Despite a slight slowdown occurring recently, gold prices reached a historical high level in the end of last year with the ounce trading at $1,900 in September. However if gold prices increased by 140% in 5 years, the FTSE Gold Mines index only grew by 20% over the same period. And over the last three months the index lost 26% when gold prices decreased by 10%. Gold mining companies' valuations have never been that low.
Rising operating costs narrowed the appetite for gold stocks
There are several ways to explain the underperformance of gold stocks:
- Operating costs kept rising over the last years because of a weaker gold concentration in rocks, increasing wages, taxes, or energy prices. Average production costs grew by 15% to reach $640 per ounce and should keep rising over the next years.
- Gold mining companies meet more and more difficulties regarding their development: permits are harder than ever to get because of environmental concerns, big gold deposits are scarce and technical and geopolitical difficulties are increasing.
An expensive gold is now necessary to unlock new investments and a strong decrease in prices could be very harmful for the industry.
But gold stocks are way too undervalued
Those factors could explain, at first look, the underperformance of gold stocks but lets take a better look at their valuation. Their valuation accounts approximately for an ounce trading at $1,000 compared with today's price of $1,565. And their average P/E is lower than the S&P 500 average P/E ratio (21.12 at the time of writing).
Market cap (B)
Production 2011 (million ounces)
AngloGold Ashanti (AU)
Gold Fields (GFI)
We could assume that gold mining companies are undervalued for good reasons but gold prices forecasts show another contradiction. Thomson Reuters GEMS forecasts an average price of $1,730 for 2012 with prices that could reach $2,000 in 2013. Therefore gold price and margins seem to grow faster than the stocks (in 6 years, margins increased by 300%, from $250 to $1,000 by ounce). As a consequence gold companies have been able to generate immense amounts of cash and start paying dividends.
Dividends against ETFs?
Those new dividends are very interesting and epitomize the competition between gold mining companies and ETFs. In my opinion, ETFs strongly contributed to lower the appetite for gold stocks. For the investor dividends can be a good way to diversify, especially when gold prices are high.
Yields are still low compared with other mining or oil companies that can provide 3%, 4% or even 5% yields but I believe that they are going to increase and quietly contribute to increasing share prices as well.
Over the last decade, production dropped by more than 53% in South Africa because of high production costs. As a consequence it could be a good strategy not to focus on South African mines.
We could then focus on Canadian super stars such as Barrick, Kinross, Goldcorp or Yamana, and play the undervaluation card.
I think that the best opportunities are now in South America, China and Russia with gold production increasing by 49%, 84% and 17% over the last decade and now accounting for 39% of the total production. Those areas benefit from low production costs as well as future opportunities in undiscovered gold deposits. We should then focus on companies having the most assets in those countries or bet on national champions, especially in China.
Main gold producers (% of total production)
AngloGold Ashanti (32%)
Yamana Gold (27%)
Kinross Gold (17%)
Eldorado Gold (EGO)
Polyus Gold (19%)
Kinross Gold (11%)
Source: goldinvestingnews,bloomberg, wealthdaily
% of Total Production
% Increase over last decade
Cost of production ($ per ounce) 2011
First of all the market being very volatile right now, a strong exposure to gold stocks is not recommended at short term and the investor should wait for more stability and visibility.
Moreover we should carefully consider the sovereign risk in our valuation, especially if focusing on emerging markets. We might then lower the revenue forecasts or increase our discount rate in the valuation process. However gold mining companies don't have yet a strategic position like YPF in Argentina for instance.
The quality of new investments and the capacity to generate cash flows should be watched carefully as well as production costs. The future of many gold mining companies is going to be strongly linked with their capacity to increase their productivity, expenses in R&D could be a nice indicator in that case.
In May, gold prices dropped to a four-month low level of $1,527 a troy ounce from its record high of $1,900 last September. Investments in gold coins such as American Eagles or Vienna Philarmonics were down 63% and 19% in the first quarter. Indeed, a recovery in the US better than expected, an easing monetary policy from the Fed and a decrease in interest rates might limit the appetite for gold at short term.
However uncertainties remain such as the US election and might reawaken interest in gold. According to Jeffrey Currie, head of commodities research at Goldman Sachs, the case for higher gold prices remain in place.
With gold remaining very expensive even below $1,600, there are opportunities in gold stocks, undervalued right now but that benefit from high gold prices. The investor should seek companies with strong exposure to emerging markets and carefully integrate the sovereign risk in its decision.