$NST Northern Star Resources – Do Better than Buffett

The investment world is buzzing over Berkshire Hathaway‘s ($BRK-A) recent disclosure that it has initiated a position in Barrick Gold Corporation ($GOLD).

Yes, it’s a very small position in relation to the size of Berkshire’s stock portfolio and it’s more likely that a lieutenant made the investment than Warren Buffett himself, but the move is noteworthy nonetheless. Buffett is known for his aversion to physical gold as an investment because it doesn’t generate cash flow, and he went so far to call the whole industry’s existence into question in a 1998 speech:

“[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Gold bugs, on the other hand, see gold as a store of value due to its historical role as the basis of the world’s monetary system. The logic follows that gold will significantly appreciate over the long run in relation to fiat currencies as governments around the world print as much money as they like, perpetually increasing the fiat money supply against a finite quantity of gold. In the twenty years following Buffett’s 1998 comments, there was practically no difference in total performance between equities and physical gold, although they took very different paths to get there and made both sides take turns looking dumb for about a decade each:

I don’t hold a strong opinion about the relative performance of either asset class over the next one, five, ten, or twenty years; quite frankly I don’t have a clue what will happen. The debate will likely rage on because both sides are partially right. Buying gold is speculation by definition, but it is sound speculation. It is very unlikely we return to the gold standard, but people’s distrust of central banks could support demand for physical gold as insurance indefinitely while new supply becomes increasingly expensive to mine. While gold is not a cash-flowing asset, gold miners are businesses that can be analyzed and valued, and a select few may achieve the status of intelligent investment.

Gold mining is not an inherently good business to be in. As with any resource extraction business, results depend on the quality of assets held and the market price of the commodity produced. Resources are finite, so companies have to find a way to replace resources as they are depleted if they want to remain a going concern, and there is no guarantee the new assets will be as productive as the old assets. Prospecting is generally a risky endeavor, so when profits are high and financing is easy, the major operators prefer to bid up prices for proven and producing assets, squeeze out cash flow to increase dividends and pump their stock up, and repeat the process as many times as they can before the music stops. Commodity cycles are inevitable but timing is difficult to predict, and long bull or bear markets can lull the average operator into doing the wrong things at the worst time.

Returns on capital that look good during commodity booms tend to revert to the mean if management is not properly incentivized and equipped with the right skill set for consistent value creation. Different sets of management expertise and capital allocation strategies are required at different stages of mine life to maximize probability of success and generate attractive returns on capital over the long run. Management teams incentivized to build empires without regard for long-term shareholder value are likely to lever up to make massive mergers and acquisitions right before the party ends and then not know how to properly run the assets as they inevitably deplete.

Barrick strikes me as possibly the worst offender in this regard. The Company issued massive amounts of equity and debt to become the largest gold producer in the world during gold’s bull run from to 2011. The $10.4 billion hostile takeover of rival Canadian gold miner Placer Dome accounted for a 60% increase in Barrick’s sharecount in 2006, and the 2011 acquisition of Equinox at peak gold prices resulted in a net debt position over $10 billion. As gold prices fell, Barrick was forced to take a $4.2 billion write-down on the Equinox acquisition. In order to deal with its massive debtload, the Company was forced to dispose of non-core assets, cut its dividend, and pare back on capital expenditures. Barrick’s production has fallen from about 8 million ounces in 2011 to 5 million ounces this year while the sharecount increased by another 75%, as the Company continued down its insane warpath of shareholder value destruction with another large merger in 2018. The net result for shareholders over the last two decades has been a massive underperformance of physical gold itself:

I think those Martians must be scratching their heads the hardest at what Berkshire is now doing, and they have become very confused about this concept we call “value investing.” Most people in the mining industry understand that if Barrick Gold is good for anything, it’s for selling out at an inflated price or for getting a great deal on a neglected mine they are putting up for sale.

Northern Star Resources ($NST.ax), perhaps the industry’s biggest success story of the past decade, has achieved staggering returns for shareholders by executing a totally different approach. The stock’s 10-year return now stands at +15,755% (+66% annualized, not including dividends), while physical gold has risen 56% (4.5% CAGR), and Barrick has registered a cumulative loss of -42% (maybe a bit better if you add up dividends):

Northern Star has built its entire business around acquiring mispriced end-of-life assets from bloated operators like Barrick and making prudent capital investments to unleash the assets’ full potential by lowering extraction costs and extending their mine lives. The meteoric rise of NST highlights the utmost importance of management quality in a commoditized industry, as the major drivers of returns on capital are management decisions around mine transactions, operations, and gold hedging activities.

Former CEO and current Chairman Bill Beament was instrumental in formulating NST’s business model. Beament’s background as an underground mining engineer gave him a unique advantage to spot value where others couldn’t. With the support of a senior management team built with a focus on underground mining expertise, the Company has demonstrated that their ability to buy non-core “tired, unloved assets” from other companies and quickly turn them around into major performers that have a significant impact on NST shareholder value is not just a matter of getting lucky, but rather a repeatable process.

Jundee, now one of four Tier-1 assets in the Company’s portfolio, is a good example of the NST Model at work. NST acquired Jundee from major operator Newmont Corporation (NEM) for A$82.5 million in 2014. At the time, reserves had dwindled down to less than two years’ worth of production. Following NST’s acquisition, the Company formulated a comprehensive in-mine and near-mine exploration strategy. The extensive drilling program resulted in a significant increase in reserves and resources, extending the mine life to 10 years and restoring its status as a world-class asset, capable of producing 300,000oz per annum (A$833 million at current gold prices). The stabilization of annual production is supported by a rapid increase in underground production. In FY2019, Jundee generated net mine cash flow of A$213 million, and the Company’s exploration program is still yielding exciting growth opportunities.

The NST Model has worked consistently well across a growing number of assets. The Company also enjoyed similar success with Kanowna and Kundana, which were purchased from Barrick for a song in 2014. As a result, NST has delivered an average Return on Equity of 30% and Return on Invested Capital of 27% over the past five years, leading the gold mining sector by a mile:

The Company has grown through acquisition to now operate four Tier-1 assets in Australia and Alaska, with two of these assets still in the early stages of a turnaround. The most recently acquired asset is a JV stake in the Super Pit, Australia’s largest open-pit gold mine. In another stroke of genius, Barrick and Newmont disposed of the asset at the end of 2019 just before gold prices surged another 30% in 2020. NST now looks very well positioned for further growth in reserves and production per share, with ample opportunities for exploration and bolt-on acquisitions, as well as management capacity for one to three more major sites, should the opportunities arise.

NST maintains fewer hedges on its production than its peers, which means it will participate more fully in any additional upside if gold continues to rise in the near-term. NST is also low-cost operator that maintained profitability and thrived throughout the last gold bear market, able to make great deals and compound shareholder value at an impressive rate. I believe the Company is inherently more attractive than its peers in both bull and bear markets and deserves to trade at a premium valuation. With a good amount of visibility into production growth and higher gold prices in the coming years, the market is anticipating substantial earnings growth as well. While relatively expensive on a trailing basis, NST is cheaper than Barrick and other peers on expected 2022 earnings, despite a much more attractive growth profile:

Despite its long run of outperformance, Northern Star Resources is still likely one of the most attractive ways to invest in gold, and it is my only high conviction idea in the sector. Part of the reason for this is that I am far from an expert on the sector and spend almost no time looking at mining companies. One thing I’m not too bad at is identifying outlier great management teams, which is even more straightforward when they are operating in a challenging industry. Northern Star’s focus on underground mining throughout the organization and relatively young workforce puts them in a prime position to continue to benefit from the challenges the rest of the industry is facing from declining reserves and waning relevance of open-pit mining. This dynamic is similar to many industries today; the best just keep getting better while the rest stay stuck in the mud. If indeed this is the start of a new bull market, then the best operator in the industry should do exceptionally well.

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