Whether you're a new or tenured investor, this has been a challenging year. The coronavirus disease 2019 (COVID-19) pandemic initially clobbered the stock market and sent the broad-based S&P 500 to a 34% loss in just 33 calendar days. But the steepest bear market decline in history was met with the most ferocious rebound of all time. It took less than five months for the widely followed index to regain everything that was lost and push to new highs.
However, big losses and exacerbated downside vacillations haven't been an issue for physical gold and gold stocks, which are among 2020's top performers.
Physical gold is up nearly 29% on a year-to-date basis, trouncing the 5.3% return for the S&P 500. Gold is also outperforming the S&P 500 on a trailing 1-year, 3-year, and 5-year basis.
In my more than 21 years of investing in the stock market and many years of watching the gold mining industry, I've never seen a more lustrous outlook for gold stocks.
A perfect storm is brewing for substantially higher gold prices
The bullishness for gold stocks begins with the underlying asset they produce: physical gold. Although physical gold has already hit a new nominal high in 2020 of more than $2,000 an ounce -- and it's currently about $40 per ounce away from that mark as of the evening of Sept. 15 -- this could be just the beginning.
On the one hand, gold is benefiting from historically low global bond yields. Last year, we saw a peak of $17 trillion in global debt price at a negative yield. Even though yields have bounced a tad, income-seeking investors are finding slim pickings when it comes to guaranteed income that'll outpace inflation. To boot, the Federal Reserve has pledged to keep lending rates at historic lows for years to come. An inflation-beating yield is what would drive investors away from gold. But when the opposite is true, we expect to see investors flock to gold and use it as a store of wealth.
On the other hand, the Federal Reserve is also pumping in gigantic amounts of liquidity to shore up financial markets and the housing market. In response to COVID-19, the nation's central bank announced an unlimited quantitative easing program that'll balloon the money supply and pressure the U.S. dollar. Since the dollar and gold have an inverse relationship, we would expect to see sharply higher gold prices as the Fed continues its assault on the dollar.
We've also witnessed supply and demand economics come into play. Since the end of February, there have been periods where gold bullion supply has run short. As with any good or service, we would expect the price to rise until demand wanes, or until supply is sufficient to meet demand.
Finally, don't discount the fear factor. I'm not a huge believer that fear can sustainably drive the price of gold higher. But when taken in conjunction with these other catalysts, and with the understanding that there are big question marks surrounding a coronavirus vaccine, uncertainty and fear could well push physical gold higher.
Gold stocks are in much better shape now than nine years ago
However, physical gold catalysts only tell half the story. We're seeing significant tailwinds from gold stocks, too.
During the last major bull market for gold, which ended in 2011, mining companies were aggressively expanding their operations. Neither they nor the investment community had a clue that gold would peak in 2011. All they knew was that the price of the lustrous yellow metal had been climbing on an annual basis for over a decade, and it had become economically viable to throw lots of money at expanding existing mines and making acquisitions. This knowledge led a lot of gold stocks to drown themselves in debt.
Over the past eight years, we've witnessed incredible progress as gold stocks have worked tirelessly to reduce their net debt, prioritize high-grade ore projects, and streamline operations. Today, the industry is in much better financial shape than it was even five years ago, with a number of gold stocks capable of producing a cash operating margin of more than $1,000 an ounce.
For example, Ontario-based Yamana Gold (AUY -0.35%) looked to have bit off more than it could chew in June 2014 when it and Agnico Eagle Mines partnered up to buy Osisko Mining and its flagship Canadian Malartic mine. By the end of 2015, Yamana was lugging around approximately $1.7 billion in net debt. However, with Yamana selling the Chapada mine in 2019 for a little over $1 billion, and the company focusing on production efficiency, it has whittled its net debt down to $768 million as of its most recent quarter.
Yamana's story is similar to many other gold stocks.
These gold stocks are built to outperform
Despite physical gold being primed for success, I don't suggest investors buy the physical metal. Gold stocks are a much better choice given that they might pay a dividend and offer leveraged returns relative to the price of gold. Their management teams can also adjust output depending on prevailing market conditions.
Which gold stocks should you buy?
One gold miner I'm more than happy to plug is Kirkland Lake Gold (KL). Earlier this year, Kirkland Lake completed its acquisition of Detour Gold, giving the company three incredibly low-cost, high-efficiency mines. Through the first half of 2020, it's already produced over 660,000 ounces of gold with an all-in sustaining cost (AISC) of just $763 an ounce. Based on the recent price of gold, Kirkland Lake should be generating a cash operating margin of close to $1,200 per ounce.
What's more, Kirkland Lake Gold has the best balance sheet in the entire industry. Following $222.2 million in operating cash flow generated in the second quarter, the company's balance sheet lists $537.4 million in cash and no debt. Mind you, these results come after spending $330 million on share repurchases during the first quarter and doubling its quarterly dividend.
I'm a big fan of gold stocks with financial flexibility, which is why I'd also expect SSR Mining (SSRM 0.13%) to outperform. SSR Mining, a top portfolio holding of mine for years, completed its merger of equals with Alacer Gold yesterday, Sept. 16. This deal creates a company with four significant producing assets that are capable of 780,000 ounces of gold output each year.
More important, even after absorbing Alacer's relatively minimal net debt, the combined company has a healthy net cash position, and it should be able to yield $450 million in annual free cash flow through at least 2022. Cash like this could allow for a dividend, share buyback program, or perhaps another earnings-accretive acquisition.
The outlook for gold stocks has simply never been better.