The plunge in gold prices witnessed in early April has had adverse effects on the performance of mining companies as such a fall decreases margins for these companies. The drop in gold price was the biggest drop in 30 years but many analysts are standing firm on their long positions in gold. Their viewpoint is supported by the actions of Federal Reserve. The fall in stock price of gold mining companies can become a decent opportunity for investors if gold prices begin to recover. Some signs of recovery have started to appear as the commodity retrieves its dollar value by 8.82%. Most of the mining companies also have stakes in copper. The volatility in copper prices is also important for the financial performance of these companies. Lastly, if the recovery of prices is proposed, it is important to identify the players in the industry which are likely to gain the most.
The world's leading gold producing company is Barrick Gold Corp. (NYSE:ABX). The company's operations involve exploration, mining, production and sale of the commodity. The company is also exposed to the oil and gas industry. Its major competitors include Freeport-McMoRan (NYSE:FCX) and Newmont Mining (NYSE:NEM). Most of the large gold producing companies have operations that spread across the globe.
Where is Gold Headed?
Sizable concerns about U.S. currency devaluation due to monetary expansion have convinced large fund managers like John Paulson that gold prices will improve. As reported by Bloomberg, Elliot Management Corp. has also suggested that gold is still the most prominent store of value. It is a fact that investors believe in gold very strongly but this belief has been held strongly despite such a strong drop in prices because of support from currency devaluation expectations. According to the Federal Reserve, the inflation and unemployment targets of 2% and 6.5% respectively are to be achieved through monetary expansion. Currently, the U.S. inflation rate is 1.5% and the unemployment rate is 7.5% (data from tradingeconomics). In an attempt to achieve these targets, the devaluation in currency will provide support as investors look towards gold as a prospective store of value in the long run. In my opinion, this support will be enough for gold prices to recover.
The long run relationship between gold price and stock prices of gold mining companies is observed to be negative. For example, the relationship between the stock price of Barrick and gold spot price from FY09 to the end of FY12 produces a relative risk factor (beta) of -0.4 with respect to gold. However, in times of bear gold markets, the two components are expected to show positive correlation for the short run as noted in previous upward trends.
Before the decline in gold prices, stocks of gold mining companies were not showing a divergence in their behavior. However, after April 11th, we see a clear parting of ways for these three players.
The above chart clearly represents the change in stock prices for the three companies in the last three months. We see that the adverse effects were felt more severely by Barrick as compared to Freeport or Newmont. In fact, Freeport seems to be very close to full recovery from the recent dip whereas Barrick is still trading at a 40% discount from its price in the beginning of February. This indicates that if gold prices recover, Barrick has the strongest potential to provide gains to investors through an appreciation in stock price.
Data Source: Morningstar
The table shows a comparative evaluation of the company with respect to its close competitors and the industry. The company is substantially undervalued as compared to its competitors across all metrics. One most important factor to consider for investors is that these large gold mining companies maintain a dividend yield which is substantially above that of the industry. In terms of dividend yield, Newmont Mining is slightly more attractive, however the valuation metrics; the valuation indicators do not fully support the stock.
Production Estimates & Potential Risk Drivers
In the first quarter of FY13, Barrick fell short of its production as compared to the results of the first quarter of previous year. This shortfall occurred due to a decreased production in South American regions but the company is still maintaining its annual estimates of gold production. This means that in the coming months, Barrick will work to expand its production. This will also support the stock price of the company.
The performance of Barrick in the coming months is subject to a few risk factors. The interest rate risk is clearly one of the major sources of possible volatility. If the low interest rate environment faced by the U.S. economy reverses, this would further deteriorate the situation for gold producing companies and produce undesirable results for investors. I am very convinced that the drive to improve macroeconomic indicators of the U.S. economy will do enough to devalue the currency against gold.
Keeping the above factors in view, a buy recommendation is proposed as the gold prices are set to recover. This improvement along with the increase in production in subsequent quarters is likely to result in appreciation of the stock price of Barrick. Furthermore, the valuation suggests that there is a sizable upside potential in the company.