Some specialist gold equities funds, such as Junior Gold, which I advise, enjoyed a much larger re-rating due to a focus on producing companies.
Returns on fund and gold price in 2014
Source: FE Analytics
The fundamentals for gold are well understood in the market. Massive liquidity programmes by central banks risk debasing the key reserve currencies.
The global economy has only recently shown some signs of growth but, at these low rates, the debt mountain will not be reduced for many years to come.
Many risks lie dormant, such as the eurozone’s instability and general unease about the solvency of its banking system. China, the main driver of economic growth since the global financial crisis, appears to confront its own problems of asset bubbles and opaque banking practices.We believe that any event that undermines confidence would cause investors to look to gold as a safe-haven again.
The massive liquidation of ETF gold holdings that caused the dramatic drop in the gold price last year could reverse just as quickly as new positions are acquired.
On the supply side, Asian investors have been amassing physical gold at increasing rates. These investors are long-term minded and will be unwilling to sell their holdings as the price rises.
The mining industry has suffered the worst bear market in recent history. Marginal operations have been suspended and new projects cancelled. Exploration expenditure has fallen to historic lows as investors and capital markets did not want to know.
Given the massive restructuring of the gold mining industry in the past two years, production is contracting rapidly, therefore, a rise in investment demand for gold would be met by constrained supply.
Assuming the price of gold rises, many people think gold shares should be a one-way bet. I would argue that, even in a rising tide, not all boats will float.
Performance of gold and gold miners over 1yr
Source: FE Analytics
Having just returned from the Indaba Mining conference in Cape Town, my feelings were that mining companies are still over-optimistic and keep on burning through their cash reserves, while investors are over-cautious.
A big factor in the gold share sell-off over the past two years has been the lack of transparency in operating costs and long-term profitability.
Most companies used to report just “cash costs” and, in some cases, “negative costs due to by-product credits”.
In reality, after all the costs of finding, developing, financing and operating a mine are accounted for and taxes or royalties are subtracted, many operations are currently losing money.
It would take a significant rise in the gold price for these mines to return to profitability.
A sensible investor, therefore, should focus on a detailed scrutiny of the cost structure as well as the prospective reserves and mine life.
A big danger in the current climate of companies trying to lower their costs to survive is that the resultant “high-grading” or mining of the more profitable zones can damage the economic life of a mine even if the gold price rises in the future.
The sweet spot, in our view, in an environment where the gold price rises modestly towards $1,350/oz and beyond are those companies with the following characteristics:
- A strong balance sheet that does not rely on the capital markets for funding.
- Organic growth in production that introduces economies of scale, thus declining average all-in costs.
- Large reserves compared with the enterprise value of the company as compared with the respective peer group.
- Low political and operational risks.
- Fully funded development programmes for new mines that would operate under the first four criteria.
However, industry players will not overpay for their targets as there are few that have the financial resources to engage in transactions.
The notable example is the hostile takeover by Goldcorp for Osisko Mining, offering a 15 per cent premium to the last closing price of its target.
With no competing suitor, there is little leverage for Osisko to demonstrate to its shareholders that it is worth more.
Some share deals and merger of equals also provide a way to increase access to financing and the ability to deliver development projects such as the all-share merger between Asanko Gold and PMI Gold, both developing new mines in Ghana. We think many other corporate deals are being prepared in the sector.
Angelos Damaskos is the manager of the Junior Gold fund. The views expressed here are his own.
