All that is gold does not glitter
So what does the future hold? Will gold continue to do well? Will gold
shares continue to under-whelm?
Andrew Joannou*
Tue Jul 17 20:37:29 SAST 2007
Many a gold-bug must be frustrated and horribly disappointed with their
gold stocks.
The price of gold has raced forward and looks on track to meet the
expectations of even the most exuberant fan.
Gold shares, wallowing in a mire of rising costs and falling grades,
have however been slow to turn these good fundamentals into cash flow.
South African gold shares have underperformed relative to South African
platinum shares, even though the price performance of gold and platinum
have been similar.
So what does the future hold? Will gold continue to do well? Will gold
shares continue to under-whelm? Alas, we have no crystal ball, but we do
have a few thoughts as to why the dollar price of gold should continue
to rise and why gold shares may continue to disappoint.
Gold has a number of factors working in its favour. The commodity's
demand and supply metrics seem distinctly skewed (over the next couple
of years) towards a supply deficit. Sentiment has also swung, once more
classifying gold as a viable asset class and giving birth to not only
new investment demand in the form of exchange-traded funds (ETF) but
less supply from central banks. While these points are indeed positive
for the price of gold, they are not what cause us to be optimistic about
gold's prospects. What we really like about gold is that it is inert and
it is unmoved and unfettered by the whims of central bankers. We do not
see the price of gold increasing so much as we see all the currencies
against which gold is measured decreasing, thereby giving the illusion
of a gold run.
Why are all these currencies depreciating? Well, it is once again a
simple demand-supply problem. With money supply as large as it currently
is, demand just cannot keep up. This, combined with the fact that no
country wants its currency to appreciate significantly against its trade
partners has caused a vicious cycle of monetary stimulation and a global
depreciation in purchasing power.
This is very good news for gold since the real value of gold stands
still and maintains its purchasing power thereby allowing its price to
increase on a relative basis. In light of these factors, we continue to
be positive about gold. The gold companies on the other hand still seem
fraught with peril. Their share prices already discount much better
earnings and cash flow. The companies have also picked the eyes out of
their mines and are now suffering declining grades and increasing costs.
Consequently, gold stocks only achieve "leverage" to the rand gold price
when the metal price increases well in excess of the firm's rampant cost
growth.
Without this leverage many a gold investor has started to question the
rationale of holding their exposure through gold stocks versus the
underlying commodity. While we take note of all these concerns, we have
an even bigger issue with the gold shares. The South African gold
companies have destroyed shareholder value over the last few years by
being too free with their equity.
This combined with poor operational performance has contributed to poor
returns against the market, other precious metal stocks and the
underlying commodity.
We will now examine some of this value destruction.
In 2003 AngloGold bought out Ashanti Goldfields. To fund the transaction
AngloGold issued about 42m shares, or 19% of its issued share capital.
AngloGold produced 5,6m ounces of gold in 2003 and hoped, with Ashanti's
help, to produce 6,4m ounces in 2004. This year Anglogold Ashanti (the
merged group) hopes to produce only 5,7m ounces. Is it therefore any
wonder that Anglogold Ashanti has performed so poorly? To be fair the
transaction was required, and did help, to fill the hole left by the
decline in the existing business. The point however is simple: Anglogold
had to dilute its shareholder's equity by 19% just to stand still. This
is blatant value destruction.
In 2006 Gold Fields bought the South Deep mine. To do this it bought out
Western Areas and acquired Barrick's 50% share in the actual mine. It
then unwound the Western Areas hedge book. All in all, by our
calculation, Gold Fields spent R20bn on the entire transaction and
funded the majority of this with shareholder equity. This is an
incredible quantum of money. If Gold Fields is to make even a 10% return
on this capital, it will have to produce R2bn in profits. This is very
unlikely given the production expected for South Deep, in fact we
believe Gold Fields (in a couple of years time) will be very lucky to
make half this amount.
Bernard Swanepoel's closing comment in Harmony's 2006 ‘Chief Executive's
Review' says that the company "will continue to create value wherever
the opportunity arises". Harmony has actually destroyed value, since it
has not compensated its shareholders for any risk.
So, what is our conclusion? Will gold continue to rise and gold shares
continue to underperform? They might, if gold companies and gold
investors continue to behave as they have. If however, as management
expect, grades start to pick up, costs start to be managed, production
edges higher ... and the companies are more frugal with their equity,
then the current trend of underperformance can change. This combined
with the shares' very shoddy relative performance has caused us to
re-examine our investment rational and assess whether our under-weight
position is still warranted - because who knows, maybe one day the
shares will once more glitter like gold.