As a contrarian investor I am looking for bargain companies with outsized return potential and a high margin of safety. What potential is and how it is measured is often basis for discussion. Many investors will see zero potential in Barrick Gold (ABX) or MGIC (MTG) or J.C. Penney (JCP) simply because they are influenced by disruptive short-term events and negative headlines. Negative events often overshadow the true intrinsic long-term value of a company as many investors believe they are superior market timers. I think that investors who purchase stocks at discounted prices when nobody else wants them and they intend to hold their investments for the long-term, they will indeed do well in the long-term. A long-term investment approach fundamentally changes the mindset out of which an investor approaches investments and short-term distractions, noise and negativity just fall aside.
Barrick Gold is such a contrarian investment. The company has fallen on hard times as the gold price declined substantially over the last two years and shares of Barrick Gold as well as other gold- and copper miners fell off a cliff:
The share price of Barrick Gold has fallen more than the underlying gold price as investors feared a continued decrease in gold prices. As such, gold bears display a textbook example of representativeness bias in which investors simply extrapolate current events in the marketplace that is, persistently low and/or falling gold prices). As negativity increases so does the differential between share price and intrinsic value. It is clearly not easy to stay focused and positive when confronted with a wave of bad news. The chart below depicts the gold spot price over the most recent two years and shows why gold investments turned out bad.
In light of crumbling gold prices, Barrick Gold does the right things for shareholders. The company just recently announced a $3 billion equity offering in order to gain financial flexibility and decrease financial leverage. In addition, Barrick Gold is focused on bringing capital expenditures down via a suspension of its Pascua-Lama mine operations in Argentina/Chile (this should relieve cash flow by about $1 billion in 2014). Further, the company streamlines its portfolio and booked $700 million in non-core asset sales YTD in 2013. Barrick also has a comprehensive cost reduction program in place that aims at cutting off $500 million of the cost structure. Going forward, I could see a sale of copper operations or a mine-/cost-sharing project with a strategic partneras further catalysts.
Long-term fundamentals still intact
Gold is a precious commodity that not only finds applications in the jewelry and electronics sectors of civilization. Investment demand for gold bars and coins also contributes to the desirability of this commodity and its reputation as a safe heaven investment was proven during the financial crisis as the gold price spiked amid extreme levels of economic uncertainty. Jewelry, of course, is the most relevant sector in the consumption sphere and demand from China and India could be instrumental in driving gold prices over the next decade or two. Growing and richer Asian economies will exhibit higher jewelry demand as Asian societies view gold jewelry as a sign of social- and economic mobility and success. Jewelry- and industrial demand are going to increase in the long-term as Asia lifts hundreds of millions of people out of poverty. Gold also has high conductivity and therefore finds irreplaceable applications in electrical wiring and contacts.
Investment demand will exist as long as people invest in stocks and bonds and need a safe heaven when other non-commodity asset classes undergo stress. Furthermore, gold investments provide investors with substantial diversification benefits especially when hold in equity- and bond dominated portfolios.
The reasons why I am particularly attracted to Barrick Gold are threefold. First, I believe the company takes the right steps for shareholders in reducing costs, realigning capex with profitability, selling non-core assets and improving the balance sheet. Secondly, Barrick Gold is a large-scale gold explorer with significant tech know-how and experience which helps in providing the company with a cost advantage. Barrick's estimated 2013 all-in sustaining costs are projected to hit $900-975/oz which compares to $1,150-1,225/oz for other senior gold producers. Thirdly, Barrick Gold shares have been driven down to such low levels that the company is just dirt cheap.
Barrick Gold trades at less than eight times forward earnings while the peer group average stands at 14.52. Goldcorp (GG) and Kinross Gold (KGC) trade at the highest P/E multiples of 19.88 and 18.32 respectively. The median of the peer group comes out at 15.53 which still is about twice as much as the P/E ratio exhibited by Barrick Gold.
Long-term gold price drivers are fundamentally intact. Investment-, jewelry- and industrial demand are secular trends that will affect the gold price in the long-term. At the same time, new gold discoveries are rare which adds to the favorable long-term supply/demand picture of the gold commodity. In addition, gold provides investors with significant diversification benefits which can help reduce overall portfolio volatility.
Most importantly, Barrick Gold trades at a ridiculous valuation. A multiple of eight times forward earnings translates into an earnings yield of 12.6% which is inappropriate for an industry-leading, large-cap heavyweight in the gold sector. Other companies in the gold sector command significantly higher multiples; most noteworthy is Goldcorp with a multiple of almost twenty. Barrick Gold also moves aggressively to counter weak gold prices through non-core asset sales and cost reductions. Strong anti-cyclical BUY on valuation, favorable long-term gold price drivers, cost cutting initiatives and portfolio diversification benefits.