Golden nuggets

In my previous post, I outlined my framework for investing in gold equities, highlighting the critical importance of ensuring a large margin of safety by only investing in companies with low cost mines at low valuations. In this post, I will take a look at the gold mining industry today in order to assess whether any such investment opportunities might exist.

To kick off the discussion, let’s look at the recent history.

The last bull market in gold started in the mid 2000s and reached its zenith in 2011-12 at the height of the Eurozone financial crisis and Federal Reserve’s (Fed) Quantitative Easing (QE) programme.

I remember this period well. The gold price was encroaching on the $2000 level, having doubled from its pre financial crisis level. Gold bulls were out in force, slamming the Fed for their irresponsible monetary policies that would inevitably lead to hyperinflation. Gold equities were also very much in vogue and widely owned amongst mainstream investment institutions. They also traded on valuations that implied huge premiums to net present value, a situation which made no sense to me, and which was usually justified with the unconvincing retort “that is just how gold equities are valued.”

Once it became apparent that the Eurozone was not going to implode and that QE was not going to lead to hyperinflation, the price of gold collapsed by nearly 50%, bottoming out in late 2015 at just over $1000.

Over this period, the gold mining industry behaved more or less exactly as you would expect. During the bull market, costs inflated as the industry scrambled to increase output as quickly as possible. Numerous expansion projects were sanctioned so that expected future demand could be met. Of course this made the early part of the bear market especially painful as supply was still growing whilst the gold price was falling.

Fast forward to today however and the situation looks very different. After years of hunkering down, cutting costs, reducing capex and repairing balance sheets, the industry is now in a supply constrained situation. As the following two charts from Bernstein show, following a number of years of growing production, the supply side looks set to flat line at best from here. It may even decline considering that much of the pipeline requires higher gold prices to be economically viable.

gold production outlook SCB

This is certainly a helpful backdrop as a potential investor in existing gold mining assets. At the very least it means that a sudden increase in mined supply is highly unlikely to happen. As I argued in my previous post, this is not as powerful for gold as it is for copper due to the fact that mined supply is a small percentage of the existing available stock, but it is clearly a much better starting point than one in which mined supply is expected to grow.

In addition, there are a number of other positives that are shining on gold equities currently.

– Firstly, after the brutal bear market, the gold mining companies that have survived are mostly in pretty good shape now. With costs having come down, profitability is back up to more normalised levels. And cash flows are looking even better since capex is now firmly under control.

– Secondly, there are signs that confidence in the industry is gradually returning. The gold price has been relatively stable for nearly four years now, trading within a range of $1050 and $14001. This has caused sentiment to slowly improve and, more recently, funding for growth projects has started to return. Capital Drilling, a diversified drilling services company, made the following comment in its first quarter update earlier this year:

“Market sentiment is optimistic, with gold and base metal prices remaining strong and major mining companies anticipating budget increases for drilling activities. The industry retains a fundamental need to replace diminishing resources and reserves depleted during the downturn, when exploration drilling was significantly reduced.” 

– Thirdly, despite this improved outlook, my impression is that investor sentiment towards the sector remains firmly in the doldrums, sitting somewhere between apathy and “un-investible.” This is surprising to me. At the very least, gold equities should be largely uncorrelated to financial markets and the economy, a feature that should be appealing against a backdrop of a very richly valued global stock market and an increasingly tired looking economic upswing.

– Finally, valuations do not look stretched. For example, even the typically premium valued Randgold Resources offers a free cash flow yield of around 7%, most of which it has indicated it intends to pay out as dividends. Randgold is one of the lowest cost producers in the world with a production profile that should be free cash flow positive even at $700 gold price2. Amongst the smaller companies, Pan African Resources is valued on 6x earnings, with a 5% dividend yield. Despite this low valuation, the company is set to grow production by 20% by 2019 through a low risk and low cost tailings project that will reduce further its already low overall cost profile3. Capital Drilling is valued on a lowly 16% normalised free cash flow, with a net cash balance sheet, a fleet utilisation level of only 50% and with profit forecasts having recently being upgraded by over 20% at the Q1 update4.

In conclusion, my sense is that the gold mining sector is currently an area where the stock market may not be fully recognising the positive changes that have happened in recent years. It is one of the few areas where absolute valuations are low and the outlook appears to be improving. Investors should consider looking beyond the “un-investible” tag – there may be golden nuggets waiting5.

Matthew Tillett

 

1. Bloomberg
2. Exane BNP Paribas, May 2017
3. Peel Hunt, company reports, based on a share price of 14.0p.
4. Finncap, company reports, based on a share price of 43.5p.
5. This is not a recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.