As we mentioned in an e-mail a few weeks ago, the markets tend to lag in September. This year was no different.
Historically, the markets have been known to lose anywhere from 0.5-1% in the month of September.
These numbers come from data compiled over the last 50-70 years, and to experienced investors losses in September do not come as a surprise.
This year however, the losses were amplified. As you’ll see by the chart below, most major indexes suffered losses north of 4%, with the NASDAQ losing over 5.5%.
Considering the run up we’ve had in 2020 and 2021, small corrections like this are completely healthy, and should be welcomed. It’s hard to not worry about short term movements in the market, but ignoring these movements is critical to becoming successful over the long term.
You’ll also notice that the TSX Index held up much better than the other major indexes. And at first, this might seem confusing. Why?
There is a good chance that your portfolio was down much more than this, unless you had a reasonable amount of exposure to a particular sector, that being the energy sector.
Despite the TSX losing just shy of 3%, XEG, an iShares Canadian energy producer ETF returned over 18.5% on the month. With the TSX index having a roughly 14% weighting towards energy companies, when energy performs well it is going to cushion the blow or amplify the gains of the index as a whole.
On that note, I have decided to re-enter the energy sector
Initially, investors were told that inflation would be transitory, primarily meaning a rise in prices for a period of 6-9 months before settling down.
Last week however, the Chair of the Federal Reserve stated:
“the current spike in U.S. inflation has proven to be larger and more long-lasting than expected.”
This is due to a multitude of things. The velocity of spending due to the economy re-opening, excessive stimulus and supply bottlenecks are driving factors that are likely to continue moving forward.
And speaking of supply issues, whether it be crude or natural gas, the oil and gas sector is seeing a significant amount of demand post-COVID. Enough to cause oil and natural gas prices to rise significantly.
As a result, I’ve (Dan) decided to purchase a capped producer ETF in XEG. The ETF contains oil producers such as Canadian Natural Resources and Imperial Oil, along with natural gas producers like Tourmaline Oil and Birchcliff Energy.
Now, if you’ve been a member here at Stocktrades Premium long enough, you’ll know that our long term 5+ year outlook on the oil and gas sector is somewhat bearish. This purchase of XEG doesn’t change our views on that.
You won’t see oil and gas producers on our Bull Lists (although we have included Birchcliff and Canadian Natural in the past) as they don’t really fit the mold of our Bull Lists, which is based off a “set and forget” 5+ year investment thesis.
But, we do acknowledge the fact that there is the potential for oil and gas companies to generate significant amounts of cash flow over the next 1-2 year periods due to excessive demand, and I’m willing to take a small position in anticipation of that happening, and exit that position when I feel things have settled.
It’s intriguing enough for me to re-enter, but this oil and gas boom is far from guaranteed
We’ve heard this all before, and we’ve heard energy based fund managers preach it practically every single year to no avail up until 2020.
Commodity booms are far from guaranteed. Look no further than bullish estimates for $3000/oz gold in 2020 that drove producer share prices sky high, only to fall back to earth when those numbers weren’t achieved.
The situation with oil is more demand based rather than fear based in golds case, but there is still a chance that this energy crisis is not as big as currently predicted.
This is why my position in XEG will be relatively small, around 1.5% of my total portfolio.
There is a strong likelihood we continue to see rising oil and natural gas prices as we move forward. However, it’s important that we understand this doesn’t necessarily translate into shareholder returns.
The potential is there, but it is far from the guarantee many oil and gas bulls believe it to be. The oil markets have been flooded twice in the last 6 years, and it is never out of the question for it to be done again.
But, I’m cautiously optimistic now, optimistic enough to dip my toes back into the sector for a multi-year hold.
Bull List stock delayed
We have been vetting and shortlisting a variety of stocks over the last few weeks for an addition to our Bull List.
However, growth stocks took a significant hit in September, enough for us to step back and decide to re-evaluate due to some corrections in stocks we think may have become attractive.
As a result, we’re going to delay our new Bull List addition until likely later in the week. It may end up being a stock we currently have shortlisted, or it may end up being a new prospect. We simply want to keep our options open as the correction in September has opened up some new avenues we once thought were overvalued.
So, stay tuned for this soon!
Kirkland Lake and Agnico merger details
Before we start with the merger details, we’d like members to know we’re moving to a “Neutral” stance on Kirkland Lake with the intentions to remove it from the Bull List.
With this merger, Kirkland Lake is likely to trade alongside Agnico until the deal closes, and considering Kirkland Lake shares will become Agnico shares, there isn’t much point to purchasing Kirkland Lake shares right now unless you believe the merger will fall through or another bidder will emerge with a higher price. Both situations we feel are possible, but unlikely.
The big news of the week was the fact that Agnico Eagle (TSX:AEM) was merging with Bull List stock Kirkland Lake Gold (TSX:KL). Right off the hop, we’ll say that we are neutral on the deal. While we aren’t exactly happy, we aren’t disappointed either.
The reason for our neutral stance is due to the fact that this is a “merger of equals” and not an outright takeover. While it may seem that way since Kirkland Lake shareholders will become Agnico Eagle shareholders, this is about two companies merging.
We know many of you were disappointed in the lack of a premium.
Let us explain the rational for why a premium share price isn’t fully deserved in this scenario
First, let’s talk about reserves as it is one of the most common ways to evaluate gold companies. Combined, the new entity will have 48M ounces of gold reserves in their asset base. Only a few weeks ago KL provided investors with an update and we know they had approximately 21M OZ of gold reserves. That is equal to 43.75% of the reserves of the new entity.
Circling back to the deal for a moment, we know that KL shareholders will own 46% of the new entity. So already, KL shareholders are benefiting here. They are effectively contributing 43.75% of the gold reserves in exchange for 46% of the new entity on a pure asset swap basis.
Now, reserves alone don’t tell the whole story. Let’s look at company valuations as of Friday, September 24. Why that date? Because that is the date quoted in the press release.
At that time, AEM was trading at $64.09 per share and had a market cap of ~$15.6B. At 0.7935 per AEM share, which is what KL shareholders will receive when the deal closes, that gave KL a value of $50.85 per share with a market cap of $13.5B.
This means that the market was valuing AEM’s gold reserves at $578/oz and KL was valued at a slightly higher premium at $642/oz. Remember, this is based on the price of $50.85 per share and not the ~$56.00 it was trading at before the merger was announced.
Now we are starting to see the picture materialize for KL shareholders
It is looking more and more like KL Shareholders are doing not bad here. There is however, one caveat that we have yet to mention – KL’s pristine balance sheet versus AEM’s long-term debt of CAD$1.9B.
Therein lies the major difference and why AEM is trading at a discount to KL on a per/OZ basis. If we shift our focus from market cap to enterprise value (which factors in debt and cash), which more accurately reflects the company’s financial state, then AEM and KL are trading at ~$640 and ~$600/OZ respectively.
That changes the narrative and is the main reason why KL shareholders are receiving a bigger piece of the asset pie (46%) when they are only contributing 43.75% of reserves.
We haven’t even broached the subject of costs, in which KL is one of the lowest cost producers at ~US$800.00/OZ vs US$1,000/OZ for Agnico Eagle. Not that $1K/OZ is bad, but it is nowhere near the KL efficiencies.
The other aspect one must consider, is that AEM is poised to grow production at a faster clip than KL
It has more projects that in the later stage of development and that are poised to contribute sooner to the bottom line, and has one of the highest growth rates in the industry.
One need only look at the material impact that recently acquired Hope Bay is expected to have over the next couple of years, as it will add between 250-300k OZ/year to annual production. Of note, it does not appear that Hope Bay was included in the reserve calculations for AEM.
All of these things were considered when discussing this ‘merger of equals’ and there are likely many additional pieces that are tough to quantify as an outsider. All in all, it feels like the merger is likely to benefit AEM shareholders a tinge more than KL shareholders. However, it’s not like all shareholders won’t ultimately benefit.
We knew KL was cheap relative to its peers – it has been for quite a while. In fact, it has traded at a discount ever since the company’s acquisition of Detour Gold. The market felt that it overpaid for the company’s assets and that it would negatively impact KL’s industry leading margins. Remember, Detour was also a much higher cost mine.
However, KL management proved that they are best-in-class when it comes to mine efficiencies
Ever since the Detour acquisition, AISCs at the flagship mine have been on a steady decline and KL turned what the market thought was a bad deal, into a lucrative mine.
We have full confidence that KL can lend its expertise to AEM and the synergies outlined in the report while estimates are likely to be achieved. Even before the $2B in synergies outlined, the new entity will have the lowest AISCs among all senior producers ($905/oz), have some of the highest EBITDA margins (57%), and will have the second largest reserves per share. It will also have an attractive dividend yield (2.78%) which is among the highest in the industry, and much higher than Kirkland Lake’s current yield.
That is a pretty strong company right there. Putting our bias as KL shareholders aside, we’d be quite interested in the new combined entity given its size, valuation, growth pipeline, and potential efficiencies compared to its peers.
The merger also opens the door for more acquisitions down the road
Given the negative reaction towards KL when it acquired DGC, we believe the markets will be more receptive to a larger company when it ultimately begins to consolidate some of the smaller industry players. We think it is only a matter of time before some of these smaller companies get scooped up, especially with gold steadying around $1,800/oz.
Moving forward, KL’s price is likely to move in tandem with AEM’s – especially since this is a merger – not a takeover. We can’t stress this point enough. If Agnico’s price moves upwards, Kirkland’s will as well, and will likely maintain that 79.35%~ gap.
What do we mean by this? Currently, Agnico’s price is $64.46 per share, and Kirkland’s is $51.80. This is around 80% of Agnico’s current share price. If Agnico were to rise to say $70, it is likely Kirkland’s price would maintain this ratio and sit at $56~ a share.
Regardless of the outcome of the vote, we are likely to keep our shares invested in KL regardless of the outcome. As mentioned, when we put our KL bias aside, the new company looks quite attractive.
