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Sid and the question of NovaGold (NG)

March 13, 2013

Sid is right. He left a comment on one of my previous posts asking how I could buy shares of NovaGold without doing a thorough valuation. I’ve been thinking about this very question since I first purchased a few shares almost a year ago. I have subsequently upped the number of shares I own to almost a full position. So what is my investment thesis? I’m afraid it’s a bit convoluted but it goes something like this.

  1. The more the market moves up, the more likely we are to have a correction and the larger the correction is likely to be. You remember my incessant drum beat over the past 6 or 9 months about having to raise cash. I’ve  actually done it to some extent, and the portfolio is now about 25% in cash. But I don’t think 25% cash is defensive enough. I think I need something for all possible outcomes; the market could easily continue its gradual rise of the past 4 years… or it could take a U-turn and dive down to where it was in 2009 or below. And I want to be ready for the Great U-Turn!  Now, I know I can’t time the market, but it’s just common sense to lighten up as the market moves upward. But what I really want to protect against is that small probability of a real market meltdown. A small correction would be OK, even bullish. But a 30% or greater correction could really shake some things out of the trees. I want to be positioned for this kind of shock psychologically (as well as investment wise) were we to face such a correction. Not only do I want cash, I want something that will grow in value when everything else is in free fall. That will give me the psychological ammunition to commit at the point of greatest desperation. I could , of course, use index puts or futures but I would be paying up for the time premium, and I have no idea how long we may continue our jolly ride upward. Plus, what I really want is catastrophe insurance, you know, with a really high deductible.
  2. I’m making a leap of faith that the price of gold will move inversely to equities during a global meltdown. This may or may not happen, just like the global meltdown may or may not happen. But I tend to think gold will move inversely to equity valuations, especially in a situation where the dollar, the world’s reserve currency, is at the center of the maelstrom. The fact that everyone has lost interest in gold as the world equity markets continue higher is a positive for me.  I could buy physical gold as my insurance. But I want something that will magnify any increase in the price of gold.
  3. I’ve hit on NovaGold because its value is highly leveraged to any change in the price of gold and, more importantly, its value is NOT linked to existing production. That’s right, I want the smell of money, not the real thing. I think that will sell better in a panic. Plus, there is increased financial leverage because the market cap is so small; the only cash spent so far has been on the permitting of Donlin Creek, not on actual operations.
  4. But what about valuation you say? Well, I’ll have to believe what NovaGold management is telling me as I have no better insight into how much gold might be extracted from the Donlin mine or what the cost to extract it might be. Yes, of course, I take everything they say with a (large) grain of salt. If you look at their fact sheet they compute an after tax present value of the Donlin Gold Project of $4.6 billion at $1,700 gold. OK, so I see that they are using a discount rate of 5% and that doesn’t really cut it, but I also think they have only been able to use a low estimate of reserves. What I looked at was the project’s leverage to the price of gold; a 17% increase in gold prices leads to a 45% increase in the present value of the project cash flows. Right now, the market capitalization of NG is about $1.2 billion (with NG owning a 50% interest in the project) so a high side estimate for the value of the project is a multiple of the current market cap. Oh, of course, the low side is that its worth zero, zilch, nada… that’s why this has to be a small position in anyone’s portfolio (even Seth Klarman’s).
  5. But Barrick Gold, owner of the other 50% interest and prime suspect for an operating partner or the origin of a buyout offer, put out a press release last June saying that they wouldn’t commit to investing in the project at that time. Doesn’t this mean the claim is worthless, and by extension, NG is worthless? That’s the conclusion Glenn Chan came to after sorting through the press release. I, however, come to a slightly different conclusion. It seems to me that Barrick would have gained nothing by committing to the project at this time. They have already committed to the permitting process which will last another 3 years minimum. If Barrick is indeed interested in buying out the NG interest in Donlin (as they were several years ago) why would they openly signal their interest at this time? Strategically wouldn’t they be better off negotiating with NG at a time when NG has a depressed market capitalization? After all, it’s a lot easier to convince shareholders that an $8/share takeover offer is ‘fair’ when the shares are trading at $4 then when they are trading at $7. My conclusion is that, at worst, I take the press release at face value, Barrick has no need to commit at this time and so won’t. At best I see it as a tactical play to reduce interest in NG’s 50% interest in Donlin with an eye to a lower-cost buyout.

That’s it, you say? So qualitative and so un-quantitative. Yep. Sorry. I’ve run some DCF numbers for myself but I don’t want to publish them and give the naïve reader (is there one out there?) the impression that I know anything about gold mining finance. There are so many assumptions to be made in a DCF model that it is hardly worthwhile as a measure of intrinsic value. Remember the life of this mine is 25+ years and it will take at least 4 to begin extraction. I consider the DCF model more useful for understanding the key financial drivers and highlighting sensitivities than calculating intrinsic value. Here, you need to look not only at operational leverage but at financing structure, partnering assumptions et al. So if you’re interested in my thesis on NovaGold take out pencil, paper and green eyeshades and get to it! Run some numbers! See if you come up with scenarios that work for your portfolio.

Note: I’ve been adding recently again under $4.00 per share

  1. “Strategically wouldn’t they be better off negotiating with NG at a time when NG has a depressed market capitalization?”
    It’s arguably not a good move for Barrick to try to depress the price of its partner. These exploration/development stage companies are often undercapitalized and need to raise money. If you hurt them, it will make it difficult to attract other partners in the future. You see some of this in the differences in press releases- NovaGold will always try to spin everything as positive as possible because a high share price is very important for them. Barrick’s share price is also important for its CEO, but Barrick’s CEO has to appease his shareholders who are starting to realize that Barrick should have made a lot more money in a gold bull market. The old CEO chased dumb projects that weren’t really economic.

    The project isn’t entirely worthless. It’s just mostly worthless unless gold prices go up a lot versus the cost of mining. Then it might be economic and worth building.

  2. Brian permalink

    Why buy the equity? Given this is all personal account money doesn’t it make more sense to use call spreads? Or even risk reversals?

  3. Like to keep things simple. With an option you’re paying for time decay. I have no idea when NG might become valuable; could be 2 weeks or 2 years. Options aren’t of much use for us value investors unless they’re very long-dated, as in leaps or warrants.

  4. Jake permalink

    new lows in NG today. it’s going to be a painful ride until paulson’s gold fund folds. however, forced selling = bargain prices.

  5. Jake permalink

    vinik is closing shop. he has been flooding market with NG shares in recent weeks. i wonder if klarman is buying more on the cheap.

  6. Sid permalink

    With Barrick (ABX) on a cost-cutting/divestiture spree, there is speculation that it will dispose off their share of Dolin assets. Overall sentiment has started to shift among the miners…from despair and hopelessness to hope…

    I noticed your “target price” of $15 on NovaGold – I’m wondering if you would sell at a lower price/earlier or is it a perpetual position in your portfolio as “insurance” ?


    • It’s kind of insurance, but if the price reaches $10-$11, I’ll be reevaluating in terms of alternative investments. The time to sell will be when everybody else is buying gold and gold miners. Until then I’m happy just sitting and twiddling my thumbs. This year’s performance has been a refreshing change.. just sorry that when I did some tax loss selling late last year I didn’t just hold onto all the shares!

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