Gold: To Buy Or Not To Buy?

Includes: SLW
by: Simon Trinh

For those of you who have been following the precious metals sector you know that things aren't going too well currently. Silver prices have fallen ~25% year to date, gold has fallen ~16% year to date, and platinum has fallen ~8% year to date. The general trend of the precious metals sector, one of downward momentum and negative investor sentiment, looks to continue, with no telling when the rebound will occur. Last week was especially dismal for investors when gold and silver prices tumbled 10 and 12 percent respectively. The only difference: gold rebounded a little whereas silver continued to fall. My article today will focus primarily on the current situation of gold, and whether the recent fall in gold prices warrants a buying opportunity for investors or whether it is best for investors to stay away from a potential "value trap."

What caused the massive sell-off of gold?

On Monday, April 15, the gold and silver market took a massive hit on expectations that the US central bank, the Federal Reserve, will tighten monetary policy by stopping its QE programme. An end to the Fed's QE programme means that the rate of US inflation will likely fall, meaning investors have less incentives to hold gold in order to avoid a corresponding decline in the value of cash investments. Another key factor that analysts pointed at was (the head of the ECB) Mario Draghi's order for Cyprus to sell its gold to cover its bailout. However, this order was made two trading days prior, so it certainly wasn't the news catalyst for Monday's gold sell off that many are trying to make it appear. Having said that, I believe investors should be extremely cautious if selling central bank gold is the new trend for obtaining bailout funds. If this is the case, what we will likely see is European central banks rushing to sell their gold to potential buyers. The question is: who will these potential buyers be? In the case of Cyprus, will it be China, Russia or the very ECB telling it to sell the gold? Since China (one of the world's largest consumer of precious metals) and its administration is just beginning to settle and solidify its future plans, and global demand for metals in general is slowing, central bankers might have to sell gold at extremely depressed prices.

Another event that occurred earlier this week, which resulted to the wider commodity and share declines, was China's economic growth figures of 7.7% in Q1 of 2013 which came in lower than forecasts of 8% as well as the pace of growth seen in recent years. China's economic fundamentals haven't changed but a Chinese spokesman at the National Bureau of Statistics made some interesting comments about China's growth strategy. I believe the new Chinese administration, with Xi Jinping as president, is willing to sacrifice short-term economic growth in order to deliver structural reforms to the government for sustainable growth in the future. I would not be surprised if China's GDP growth for 2013 comes in under 6% given that China missed nearly every single forecast number earlier this week, and given the industrial and power generation slowdown during the first three months of 2013.

The future outlook on India (the world's largest consumer of gold) doesn't look too good either. A combination of decreasing middle class consumption and a worsening trade deficit is threatening an economic slowdown for India. A major catalyst for gold moving forward is whether the Indian policymakers can remove structural hurdles that is threatening external demand and leading to a deterioration of the countries investment situation. The Asian Development Bank (ADB), on Tuesday, maintained that these structural reforms will take place and that the Indian economy could grow at an improved rate of 6% for fiscal year 2013.

Let's do a quick recap of all the factors which led to gold prices falling last week: (1) the Fed announced its intention to stop the QE programme; (2) the ECB ordered Cyprus to sell all its gold; (3) China posting lower than expected economic growth numbers; and (4) India's continued economic deceleration.

To buy or not to buy?

With so many factors pressuring gold prices to fall even further, it appears the easiest strategy for investors is to not buy at all! However, as an investor (not a trader), I'm less worried about the noise surrounding the price of gold and more focused on the long-term outlook (2-3) years of the precious metals sector. In my perspective, gold can easily fall to $900/oz by early 2014, but I'll still invest in gold with both hands. I wouldn't invest in physical gold or ETFs, but I would definitely invest in mining companies.

Over the past two quarters, every single junior and senior mining company has experienced double digit declines in their stock price. Even worse, many mining companies are now operating in a net loss. This is because most mining companies begin projects with the expectation that gold can be sold at certain spot prices. When actual prices fall below these expectations (even by a dollar or two in the case of silver miners) the result can be a major deficit in net income. At a spot price of $900/oz, hundreds of junior miners will go out of business. Even companies who claim to produce gold at $600/oz will go out of business because mining companies generally leave out G&A, and other fixed and overhead costs. For example, albeit Goldcorp (the second largest senior mining company in the world by market capitalization) reports mining cash costs of about $630/oz, their all-in cash costs were actually over $1200/oz. You can see very quickly how many companies will go out of business at a spot price of 900.

My views

What I would tell investors is to look at companies with the following characteristics: (1) diversified asset portfolio with low political risk; (2) access to capital funding; (3) low all-in costs of production; (4) conservative balance sheet-i.e. low debt levels; and (5) healthy pipeline of high quality projects.

Currently, I like Silver Wheaton (NYSE:SLW), one of the world's largest silver streaming companies. Streaming companies don't actually mine precious metals, instead they purchase stakes within mining companies in exchange for a percentage of metal productions for a definite period of time. SLW currently has 17 long-term silver purchase agreements (14 to 25 years of a mine's production) with cash costs of approximately $4 per ounce of silver. That is, for the next 14 to 25 years, Silver Wheaton will be able to purchase silver at $4 per ounce and sell silver at $20-35 per ounce (depending on what the market price of silver is at the time). This provides the company with a 75% net income margin and an 85% EBITDA margin. The streaming business is relatively new to market, extremely profitable, and offers a hedge against falling metal spot prices. Since silver prices tend to move in tandem with gold prices, even if gold and silver prices fall this year and next, SLW's common stock will not be hit as hard as many junior or senior mining companies. SLW also has a healthy balance sheet, an experienced management team, and a strong pipeline of projects. Despite the tax audit debacle at SLW, granted no significant changes in capital expenditure or tax structure, we should see SLW's common stock creep up towards the $45 level within the next 2-3 years. SLW is currently trading at $23 per share and has fallen nearly 30% year to date.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.