD.com (JD). JD is the most pure-play e-commerce stock in China, their core business is akin to Amazon (while Alibaba’s ecommerce arm is more like eBay, not actually taking possession of stuff and warehousing and selling it, just processing sales), and I think there’s a good chance that they’re building up a meaningful competitive advantage in distribution and logistics in a young and fast-growing e-commerce market, much like Amazon quietly did in decades past.
That’s a reason to possibly speculate on JD.com longer-term, too, but I haven’t done that yet — so far, I’m just speculating, with a small call option position, that the recent dip was overdone and will be overcome in the next few months. That may or may not happen, of course, but this is now added to my speculative position in options on Chinese growth stocks and ETFs. That group, to summarize, now consists of the following:
Alibaba (BABA) long term calls — June 21 2019 $260 call options (0.9% of portfolio)
Kraneshares Chinese Internet (KWEB) ETF — Feb 16 2018 $60 call options (0.4%)
Global-X China Consumer (CHIQ) ETF — Dec 15 2017 $5 call options (0.3%)
Momo (MOMO) — Jan 17 2020 $55 call options (0.2%)
China A Shares Trust (ASHR) ETF — Jan 18 2019 $35 calls (0.1%)
Momo (MOMO) — Jan 18 2019 $60 calls (0.1%)
JD.com (JD) — Jan 19 2018 $50 calls (0.07%)
So that represents a fair amount of exposure to China, spread out quite a bit in time (from two months to 2+ years), and very much on the speculative end of my portfolio (most of those, other than CHIQ options, are well out of the money and require substantial share price improvement to make them profitable)… but it’s still less than 2% of my portfolio, so that’s the maximum loss, which means I get some possible upside if China keeps rocketing but very controlled and limited downside if things get ugly.
When in doubt, if you’re going to do options speculating to fish for big lunkers (which is a low-probability game, but fun when it works), the best gains tend to come when you speculate that the trend will continue beyond what the market “common sense” is saying — you’ll probably be wrong when you think “it’s getting too expensive.” If analysts are at all right about Alibaba, for example, then BABA could hit $260 well before summer 2019 expiration if it gets just a forward PE of 30 on the estimated $8+ in earnings for 2020, which would be a fine price for a stock that’s growing earnings at about 30% a year.
That might not happen, obviously, but the possibility that they could do better than analysts expect, as they often have in the past (growth stock analysts like to have at least a modicum of caution in their estimates), makes it worth the risk to me, and I don’t have to commit 10% of my portfolio to see a meaningful return if that’s true. One percent is just fine, with a 1% loss for my portfolio if it turns out I was wrong about growth accelerating over the next couple years. That trade is essentially a bet that BABA shares will rise by at least 50% over the next two years, and it costs roughly the same amount as a similar bet on Facebook (FB) and less than a similar bet on Alphabet (GOOG)… but I think the growth prospects for Alibaba are substantially more turbo-charged and more likely to be underestimated at this point. I think the risk is higher as well, which is why I’m using options instead of a large equity position.
That’s actually a pretty high-conviction bet for me when it comes to options, since I don’t generally like to risk that large a chunk of my portfolio on time-based all-or-nothing bets, but Alibaba is a pretty special company and two years is a long time — just think of what they’ve done in their core business: lacking a “natural” consumer holiday in China to spur sales, like Christmas does for Amazon, they essentially invented one, and it worked. I think, despite their massive size, that they’re just getting started. There is no national brand for them to beat, no Target or Macy’s or Best Buy, the large internet companies in China also have the benefit of being some of the best early brands in the Chinese consumer economy.
If China crashes because of their debt overhang or government slamming on the brakes or anything else, that will likely take a lot of the rest of the world with it, of course, particularly materials names and cyclical stocks, but there’s little sign of an actual crash, yet… just warnings by the central bank that things are getting a little worrisome on the valuation front (that should elicit a “duh!”), and a slight slowdown from 6.9% to 6.8% GDP growth. I wouldn’t want to own a Chinese bank, but I will probably keep speculating on other names in the Middle Kingdom, and I would like to add some Tencent/Naspers to my portfolio, (I’ve resisted that move to this point out of pure stubbornness, though Tencent is the largest holding in the KWEB ETF, so I guess I’ve got some exposure there).
So that’s what’s percolating down at that speculative end of the portfolio, we’ll see what happens with BABA, JD and all the others.
And with that, dear friends, I’ll leave you to enjoy your October weekend. Feel free to post any comments or questions in the post below, and I will continue to respond to questions that folks have about my portfolio (or anything else) in future Friday Files.
P.S. For those who watch stop loss trigger points, Retail Opportunity Investments Corp (ROIC) is within a whisker of hitting its Tradestops stop loss of $18.59 — that could easily happen next week, particularly since all the REITs tend to trade en masse when there’s chatter about interest rates (or the dollar rising or falling… the REITs often trade in sympathy with gold prices because of that dollar connection). If it hits the stop loss point, I’ll stop, take a breath, and re-analyze the stock to decide what to do… and let you know, of course.
Disclosure: I own pretty much all the stocks mentioned above, as detailed in my Real Money Portfolio and will not trade in any stock covered for at least three days per Stock Gumshoe’s trading rules.
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