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Miners are looking to capitalize on the rising price of precious metals

It has been a tough time for precious metal miners. The spot prices have been kept artificially low, the recent covid-19 disruptions have made it more difficult to do the job and now there is a virtual store of wealth that is yielding massive returns for speculators and diverting money out of traditional sources of stores of wealth. But could that all be about to change?

Weekly Investing Idea - Fresnillo (FRES)

A sideways day to start the week ended with the FTSE 100 index at 7305 at the close in London today. In response to the Bank of England's decision to leave interest rates unchanged last week, traders re-priced the pound and worked out whether or not the Fed will raise rates in 2022. GBPUSD appears to be stuck between a rock and a hard place at the moment, while the FTSE 100 has stalled at its recent highs.

While Fed policymakers were speaking at various events, equity markets generally remained subdued. Consumer inflation data also reflected the current expectation of higher interest rates in the future in order to combat persistently high inflation. Precious metals and interest rates are symbiotic, so monitoring nominal and real yields can help determine which direction gold will take.

TLT's price action today reflects the trend in US Treasuries over the medium to long term, and the US Treasury has a number of refinancing programs due this week. The benchmark 10-year notes will be auctioned tomorrow, so if there is greater demand than the last auction, we could see the likes of TLT go higher and the US 10-year yields drop. This would be good for precious metal stackers, miners, and everyone in between.

Fresnillo (FRES), which for the past five years has been struggling to break out of a technical downtrend, is one of the companies on the rise in the UK FTSE 100. In 2020, gold prices spiked higher as a result of global lockdowns, giving the company a much-needed bear market rally. However, this recent price movement looks like it has reached a steady level for a more prolonged rally.

The Fundamentals

Fresnillo plc is a holding company based in Mexico with shares listed on the LSE. The company's subsidiaries are engaged in the mining of precious metals and non-ferrous minerals. The company mainly targets silver, gold, lead, and zinc. Fresnillo operates three gold and silver mines in Mexico. The largest mine, in terms of silver output, is Mina Proaño located near the city of Fresnillo in the state of Zacatecas; the other mines are at Cienega, in Durango, and Herradura, in Sonora.

Its competitors include BHP Group (ASX: BHP), Rio Tinto Group (LSE: RIO), and Glencore (LSE: GLEN).

Based on the chart above, there are some positive moves taking place in Fresnillo's price action, and the company is well-positioned to weather sideways markets as we have seen in spot gold and silver. Of the 3 other companies, only Glencore has seen a rally along with Fresnillo, so not everyone is benefitting from the underlying market conditions.

Clearly, investors see some potential for returns, and a metric they could use to find value is Return on Capital Employed (ROCE).

What is Return on Capital Employed (ROCE)?

The return on capital employed (ROCE) is a financial ratio that can be used to measure a company's profitability and capital efficiency. This ratio can be used to assess how well a company is generating profits from its capital.

When analyzing a company for investment, financial managers, stakeholders, and potential investors may use ROCE ratios.

On Fresnillo, the formula is as follows:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.18 = US$1.0b ÷ (US$5.9b - US$430m)

The ROCE for Fresnillo is 18%. That's a typical return on capital and corresponds to the industry's average return of 18%. A company that has a high return on capital employed (ROCE) wisely uses its assets and earns a decent return. When a company keeps increasing its capital employed, it shows that it is reinvesting profits at increasing rates of return.

Fresnillo has shown it can reinvest in the business and generate higher returns on that capital which is a positive for a company coming out of a deep downturn (-42.14% from its five-year high), where dividends did not increase. The dividend payment for Q1 2019 was 21.3, with a yield of 2.71%. By Q2 2020 the dividend had dropped to 11.34 with a yield of 1.25%. Dividend track records that are unsteady don't do much to entice investors, but it's clear that value can still be found at these current prices. This latest round of earnings reports showed that in Q2 2021, dividend payments were 23.74 with a yield of 2.65%.

Underlying macroeconomics

Inflation expectations for US consumers are going up, with consumers worrying about large ticket item prices rising as well as food and energy.

The graph above is basically showing gold prices in blue, versus the PCE and CPI inflation measures. Since 2008 there has not been a tireless correlation between increasing or decreasing inflation and the spot price of gold. What could be gleaned from this graph is that when inflation begins to rise, as markets come out of turmoil, the inflation index rises in step with the price of gold. When inflation goes from being a function of growth to being a drag on an economy (where interest rates must rise according to the central bank book of inflation 101), the price of gold appears to go lower with the falling inflation.

The markets have been in a reflation trade since March 2020 and the move into gold preceded the rise in inflation as gold is a store of wealth and a safe-haven asset. If inflation is set to be persistently higher, but the fed is not going to raise rates and therefore bond yields, portfolio managers move into gold to protect their purchasing power. In the same way, some are arguing Bitcoin will protect your wealth measured in your purchasing power.

Currently, the rising PCE and CPI inflation, plus the falling benchmark 10-year yields are putting real yields into the negative. This is where we see the real correlation between inflation and gold.

The Fed announced that they will taper their asset purchases, which will help raise the short-term yields and interest rates, but they are not looking to raise the Fed Fund Effective Rate which means that yields will keep around the current 0.100 level.

This monetary policy I believe will be good news for the spot price of gold.

On the daily gold chart, there is clearly a triple top level of resistance at $1831, which will have a pool of stop-loss orders and buy stops above ready for an acceleration higher. Whether the price can get to the swing high from June 2021 I am not sure, that may depend on how quickly the Fed speeds up their taper and get to the lift-off for interest rates. Most gold bugs think we should be trading a lot higher in both gold and silver and the consensus is that we could be back to $2,000 /oz gold and possibly $50 /oz silver in the coming months.

Technical Analysis

For Fresnillo, they are obviously turning the corner, and fundamentally seeing a rising dividend will be attracting new buyers. The weekly chart shows that there is some dynamic resistance from the 200-period moving average but that the price action is above the 20 and 50-period moving averages. These shorter time frame indicators will be acting as some support levels where buyers possibly step in on a pullback.

The significant price action has formed a high and a higher low. What we need to see now is a higher swing high. That would put the share price back above 1405 so at least 50% higher than the current price.

On the daily chart, we have now not only completed one of my favorite bullish patterns, the breakout, retest, and continuation, but the price has also tagged the most recent swing high. The momentum in the moving averages on this daily time frame points to the probabilities of higher prices. With first resistance coming in around 1050.

Buying the dips is the best course of action whilst we wait for the weekly acceleration higher to play out, so patience is needed, rather than chasing price action. On the daily time frame, the pullback into the 20 and 50 moving averages will signal when to start looking for a buying opportunity.

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