Sent: 26-11-2014 09:16:02
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Gold Equities Fail Value Test
A few days ago, the price of gold equities was the same as in April 1997. Meanwhile, the gold price itself had risen from less than US$350/oz to US$1150/oz. This is not an instance of temporary financial market mispricing.
In early November, the New York Stock Exchange index based on a basket of unhedged gold stocks, widely known as the gold BUGS index, fell to a level which had prevailed very briefly during the worst of the financial crisis in 2008, for a more prolonged period in 2002 and, before that, in 1997.
There are other indices describing what has happened to the price of gold equities over the last 20 years or so but they tell much the same story. The price of gold equities has undershot the gold bullion price by a long way.
Some analysts are promoting gold equities as investments because they have underperformed the gold bullion price so dramatically. There are reasons to be wary about accepting this line of argument.
Most importantly, the industry has a disappointing history of cost management. Companies are more likely to be losing money at gold prices around $1200/oz than they were when the gold price was less than $500/oz. The lack of cost control reflects a combination of uncontrollable pressures and bad habits.
- Falling ore grades imply ongoing rises in production costs no matter what the intentions or abilities of mine operators.
- A belief that gold prices would rise indefinitely has resulted in behaviour that downgrades the importance of cost control.
- Gold production, whether in Australia or elsewhere, frequently occurs within regions in which individual companies must compete for labour and other resources. This competition intensifies as gold prices rise.
- Companies with the highest ore grades will typically be able to pay more to secure labour and capital and, in doing so, set the costs for the remaining majority of the industry. Companies with inferior resource bases are unable to tailor their costs to their own circumstances.
Such pressures are likely to persist. While companies will frequently talk about how they are embarking on new rounds of cost containment, few of these result in sustainable cost reduction measures. Frequently, they are stop-gap alternatives applied in the hope that a rise in the gold price will quickly come to the rescue.
The second reason to be wary about the investments on offer is that stated project valuations are frequently exaggerated. Kula Gold, for example, has said that its Mount Woodlark project in PNG has a net present value of US$110 million. Juxtaposing this valuation against a market capitalisation for the company of just $9 million is designed to lure investors toward a certain conclusion.
These valuations will almost certainly assume that costs do not increase over the life of the foreshadowed operations. Recent history suggests this is improbable.
The Kula Gold valuation was also struck using a gold price of US$1400/oz, more than $200/oz higher than recent gold prices. Even a presentation made as recently as 31 October has not modified this assumption despite its importance. At the current gold price, the Kula Gold project value would all but disappear but there are no rules telling a company to say this.
Companies are also prone to use discount rates for valuation purposes far lower than anything acceptable to mainstream equity investors. Orbis Gold, developing a mine in Burkina Faso, has used 5%. This might be consistent with the marginal cost of debt funding for the project. An equity investor with a less secure claim on the assets, on the other hand, would want to see a return which competes against the alternatives in the market and accounts adequately for the difference in risk between an investment such as Telstra and a company trying to build a mine in a west African country where a coup has recently resulted in riots, damage to property and deaths.
Thirdly, the industry is neither structured nor culturally inclined to return the cash flows anticipated by published consultants' valuations used to attract investors. The most typical business model involves companies failing to realise their initial expectations and then using actual cash flows to keep a lid on costs as far as they are able, extend the mine life through exploration and, frequently, buy new assets to distract attention from those that are passing their prime.
Short mine lives are another blot on value. Companies are frequently seeking to develop mines with resources sufficient for only five to seven years of production. Those with the shortest operating lives will tend to emphasise a single year's profit snapshot to lure investors. They will compare themselves to the far rarer companies with 15, 20 or 30 year operating potential. The latter group will always appear expensive relative to the short life company where profits or a single year's production are the basis for comparison.
So, how much should an investor pay for a business that is battling to be profitable (or at risk of lurching into losses in the face of even modest falls in the gold price) and, even where it is profitable, remains steadfastly disinclined to share the benefit with investors? The answer is "not very much". And this is exactly what the market is doing. Low prices are no mistake in need of correction.
At least an ounce of physical gold will still be an ounce of gold in 20 years. In addressing whether to buy a gold related equity in preference to gold bullion, the question an investor needs to address is what he or she will still have in their hand after 20 years or even five years from an investment in a gold mining company.
This is the single most important question to put to anyone promoting a gold mining investment. Can it do better than bullion?
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.