In the years since the vertigo-inducing success of gold ETFs – currently accounting for around 40moz of gold investment – the question of the continued relevance of gold equities has been raised on several occasions. As the platinum market is now bracing for the potentially game-changing effects of introducing a new platinum ETF on New York market, the issues of comparable risk, leverage, beta and relative merits of ETF vs. equity investments in the precious metals space are resurfacing again.
Arguably, the platinum market has always suffered from equity under-representation. The production of this metal is highly concentrated in the hands of 3-4 miners, the largest of which has only a limited free float. This relative paucity of investment vehicles may not be unique to PGM space, but can hardly be compared to the wealth of choice offered to a global gold investor. The geography of gold equities largely reflects the geological ubiquity of the product. The question remains, however, whether the equity market served with highly liquid gold ETFs is large enough to accommodate hundreds of producing, near-producing and exploring gold companies.
If recent capital-raising offers any clues, then the answer to this last question is an emphatic “yes”. In 2009, gold companies raised an unprecedented $18.5bn in financing for exploration, expansions and operations. This number dwarfs the previous record (in 2007), but has not prevented gold stocks from outperforming the commodity, for the first time in 5 years. While in 2009 gold notched a respectable 25% increase in dollar terms, gold equities ran up between 44% (HUI index) and 39% (GDX index). This was a far cry from 2008, when the extreme deterioration in the liquidity conditions reduced annual return on gold equities to negative 31%. Over the same period, gold held relatively well, becoming a rare asset above the water, albeit only at 3% annual return.
In fact, the high-beta characteristics of most gold equities are usually reflected in negative returns for the indices whenever gold fails to achieve at least a double digit return. Such conditions occur with surprising regularity, at about 4 year intervals (2000, 2004, 2008). However, since the advent of the ETFs in the middle of the last decade, it was not until last year that the gold equities benefitted from the tsunami of liquidity, offering returns above those ‘guaranteed’ by the underlying commodity.
Where do these precedents leave gold stocks for 2010? The good news is that after two years of liquidity-driven trading, fundamental analysis may finally come back in fashion. The bad news is that the investors must now do their homework properly, rather than hoping for momentum trading and another bandwagon liquidity event.
From this perspective, gold stocks that offer potentially attractive returns fall into two categories. On the one hand, there are stocks with very comfortable operating margins, owing to favorable cost environment. While they may not be the cheapest equities on near term multiples to cash flow, they offer attractive returns on equity in the months to come. The exposure to this group is not riskless, as most of them (e.g. Alamos, Kingsgate) are one-mine wonders, and should only be considered in the context of a larger, diversified gold portfolio.
On the other hand, there are stocks characterized by considerable growth in cash flow per share. Large expected volume increases offset somewhat these companies’ slightly higher costs. Despite the promise of significant earnings increases, their multiples are low, both in terms of EV/Ebitda and price to cash flow. Here, the most typical examples are Great Basin Gold and Jaguar Mining. The relative undervaluation of both stocks may owe something to the market’s nervousness regarding the structurally overvalued operating currencies – South African Rand and Brazilian Real, respectively. In 2009, the US dollar may have lost only 4% to Euro, but the greenback continues to wobble in relation to emerging market (and especially commodity-exporting) currencies, whose movements now determine most of the changes to the value of trade-weighted dollar (DXY).
Betting on the former group would align an investor with the dominating theme in the equity market today – disciplined growth. The latter group, on the other hand, falls into “contrarian value” category, which enjoyed an enormous success in broader equity markets since March 2009. Interestingly however, neither of the two stocks mentioned above have benefited from this run.
Astonishingly, the same applies to gold companies with significant copper by-products, despite the fact that the red metal outpaced gold five times over the period, keeping the lid on production cost creep. But should China become serious about reining the credit binge, copper prices may suffer soon, exposing these gold-copper producers to even higher discount. It is as if the gold equity market was alone in anticipating such a turnaround for several months now.
The above opinion does not represent investment advice and is not subject to FINRA or NYSE rules.
Tags: copper, ETF, gold stocks
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