In spite of the gold price weakening once again this week and coming dangerously close to breaking an important support zone, gold investors have actually reason to take heart. Readers may recall what we wrote in our most recent update on gold about gold mining margins:
The market has not yet really given any credit to the fact that mining margins are improving due to strength in the real price of gold. Management boards of gold companies may be coming around to a different view though - after all, they are acutely aware that the real gold price is the only thing that counts with respect to their margins."
Image credit: Rocco Fazzari
As data from our friends at INK Research in Canada show (a highly recommended service), gold mining managers are indeed "acutely aware" of their improving profit margins. Insiders of several major and mid-tier gold mining companies have embarked on a buying spree. Here is Barrick Gold (NYSE:ABX) as an example:
Recent insider activity at Barrick Gold: the green crosses denote purchases
To put a few concrete numbers to this: On March 27, ABX chairman John L. Thornton bought 360,000 shares in the open market. In early March, four different board members acquired 23,200, 10,200, 3,200 and 30,750 shares respectively (amounts are rounded), also in the open market. It is nothing special when insiders are selling - it does, however, mean something when they are buying, especially when they are buying in size and seemingly without concern for short-term price gyrations. Note here that the gold sector is really standing out in this respect. In most other market sectors, insiders are bailing out as fast as they can.
Newmont Mining's Earnings Support our Contentions
Today, investors in Newmont Mining (NYSE:NEM) were treated to a nice surprise. The company's quarterly earnings report beat market expectations in every respect. As the chart below illustrates, in this case the market has actually noticed that something is changing:
The share price of Newmont Mining, daily, as well as the NEM-gold ratio and the price of gold. Newmont's profit margins and free cash flows have soared relative to last year, in spite of the fact that the nominal gold price is much lower.
Here are a few relevant data points from Newmont's report:
Newmont Mining Co. put together another solid quarter as the company boosted year-on-year profit and set measured production growth from their production pipeline. The company reported net income of $175 million, or 35 cents per share, after market close Thursday, compared to $117 million, or 23 cents per share, during last year's first quarter. Adjusted net income totaled $229 million, or 46 per basic share, up from $121 million, or 24 cents per share year-on-year.
Cash from continuing operations totaled $628 million and free cash flow from continuing operations of $344 million, compared to $183 million and $52 million, respectively, from the prior year quarter, they said.
"We lowered gold all-in sustaining costs for the third quarter running and by 18% compared to the prior year quarter," said Gary Goldberg, president and chief executive officer of Newmont, during the company's first quarter earnings conference call.
"This was the result of sustained cost improvements and higher grades, favorable oil prices and exchange rates, and some delayed capital that we'll spend later this year," he said. "We also kept gold production steady quarter-on-quarter, offsetting divestments."
Gold and copper all-in sustaining costs (AISC) dipped to $849 per ounce and $1.73 per pound, respectively, compared with $1,034 per ounce and $3.67 per pound, respectively, year-on-year.
Production totaled 1.21 million ounces and 37,000 tonnes of gold and copper, compared to 1.21 million ounces and 24,000 tonnes compared to last year's first quarter. The company is maintaining its full-year 2015 outlook between 4.6 and 4.9 million attributable ounces of gold, at AISC between $960 and $1,020 per ounce." (emphasis added)
Among other things, NEM has benefited greatly from the plunge in energy prices, as it runs a number of energy-intensive large open pit mines. Luckily, it has apparently not hedged its exposure to oil and so the benefits have accrued to it immediately (a few gold miners like e.g. Gold Fields Limited (NYSE:GFI) have unwisely hedged most of their oil input costs and must now wait for these hedges to run off). The surge in free cash flows is really remarkable: $344 million compared to $52 million a year ago.
Just as we have consistently contended over the past year or so, the Wall Street consensus on gold mining input costs has been 180 degrees wrong. The consensus assumption was that costs would continue to increase even as gold prices fell. This argument never made any sense, and by now we have plenty of evidence to prove it. While gold shares in the aggregate are likely to struggle as long as the gold price remains weak, the fact that the margins of the business are improving has not gone entirely unnoticed (investors and analysts always tend to extrapolate recent price trends into infinity, which is really stupid, but creates great opportunities for contrarian investors). The ratio of gold stocks to gold has clearly improved relative to the lows of last year, and this is precisely how bear markets in the sector are usually coming to an end.
As always, there is of course a caveat: should the gold price decline to the long-term technical price attractor around $1,040-1,050, which is a possibility that one cannot dismiss out of hand, many or even most gold stocks are likely to fall to new lows for the move. However, our long-term assessment is that the gold price has risk amounting to between $150 to $250 at worst, compared to potential reward in the thousands of dollars. At the moment this sounds preposterous, but we are sure people thought the same thing after the gold price had been cut in half between late 1974 and mid 1976. At the time, gold was trading at $100 and the risk was $10 to $20, while the potential reward was in the hundreds of dollars. Nowadays, we simply have to multiply these figures by ten.
Meanwhile, the gold mining business has clearly improved as the real price of gold has strengthened significantly in spite of weakness in the nominal gold price. We believe therefore that any dip in the sector represent a long-term buying opportunity, even though there is a remote chance that new lows may be seen before a durable turnaround occurs. Readers may recall that we have voiced similar opinions on Japanese shares in 2012 and Russian shares (as well as the ruble) in the course of last year. Everybody is aware how big a rally the Nikkei has in the meantime delivered, but it may be less well known that the Russian stock market has been the by far best performing market in the world in dollar terms this year (up more than 40% YTD). It took some patience in both cases, but value will always win out in the end. After all, the single most important determinant of investment success is whether one is actually buying low. We have no idea when the gold sector will reward investors - it is certainly possible that will still take a lot more patience. We believe though that the sector continues to represent an excellent long-term contrarian opportunity at current levels.