(Yes, this is arguably the most gratuitous use of the word "gold" in a headline ever).
As one can glean from the title, in this comprehensive report by Goldman's Paul Hissey, the appropriately named firm deconstructs the divergence between gold stocks and spot gold in recent years, a topic covered previously yet one which still generates much confusion among investor ranks. As Goldman, which continues to be bullish on gold, says, "There is little doubt that gold stocks in general have suffered a derating; initially with the introduction of gold ETFs (free from operational risk), and more recently with the onset of global market insecurity through the second half of 2011. However, gold remains high in the top tier of our preferred commodities for 2012, simply because of the extremely uncertain macroeconomic outlook currently faced in many parts of the world. The official sector also turned net buyer of gold in 2010 for the first time since 1988, and has expanded its net purchases in 2011." And so on. Yet the irony is, as pointed out before, that synthetic paper CDO, continue to be the target of significant capital flows, despite repeated warnings that when push comes to shove, investors would be left with nothing to show for their capital (aside from interim price moves of course), as opposed to holding actual physical (which however has additional implied costs making it prohibitive for most to invest). Naturally, this is also harming gold stocks. Goldman explains. And for all those who have been requesting the global gold cash cost curve, here it is...
- We feel there are some obvious solutions to the flight to physical gold ETFs. In order to entice investors away from the gold ETFs, producers
must- Reduce perceived operational risk
- Deliver to market expectations (which includes managing those expectations)
- Demonstrate volume- (not just price-) driven EPS growth
- Return cash to shareholders
- Continue to replenish resources and reserves
- It is also likely that some of the derating we have seen recently has been as a result of changing sentiment towards sovereign risk. With a skittish view toward equities in general, and a decreasing willingness to pay for future earnings, it appears as though the market is less inclined to favour exposure to companies in locations where the perceived risk is higher - rightly or wrongly (West Africa, Philippines, etc.).
Investment View:
- However, we would continue to favour exposure to gold companies in the current global financial climate.
- In particular, we would look for those companies which are trading at a discount to valuation AND which we believe to be operationally sound
(thereby minimising the risk of further derating). - Those companies with little/no debt would also be favourable, given the reduction in financial risk and good cash margins (at least currently…).
- Alternatively, we would be comfortable pursuing those stocks that are trading around NPV, but are well managed, have low execution risk and a growth profile that we believe is not at risk of being deferred.
And the chart that lays it all out:
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In summary, here is what needs to happen, according to Goldman, to end the flow into ETFs and redirect it back into stocks.
We feel there are some obvious solutions to the flight to physical gold ETFs. In order to entice investors away from these funds, producers must reduce perceived operational risk and provide something that a fund cannot (in this instance growth and capital return).
1. Consistent operational delivery
First and foremost, companies need to deliver on quarterly operational production and cost performance. Companies which fail to meet market expectations (or appropriately manage expectations...) provide investors with an easy excuse to deploy capital elsewhere. We provide further exploration below for specific companies, however in general many of the producers in our universe have released consecutive downgrades in either costs or production volumes in the last 3-4 quarters.
2. Volume-driven EPS growth
In our view, one of the key drivers of outperformance is EPS growth, driven by an increase in volume (hopefully with stable unit costs). Whilst price-driven growth is also beneficial, clearly pricing outcomes are not certain, particularly given the recent volatility of the gold price. Several gold companies in our coverage are building or commissioning expansion projects which should deliver volume growth - however, execution risks are also present.
3. Yield/capital management
The current gold price should be yielding excellent cash margins (see chart below) for many of the gold stocks in our coverage universe. Some of the companies have significant capital projects which will require cash, however there are also others which should be able to consider meaningful returns to shareholders in lieu of expansion opportunities. This chart clearly highlights the various margins by comparing C1 (direct) and total operating costs along with the gold price over the same period.
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4. Continual resource/reserve replacement
Although less important for large companies with >20 years or resources and reserves (such as NCM), in our view it is important that companies continue to replace ore through resource and reserve additions. The two tables below highlight the significance of resource growth on gold majors, with Barrick (top) replacing reserves through both acquisition and exploration.
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Much more in the complete report: