Gold Shares are Cheap

March 20, 2008

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.

Appendix

John Hathaway, CFA, Senior Managing Director, Co-Portfolio Manager

Mr. Hathaway is a co-portfolio manager of the Tocqueville Gold Fund, as well as other investment vehicles in the Gold Equity Strategy. Mr. Hathaway also manages separately managed accounts for individual and institutional clients.  He is a member of the Investment Committee and a limited partner of Tocqueville Asset Management (www.tocqueville.com). Mr. Hathaway began his career in 1970 as an Equity Analyst with Spencer Trask & Co. In 1976, he joined investment advisory firm David J. Greene & Co., where he became a partner. In 1986, he founded Hudson Capital Advisors and in 1988 became Chief Investment Officer of Oak Hall Advisors. He joined Tocqueville as a Senior Partner in 1998. Mr. Hathaway has a BA degree from Harvard College and an MBA from the University of Virginia.  

One cubic foot of gold weighs more than half a ton (1,306 pounds).

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