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 Tocqueville Asset ManagementGOLD SHARES ARE CHEAP John Hathaway
Portfolio Manager and Senior Managing Director ©
Implausible as it may seem, gold shares, which have outperformed equity markets and most
other asset classes over the past eight years, are out of favor. Less plausible still is that sentiment
on gold is at bullish extremes following its recent run to historical high levels (in terms of
nominal prices). Please see the appendix which shows that shares relative to net asset value are
the cheapest in six years whereas various sentiment gauges on the metal itself such as Market
Vane and trader’s commitments are at the high end of their multi-year ranges. The shares have
posted average annual returns of 15.7% (basis XAU) since the bear market low reached in
August of 1999. A gale of negatives has battered down valuations, despite their rise in absolute
terms. Gold shares are firmly supported by the tenets of contrary opinion. While the better trade
over the last two years was to own gold and not the shares, the opposite may be true from this
point forward.
Since the third quarter of 2007, gold shares have become exceptionally cheap relative to the gold
price. Historically, when the XAU benchmark index (Philadelphia Stock Exchange Gold and
Silver Sector Index) has traded at a ratio of 20% or less compared to the gold price, the
subsequent twelve month returns in the shares has averaged 40%. Despite the recent rally in gold
shares, the ratio is hugging 20% and the coat tails of the metal itself which has broken out to
historic highs.
Over the past two years, the metal price itself has slightly outperformed the share index as shown
on the chart below. These days, the metal itself is more highly rated than the shares of mining
companies that produce it. Historically and traditionally, shares have offered leverage to the
gold price. In this current cycle, the relationship has been altered for reasons that we will
discuss. We also believe that the shares are about to regain their zip relative to the metal.
The reasons that gold stocks have become cheap begin with the anemic behavior of global equity
markets. Even though gold shares are linked to the gold price, they are held by equity investors
who may need or desire to raise cash, or have become more risk averse because of the adverse
investment experience that has been widespread this year. First and foremost among the reasons
for the sluggish performance of gold shares, especially those below the top tier in terms of
market cap, has been the general panic to liquidity. However, gold shares should come to life
even if the gold price merely stabilizes around these levels. A further strong rise in the gold
price driven by systemic financial distress might delay the renewal of interest in the shares, but
the ultimate outcome for the shares in such a scenario would also be positive.
Also high on the list of reasons for the shares’ underperformance is GLD, the gold ETF
(Exchange Traded Fund which holds metal rather than shares), and its various iterations on 12
stock exchanges around the world. In 2007 gold ETF Shares outstanding rose 28%, supporting
our long-held view that in making gold “user friendly”, the ETF has become an important driver
of the gold price. In so doing, however, it may have temporarily siphoned off capital market
flows that were otherwise destined for gold shares. We expect continued strong growth for the
ETF in the years to come, but impact for gold shares will, on balance, be more positive in the
future than they have been to date. Aside from issues of relative performance, one cannot forgetthat ETF instruments have created an important bid for physical gold. In so doing, they have
become important drivers of the gold price, facilitating a rising tide that is floating an armada of
boats, many of them quite leaky. In the absence of the ETF, the rising tide would have been far
more anemic.
The third, and perhaps most important reason the shares have become cheap is that, unlike gold
itself, there has been massive new supply. Financing activity in the fourth quarter (according to
BMO Nesbitt) totaled US$4.2 billion compared to US$1.1 billion in the fourth quarter of 2006.
The yearly comparison is US$17.7 billion vs. US$6.7 billion. Equity investors can be excused if
they suffer from “deal fatigue.”
A key factor driving financing activity is that gold mining is a capital intensive industry. The
gold share sector was shocked by the November 2007 news that the estimated capital budget for
Galore Creek, a joint venture between Teck Cominco and NovaGold, had escalated to “as much
as” $5 billion from $2.2 billion based on a feasibility study completed only one year earlier.
Teck and NovaGold decided jointly to suspend project construction. NovaGold promptly lost
50% of its market value. While all new mining projects are not comparable, those in remote
areas such as interior Yukon require significant infrastructure investment over and above
construction of mining and milling facilities. The event has cast a cloud over all mining shares
for which mine construction activities are important components of valuation.
As if such challenges were not enough, the industry is further constrained by darkening political
attitudes toward gold mining, with respect both to host country politics and the strictures of
global environmental morality. Less hospitable tax and fiscal regimes are becoming more
common and affect risk perception in the form of higher hurdle rates for potential capital
investment. More stringent and ever changing environmental compliance standards translate into
higher over all costs and risks. They string out the process for permitting and approvals. Such
delays add directly to capital costs and magnify uncertainty.
To the casual observer, a gold price in the neighborhood of $1000/ounce, four times the bear
market low of $252 in 1999, would indicate that the industry is flush and able to meet such
challenges. Until recently, the price of gold had not outpaced most of the important cost factors
relevant to mine operation and construction including energy, steel, chemicals, specialized labor,
and capital equipment. An August 2007 recent study by Macquarie First South asserted that at
$500 gold, only seven companies would generate cash over the longer term. When all is said
and done, global cash operating costs per ounce of gold produced in 2007 will easily exceed
$400/ ounce, and they are headed higher in 2008. While capital costs vary widely depending on
the type of mine, location, infrastructure, local economics and numerous other considerations, a
broad brush figure would exceed $200/per annual ounce of production. Adding in allowances
for contingencies and most importantly, return on capital, the all in cost to produce an ounce of
incremental gold for 2008 probably exceeds $700.
Until recently, this back of the envelope math meant hard times for gold miners. But, when
investors and analysts finally wake up and notice that a gold price over $900 is sustainable, they
will also anticipate significant daylight for operating margins in this difficult industry. And if the
gold price continues to elevate while interest rates and the economy sink, this miniscule sector of
the S&P will show year over year progress in earnings and cash flow that is distinctly stellar in a
universe of black holes.
Global gold mining production is unlikely to increase over the near or intermediate term. In fact,
it is more likely to decline modestly assuming current gold prices. It will decline precipitously
should gold prices decline much from these levels. As Dick O’Brien, CEO of Newmont Mining
recently asserted, the gold industry has chronically over invested. It has been managed
according to the requirements of a net present value (NPV) financial discipline, which means
simply that the incremental ounce has been produced as long as there is an incremental operating
profit to be earned by so doing. As a result of overinvestment, this industry ROC was
somewhere in mid single digits in 2007, strong gold prices notwithstanding. Should the industry
become more enlightened (as is our fervent hope), it will make financial decisions based on
return on capital. Such a shift would keep a lid on gold production for years to come, and quite
possibly induce a significant decline. Perhaps this is only a fantasy based on hope, for there is
little basis in history. The reality is that the gold mining sector is the industrial poster child for
sub prime credit. Despite perennial poor returns on capital, investors and lenders shovel new
capital in its direction looking to greater fool dynamics to come out ahead. Does this mean gold
mining shares are a poor investment? On the contrary, the foregoing litany of woes is what
makes them so intriguing.
As the industry struggles with operating and capital costs, mired in a purgatory of skimpy returns
on capital, disappointing earnings and investor dismay, they have been forever poised to become
significantly more profitable if only the gold price would cooperate. Bullion has finally done so.
Profitability is set to blossom. It can happen. It has happened in the past and it will happen
again. The “optionality” of gold shares relative to the gold price will juice returns on the former
relative to the latter.
Gold mining equities are in reality long dated options on the gold price disguised as interests in a
lousy business. Gold bullion appears set to advance strongly in in the years ahead.. Gold shares
should outpace the metal as the predisposition against them recedes. A quote from a major (and
reputable) bullion bank on a gold five year gold call illustrates the option value inherent in the
shares. A five year call on gold at $1100/oz (which is slightly in the money based on the
contango) would be $250/oz. The size of the requested quote was 100,000 ounces. To overstate
the obvious, the holder of such an option would require gold to trade at $1350/oz. within the five
years to make a profit on the underlying metal. Of course, a paper profit on the option itself is
always possible, but we would be willing to bet that the bid on the contract would represent a
substantial haircut on the intrinsic value. The market is sufficiently liquid that a call option of
this size would be routine. A call of 500,000 ounces would still be achievable but might have to
be done in tranches.
In comparison, the global gold mining industry produces around 85 million ounces a year, and
the duration of this approximate level of production certainly exceeds five years. While the
valuation of certain individual gold mining shares might compare unfavorably to the option
metrics cited above, there are far more numerous examples where shares that are cheap by
comparison. Without naming names, here is one real-life example. Our ever-vigilant
compliance overseers prevent me from being more specific.
Company A is building a 300,000 ounce per year mine in a country where the political risk is
comfortably above median. The anticipated cash cost of producing the gold is $425 per ounce
after capital expenditures of $400 million. The reserves are sufficient to produce at this rate for 10 years so the capital cost per ounce is $133.33 based on current known reserves. Of course,
there must be provision for return on capital of, say, 15%, which adds $60/ ounce. Let’s throw in
another $125/ ounce (30% of profits) for taxes (never included in cash costs, but these do not
usually kick in until after significant return of the capex), escalating costs of production, and
other contingencies. Therefore, the strike price on 300,000 ounces per year to be delivered
roughly from 2010 to 2020 is $743.33/ oz. Let’s call it $750 in round numbers. What one pays
for this notional option is the market cap of Company A which in this case is approximately
$600 million. The option premium is $200/oz.
So there we have it. Option number one is for 100,000 ounces to be delivered within a period of
5 years, at a strike price of $1100. The premium is $250/ ounce. Our bullion dealer friend
thought it would be extremely difficult, if not impossible, to structure a call option to deliver
300,000 ounces a year over a ten year period with a deep in the money strike. Option number
two is for 300,000 ounces per year over ten years with a deep in the money strike price of $750
and a per ounce premium of $200. In the first instance, (other than the gold price) all one has to
worry about is the passage of time and the inevitable degradation of premium value. In the
second instance, there is a longer list of worries including political risk, escalating production
and construction costs, inaccurate statement of reserves, dilutive financings, or other ill advised
management actions. On the other hand, built into the company A share option for free is the
possibility of expanding reserves at the existing, development or acquisition of additional mines,
process improvements which could lower costs, and value accreting decisions by management.
At the moment, gold sector sentiment is bifurcated, even schizophrenic. High esteem for bullion
is offset by loathing for gold mining equities, especially the mid to smaller cap issuers that lack
liquidity. Sell side analytical commentary on gold shares is all too often an exercise in wasted
motion. The analytical community’s obsession with costs and irrelevant minutiae that dominates
quarterly conference calls reminds us of Peter Drucker’s observation that there is no greater
waste than to do something well that did not need doing in the first place.
There is only one fundamental consideration that really matters for gold shares and that is the
future price of gold. All other considerations are a distant second. As far as the shares are
concerned, gold has already done its work. A sustained gold price in the area of $1000/oz
heralds a period of prosperity not seen in decades. If further steep rises in the gold price lie
ahead, even better. In either instance, the most despised gold shares could produce the most
spectacular returns.
John Hathaway
© Tocqueville Asset Management L.P.
www.tocquevillefunds.com
March 17, 2008
This article reflects the views of the author as of the date or dates cited and may change at any
time. The information should not be construed as investment advice. No representation is made
concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or
opinion will be realized.
Appendix
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