Tapping into a rich seam: the case for gold miners

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

“Although men are accused of not knowing their own weakness, yet perhaps few know their own strength. It is in men as in soils, where sometimes there is a vein of gold which the owner knows not of” (Jonathan Swift)

“When gold argues the cause, eloquence is impotent” (Pubillius Syrus)

If the reader of this piece were to have received a gold bar every time they had read an investment note making the case for gold in recent years then he or she would now likely be as rich as Croesus. Had one actually heeded such recommendations, then it clearly would have been beneficial, with the precious metal having increased more than six fold and delivered annualised returns of greater than 15% from its August 1999 low. In the last five years, annualised returns have exceeded 20%, and even with risk being definitively back ‘on’ since the start of this year, gold’s 2012 to-date gain has been more than 9%.

Our intention is not to ‘argue the cause’ for gold per se since not only may our eloquence be impotent, but clearly its recent performance speaks for itself. Rather, to follow Swift, our ambit is to identify those less appreciated veins – or investment opportunities – that also allow for exposure to gold. In particular, it seems highly anomalous that gains in gold bullion have not been matched by gains in listed gold mining companies. Gold’s 20%+ annualised returns in the last five years compares to an annual rise of less than 10% for most gold mining proxies. As will be detailed below, both assets share a number of common drivers and owning not just the metal, but also the miners need not be mutually exclusive. If rising/ higher gold prices are sustainable, then this is a clear positive for the miners too.

At first sight the two assets classes may appear to have little in common: while investors in bullion are typically risk averse, the case for the miners seems much more opportunistic. Nonetheless, both physical gold and those who mine it are clear beneficiaries of the structural imbalance between demand for and supply of the precious metal. With the former set to outstrip the latter, this is clearly good news for miners. What matters most for these listed businesses is not the spot price of gold, but the average price over a period of time, since rising prices are correlated with higher levels of profitability for the miners. In other words, these listed businesses constitute long-term plays on (extracting) gold; an effective option on the gold price, or put differently, a leveraged play on rising gold prices.

The generic case for gold has been oft-discussed, but it is worth remembering that it has been a store of value and a form of currency since ancient times, with the oldest known gold artefacts dating back at least 6000 years, identified at the Vama Necropolis in what is now Bulgaria. As these artefacts would clearly demonstrate, gold in contrast to many other commodities, has unique properties as a store of value, neither perishing nor degrading over time. As importantly, there

simply isn’t very much of it around. The World Gold Council (WGC) calculates that there exists only 170,000 metric tonnes of gold at present, equivalent in quantity to less than four Olympic-sized swimming pools. Moreover, supply has been broadly static in the past century, with only around 2,000 tonnes mined a year. According to research from Citigroup, average annual gold production has increased by just 1.6% in the last ten years; or, put another way, since the beginning of 2007, gold supplies have risen by a mere 7%. By contrast, the US monetary base has increased three times in this period.

Meanwhile, demand for the precious metal remains unabated. The most recent figures from the WGC show that in the third quarter of last year, demand reached in an all-time high in value terms, totalling US$57.7bn, equivalent to more than 1,050 tonnes. WGC statistics show that less than 10% of gold demand comes from industrial purposes (much less than silver or platinum – which also implies that gold has inherently lower cyclicality) and that the two main drivers are consumers and Central Banks. In the last ten years, over 80% of gold purchases have been made by consumers, particularly in emerging economies. According to Reuters, gold jewellery demand has trebled in India and China in the last decade. It is not just the consumer, however, that is attracted to all that glistens. Central Banks globally, but particularly in China, Russia, Turkey and even Iran (based on recent reports) have been adding to their gold supplies. Beyond its well-known safe haven status, for many gold is being seen as an alternative to the US Dollar. The above trends do not look likely to reverse in the near-term.

Against this background, owning listed gold miners would seem a logical strategy. These stocks have the potential for capital appreciation (a function of organic growth from increased resource production), but also offer two things that the precious metal is unable to provide, namely income and take-over potential. Beginning with organic growth, miners have rarely looked in a better position. With gold production costs averaging US$840 per troy ounce in 2011 against an average sale price of US$1,572 per troy ounce, most established gold miners are enjoying record levels of free cashflow. The three largest gold miners by market capitalisation – Barrick Gold, Goldcorp and Newmont Mining – had more than US$4bn surplus in net current assets at the end of last year.

Net cash combined with new technologies (deeper, more targeted underground drilling) and stable input costs (energy and labour – the two main costs – are both rising more slowly than the gold price) are helping to drive production growth. Mining companies already own large tracts of land where gold has been discovered but where developmental work has yet to be performed; existing resources are also being upgraded. Correspondingly, Goldcorp is for example targeting 70% production growth by 2016 and Newmont a 35% rise by 2017, while Randgold Resources foresees a 19% increase in 2012 with further growth for the next five years. Miners represent the only way for investors to gain exposure to increased supply.

Dividend growth constitutes an additional attraction. Cash returns within the industry are improving with AngloGold Ashanti and Randgold Resources at least doubling dividends in 2011, while Newmont’s policy is more explicit, linking its annual cash payments to shareholders directly to the gold price. As a consequence, Newmont’s yield is currently more than 100 basis points ahead of the sector’s at present. Moreover, based on an investor survey undertaken by JP Morgan in December last year, the miners could be doing more: some 87% of respondents – higher than for any other category – felt that excess cash generated by these businesses should be allocated to dividends, with at least a 3% yield being seen as an appropriate return. Despite the growth in returns from Randgold, Ashanti et al, the sector currently yields 1.5%.

If the attractions of the mining sector are clear, then it is logical that deal-making within the sector ought to follow. Despite ambitious production targets from the major listed gold miners, it remains the case that smaller companies within the space are often more entrepreneurial and hence successful in discovering new resources. Junior miners often lack the financing and expertise to optimise output at their projects, enabling mergers and acquisitions to unlock value. There were over US$70bn of transactions within the sector in 2011, according to PWC. More look set to come; three small deals have been announced month-to-date, and it was notable that even the CEO of Randgold Resources mentioned on Bloomberg recently that his company would be “open to an approach from a buyer with deep pockets.”

Mining companies are inevitably not without their risks and indeed can constitute a volatile asset class. For some, the very attraction of gold is its inherent safety; gold is insulated from both the potential project risk and cost inflation that the miners must face. These companies often operate in politically unstable countries subject to civil unrest, regime change, prolonged labour disputes and the possibility of monies being repatriated (a discussion on this latter point has been escalating in South Africa and recent problems have also arisen in Peru, Brazil, Ghana and Pakistan among other locations). The industry is also highly contingent on natural conditions such as weather and geological stability. Correspondingly, near-term visibility for the industry can be low, with mines moving in and out of production. While the long-term outlook is clearly compelling, companies may not consistently be able to deliver on their immediate targets. Both Barrick and Newmont have recently revised their 2012 production guidance lower. Higher cash costs relating to production inevitably eat into profitability.

Diversification therefore seems a logical strategy with regard to investing in the gold miners, particularly given geopolitical sensitivities. Ranked by market capitalisation, Barrick Gold is the world’s largest gold miner, with production more than a third larger than its nearest rival. In size terms, Barrick is followed by Goldcorp, Newmont and AngloGold Ashanti. These four companies benefit from scale and strong cost control discipline, while their future production pipelines also look attractive. An alternative to investing in individually listed businesses would be to consider the Market Vectors Gold Miners ETF, comprising holdings in 30 large mining companies (with over 40% of the product held in the four largest listed names mentioned above), while for investors with greater levels of risk appetite, the Market Vectors Junior Gold Miners ETF, with positions in over 70 listed business may provide a compelling opportunity, benefiting from possible further industry consolidation.

To hold gold as part of one’s investment strategy seems eminently logical given its attractions, particularly in a world where real interest rates look set to stay negative for now and global risks remain elevated. However, owning listed gold miners as well as physical gold also has clear merits. The miners represent a leveraged play on rising gold prices as well as providing a source of dividend income and possible upside from take-over activity. That they have underperformed in recent times seems anomalous and arguably unjustified especially given record levels of earnings and free cashflow generation. The gold miners represent a rich seam indeed.

Alexander Gunz, Fund Manager