Sent: 10-12-2013 09:07:02
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Gold Equities to Face Ongoing Share Price Pressure
Incessant cost pressures are stripping value from gold miners leaving the sector vulnerable to ongoing share price falls even if gold bullion prices do not fall any further. These pressures warrant a re-assessment of how gold miners can add value in an equity portfolio. E.I.M. Capital Managers is removing established gold producers from its PortfolioDirect model portfolios in favour of direct bullion exposure.
A 43 percentage point difference in the return between gold bullion and gold equities since the beginning of 2012 seems, at face value, extreme. Many like Soros Fund Management, which pumped $27 million into gold equities via an ETF in the September quarter, have concluded there is something amiss in the pricing of gold equities leaving scope for the bullion-equity gap to be closed or, at least, narrowed.
The chart at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm shows movements since 1997 in the US dollar London gold bullion price and movements in the NYSE Arca Gold Bugs Index of 18 listed gold mining companies.
Between 1997 and late 2010, the gold price rose at an annualised rate of 10.0%. The equity index rose at 9.3%. Subsequently, the gold price continued to rise from $1,383 to $1,896 in early September 2011, or just under 40%, during which time the equity index increased by only another 9%.
Near the top of the gold market, equities were discounting apparently extreme prices driven by momentum as they generally do in markets for other commodities in which price patterns suggest the nearing of a cyclical turning point.
In the next phase of the cycle, the gold price fell 30% and the prices of the gold equities fell by 65%. Using a simplified valuation model helps to understand why the prices of gold equities are so highly leveraged to falling or even static gold prices.
Let's assume a gold miner has a 20 year mine life with all pre-production capital behind it and ongoing costs of $850 an ounce. A standard cash flow valuation model would suggest that, at a gold price of $1400, an investor could reasonably pay around $5,000 an oz of annual sales for the company described in this model.
In practice, at the end of December 2012, Newmont Mining Corporation was priced at $4,200 an ounce of production in that year and Barrick Gold was priced at $4,700.
The model valuation assumes static output and costs. Neither is likely. Production is likely to fall over time (and will almost certainly fall without a heavy capital infusion to sustain production at existing or new mines). Costs will rise due to inflation but also due to problems from mining less accessible resources.
Rising costs have the potential to create havoc for the valuation. With no cost inflation, the value of the model company will halve in 15 years because, as time goes on, remaining mine life will fall. If cost inflation is set to 3% a year, the value halves in seven years. The value of the model company halves in three years if the rate of cost inflation is set at 5%.
In practice, over the nine years between 2003 and 2012, Newmont's cash unit production costs increased at an annual rate slightly under 14%. Barrick's costs rose at an 8.5% annual rate. Thomson Reuters GFMS has estimated that average total cash costs for the industry were 7% higher at $782 per oz in the first half of 2013 compared with the same period a year earlier.
All-in unit costs, the newly adopted standard industry measure, were estimated to have risen to $1,250 leaving many in the industry with margins similar to when the gold price was below $500.
If gold prices do not increase and companies continue to face cost increases similar to those which have prevailed for close to a decade, value is stripped quickly from the sector.
So great is the potential value erosion that the apparently extreme fall in equity prices (as represented by the index) could even be construed as an overly bullish view by the market rather than a pessimistic assessment of what the companies are worth. Implicit in the current equity price is an assumption of some combination of lower cost inflation and rising prices in the years ahead. Both may simply be wishful thinking.
To sustain stock prices at current levels, without bullion price support, implies an ability to eliminate the negative effects of cost inflation through offsetting production increases. Barrick did manage to raise its gold production. It sold 7.4 million ozs in 2012 compared with 5.5 million ozs in 2003. However, its sales peaked in 2006 at 8.6 million ozs. Newmont production in 2012 of 5.5 million ozs compared with 7.4 million ozs in 2003.
These production trends among the two market leaders highlight the difficulty faced by even some of the individual companies best positioned through access to capital for exploration and development to keep production aloft.
The experiences of Newmont and Barrick are replicated globally. Production outside China, where the activities of most of the listed companies are focused, was static between 2000 and 2012. Mine output in Latin America and Africa (outside South Africa) rose but was offset by production falls in Australia, Canada, the USA and South Africa.
Against this backdrop of sustained cost increases and static or falling output, the only way in which equity prices could be expected to recover is for a rapid rise in gold bullion prices to paper over the value paralysis afflicting the sector. That leaves the argument for holding gold equities considerably weakened.
Even in the event gold prices rise, they may not go up enough to compensate for the fundamental value erosion occurring at the company level primarily due to rising costs.
That is not to say that gold related equities should be permanently eschewed. Explorers can generate value through previously unanticipated exploration success. Once that is achieved, however, this value analysis does point to the sensible investor selling out.
There may be other instances in which it would make sense to buy a gold equity to take advantage of a short term trading opportunity. This could involve a temporary expansion in production or a change in operating conditions which might generate expectations of improved prospects.
Other than those specific and special situations, unfortunately, the burden of the maths is simply too great for a gold miner to escape. Without an increase in the gold price, valuations are on an accelerating downward slide the larger the rate of cost inflation.
Costs have now been eating away at sector values for almost two years without any compensating bullion price benefit. This is permanently lost value unless bullion prices rise by enough to compensate for the cost rises which have already occurred as well as those that are going to occur in the future.
In the event bullion prices do not rise, equity prices should continue to fall and the gap now evident between the two should grow wider. This would be a sign of the market working.
Equity prices may match rising bullion prices but they failed to do so in the most recent cyclical upswing which presented some of the most favourable conditions imaginable for the sector. Otherwise, when gold prices are static or falling, they are likely to produce inferior investment returns. The combination of analysis and empirical evidence suggests a negligible chance of equities doing better than bullion over a medium term investment horizon.
PortfolioDirect (see a sample investment report here: http://www.eimcapital.com.au/PortfolioDirect/PD_resources_sample.pdf) is taking the radical step of removing producing gold companies from its recommended model portfolios in favour of an exchange traded fund offering gold bullion price exposure. A gold company would only be included if there was clear evidence of it being a better investment than a medium term direct holding in gold. This would normally imply exposure to an event unrelated to the gold price raising the company's value proposition.
(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).
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