As a relatively conservative investor, I spend a lot of time looking for ways to avoid losing money and also identifying potential dangers in the practices of businesses I analyze. I also like to keep records of previous booms and busts so I can watch for repeats of the same practices, patterns and conditions within the same or other industries in the future.
I am also not a big believer in the hype we all receive in our emails regarding the “next stock that is about to soar 538%!” or “Protect yourself now from the coming 57% market collapse!” Do you ever wonder where they come up with the odd numbers they use? If they give you a very precise number, it creates the illusion that it was actually calculated rather than just pulled out of thin air. It gives the impression that there is some factual basis behind the number. In reality, we are almost always better off to keep our capital in our pockets and ignore this kind of puffery.
I have recently been looking at the auto industry for potential investment opportunities due to the recent growth in sales, and have stumbled across something that I think is quite disturbing and eeriely similar to the practices being used in the mortgage industry in the mid-2000’s that helped create the meltdown of the mortage industry and took us to the verge of financial collapse. This is subprime lending.
If you think back between 2005 and 2007, virtually anyone could get a home loan. You could even get loans without the need to verify income. People were buying homes before construction even began, and selling them before construction was ever completed. The practice became so widespread and common that the term house-flipping was coined to describe it. People were leaving professional level jobs to participate in it, and the money flowed freely to people who were completely incapable of ever meeting a mortage obligation.
That was okay; they developed brand new products for these people called negative amortization mortgages. These were mortgages where the payments were not high enough to cover even the interest on the loan and were given with the expectation that the home value would rise faster than the mortgage balance forever. You may recall that it didn’t quite work out that way.
Do you remember how the institutions making these bad loans bundled them together under fancy sounds acronyms like CDO’s (collaterized debt securties) and MBO’s (mortgage backed securities) and sold them as safe, stable investment vehicles backed by safe, stable assets?
When the house of cards collapsed, do you remember the politicians who helped create the problem all thumping their collective chests and shouting how they would punish the evil doers and this type of thing would never happen again?
Well…
Subprime Lending Is Back…And It’s Big
You might have been wondering what on earth the collapse of the mortgage industry in 2007 and 2008 could have to do with my analysis work looking for opportunities in the car market? Well, when looking for individual opportunties, one must understand the broad industry segment where those opportunities are located and safety of the financial foundation upon which the overall industry rests. Guess what I found in the auto industry?
A great deal and increasingly large share of the recent growth in sales in the automobile industry is coming from sales of vehicles to SUB-PRIME borrowers. For anyone who doesn’t aleady know, a borrower classified as “sub-prime” is someone with a poor credit score or poor credit history that makes them statistically more likely to default on a loan.
Credit.com reports that the average car loan has increased over the last five years from $14,700 to $17,400. On June 1, USA Today reported that the average new car loan has reached 67 months, which is an all-time record. This article stated that the number of loans with terms between 73 and 84 months had also grown to a record level of 29.5% in the first quarter of 2015. This increase represents an 18% increase from the corresponding period in 2014.
And exactly what is happening to all of these long-term obligations for car payments? See if this sounds familiar. Santander Consumer USA Holdings (SC, Financial), a car financing company, just sold $700 million worth of bundled subprime auto loans to investors as Auto ABS (Auto Asset-Backed Securities) investments. Sound familiar? Do you suppose the people who bought these bundled loans are fully aware that the average FICO credit score of the people who now owe them money is only 552? Do you think anyone pointed out to them that 13% of the loans contained in these bundled securities were made to people with NO CREDIT SCORE? Since the Credit.com article stated it only took Santander Consumer a few hours to sell these bundled loans, we can only assume that these particular tidbits of information were not prominently displayed in the prospectus or the buyers paid a low enough price to simply flip them at a profits to less discerning buyers.
There will be those who will point to the fact that loan default rates for car loans do not seem to be rising at an alarming rate, so there is nothing to worry about. Well, it seems that a new twist has been added to the auto loan business to help hold down those pesky defaults that might make it more difficult to sell Auto ABS’s as an attractive investment. It is called a loan deferment. What this amount to is an agreement from the lender to allow a borrower to skip one or more payments and add them to the end of the loan. By doing this, the borrower’s credit score (if they had one at all) is not advsersely affected and the lender can still report the loan as current in its status. Presto! Bad loans are now good loans.
On Aug. 13, The Wall Street Journal reported that the total outstanding balance for auto loans in the U.S. surpassed $1 trillion for the first time ever. Forbes magazine stated in January that, as of Q3 2014, subprime auto loans comprised 23% of the overall loan total.
So, we have a high volume of subprime debt. It is being built up in a single segment of the economy. The questionable loans are being bundled up and sold to “investors” who are hungry for better yields. I am sure you can see where all of this is heading. I expect this situation will work out just as well for the buyers of Auto ABS’s as it did just a few years ago for the buyers of the bundled mortgage debt.
Just like the housing bubble, it is hard to say when this will end. But, any objective view of the facts tells us it is not going to end well. Starting now, it would seem to be a wise move to avoid anything related to the financing or selling of automobiles.
How Is Any Of This Going To Make Us Rich?
Well, first of all, by looking ahead and seeing what appears to be coming, we can avoid taking the losses others will who fail to recognize the danger and have exposure to this segment of the market when the next crisis arrives.
Next, we need to consider what the response will be from investors and government agencies such as the Fed and Treasury Department in the face of yet another potential meltdown that could sink the credit industry. Surely there is no one who has already forgotten the term “quantitative easing”. A new series of quanitative easing moves from the Fed to stave off a collapse of the credit industry in the face of massive defaults by subprime borrowers on auto loans could seriously threaten the stability of the U.S. dollar.
Historically, a weakening dollar is good for commodity prices in general and gold, copper and silver prices in particular. Where this becomes really good news for investors is that these commodities have been mired in a brutal, four-year long bear market that has seen the share prices of the exploration companies and producers decimated.
Where this becomes really good news is when we can find a business that is already in possession of the world’s largest undeveloped gold and copper deposit in the world and is expanding the value of the contained resource seemingly with every new hole they drill. Even better, because this property is not an actual operating mine, they can stop further exploration drilling at any time and cut their ongoing expenses to just about nothing while waiting for an improvement in metals prices to increase the value of their metal in the ground.
The company I am writing about is Seabridge Gold (SA, Financial) and it owns two major gold deposits known as KSM and Courageous Lake, both located in mining friendly Canada. All together, these deposits are currently known to contained proven and probable gold equal to almost 50 million ounces, copper resources of about 10 billion pounds and in the neighborhood of 212 million ounces of silver. What has always somewhat surpressed the value of this property has been questions surrounding the company’s ability to gain the permits required to construct and operate a mine and processing facility and the low grade of the gold deposit.
In the past 12 months, the company has received the approvals necessary for the constrution and operation of a mine and processing facility. But they have done much more than that. Over the past two years, the company has begun to answer the question as to where all of that low-grade deposit came from with their drilling programs in two areas known as Deep Kerr and Iron Cap. The drilling in these two areas has not only expanded the total resource, it has improved the grade of the deposit and appears to be answering the question as to where all of that low grade metal near the surface came from. The first reported drilling results from Deep Kerr from 2015 have produced core samples that CEO Rudi Fronk describer to me as “nothing short of spectacular”. If it turns out that Seabridge has located the richer veins that carried the low-grade metal to near the surface, it would be a game-changer for the company even at today’s metals prices.
We will not know the full extent of the resource expansion at the KSM project from this year’s drilling until some time during the first quarter of next year. However, if the intial results are consistent with the overall results, we should expect a significant upgrade in the total resource and an overall improvement in the economics of the eventual mine and processing facility.
What Could Be The Catalysts That Unlocks The Value?
Any time we are looking to invest in a depressed market in expectation of a turnaround in sentiment, we need to have a percieved catalyst that will unlock the value and cause a share price ot rise. I believe a meltdown in the automobile financing market that would decimate new and used car sales and prices could trigger a new panic in the credit markets as investors recall the stil relatively fresh wounds from the last major meltdown and begin to flee debt instruments for more traditional stores of value.
One of the long standing “safe havens” in times of crisis has been gold. It has an historic perception of value as real money over 5,000 years of recorded history. The chart below shows the all-time high of $1,900.30 for gold that was reached in August of 2011 and its steady decline up until the very recent uptrend clearly shown beginning in late July in the one-year chart shown below.
The 10-year price chart for Seabridge shown above shows the same beginning of what looks like a new uptrend in the share price and also shows a strong, but leveraged price move directly related to the price of gold. What Seabridge has, that gold does not, that is not reflected in the current share price compared to its past valuation, is a resource size that has grown with seemingly every new exploration hole they have drilled over the past 10 years.
Better yet, the company carries no debt. All of its drilling exploration activities have been funded with the issuance of new shares and each time shares were issued it was done at a premium to current market value in private placements. Also, the exploration funded with each new round of shares being sold has resulted in an increase in the amount of gold represented by each outstanding share of stock.
So we have a commodity with a history of being viewed as a safe haven in times of financial crisis that seems to have formed a bottom and to be starting into an uptrend after a brutal four year decline. We have a business that owns the largest undeveloped deposit of that asset in the world. AND, we have a potentially huge financial crisis that could explode at any time. Best of all, our security against this potential crisis is a business that can stop virtually all of its expenses at any time and simply wait for a rising price for the resources it owns.
What Is The Value Of Seabridge Gold?
This is really a very difficult question because there are so many variable involved. There is only one analyst covering the stock and offering a price target for the shares. That one target price is $14.00/share, or 136% above Friday’s closing price of $5.93.
Should we begin to see the development of another financial crisis through the unravelling of the automobile financing market and the junk paper they are selling off packaged as high-yield investments, panicked investors fleeing to gold to protect their money could send the price of gold to new highs. Given the improved size and quality of Seabridge’s proven and probable resources compare to what they were in 2011 when the stock traded near $35.00/share, it is very easy to see how a major panic could send these shares well beyond the $14.00 target that is the only estimate currently out there to a price well beyond the previous high.
I personally believe the stock will eventually reach a price range between $45.00 and $84/share with existing shareholders receiving somewhere between 50% and 60% of that amount after completion of a joint venture agreement with an entity that will build and operate the eventual mine a processing facility on the property. The construction and operation of a mine and processing facility is something Rudi Fronk has long maintained would require a joint venture agreement as it is something for which Seabridge lacks the financial means and technical expertise to perform on their own.
There are current about 10 entities that have executed confidentiality agreements wit Seabridge that allow them access to the proprietary information necessary for conducting due diligence on the assets of SA.
Why And When Do You Want To Own Seabridge Shares?
There are two excellent reasons for owning shares of Seabridge Gold right now. The first is that even a small position could provide an excellent hedge for your portfolio in the event of a new credit crisis developing due to the poor lending practices being employed in the auto financing sector.
After establishing a 52-week low of $3.31/share on July 24th, the shares have rebounded strongly and the price of gold seems to have also found a floor around the same time. Right now seems to be an excellent time to open a position in this stock.
Having made that statement, this is the type of stock I would classify as a conservative speculation. I think the assets of Seabridge Gold have real and quantifiable value. I also think it is very difficult to project exactly when and what will cause the market to begin to recognize that value and assign an appropriate value to the shares. The lack of my ability to place a time estimate on when I think the value will be realized is why I view this as being a bit speculative in nature.
I don’t think shares of Seabridge Gold will make you rich overnight. I do think there is a real possibility of triple digit gains in the next 12 months with the prospect of much larger gains over the next two to three years.
