The bullion-gold stock disconnect

Illustration by Juan Carlos Solon

From today's Financial Post

Peter Koven May 27, 2011 – 3:16 PM ET | Last Updated: May 27, 2011 3:12 PM ET

For gold miners, success has been anything but fun lately.

Everything these companies prayed for a decade ago, they got. Collapsing global currencies. A gold pricing rising from US$250 an ounce to more than US$1,500. Incredible earnings and cash flow growth. It played out exactly as the gold bugs said it would, and then some.

Yet you won’t find many gold CEOs with smiles on their faces these days, because over the last 12 to 18 months, their share prices have barely responded to the accelerating gold price.

Barrick Gold Corp.’s 12-month return (including dividends) is about 5%. Newmont Mining Corp.’s is 2.6%. Goldcorp Inc.’s is 8.15%. Kinross Gold Corp.’s is minus 17%.

The story has not been much better of late for the junior and intermediate companies. While their shares did very well in 2009 and 2010, they have had a rough ride the last couple of months.

The weak stock prices, which seem to have little to do with the actual operations of the miners, has left investors wondering if and when these companies will start to perform in line with the commodity they produce.

The overwhelming theme for gold equities in recent months is that as earnings and cash flow go up, trading multiples go down. Charles Oliver, who co-manages a gold fund at Sprott Asset Management, says that Barrick and Newmont traded at 40 or 50 times earnings a decade ago (though they had much less in the way of earnings in those days). Today, Barrick’s price-earnings multiple is a little over nine times, he says.

A key difference between then and now is that investors who want bullion exposure have the option of going to exchange-traded funds. Many of them have taken that path, getting exposure to gold with none of the risk of having to operate mines. While that has helped mining companies by boosting the price of gold, it has taken some investor capital out their stocks.

“That’s a process that has gone on for six years and I think still has some impact on the markets. Though at this point, anyone who wanted to own gold ETFs should have taken a position,” Mr. Oliver says.

The ETF proliferation cannot be held entirely to blame, as the underpeformance of gold equities is a more recent event. From 2002 to around 2007, the equities outperformed bullion (though there are exceptions, such as Barrick).

The relationship got disrupted when financial markets went haywire in 2008, and the equities have been mostly disappointing since then.

So what happened? When analysts talk about why gold equities underperform, they often cite lack of production growth, execution problems, political risk and a host of other reasons. But none of those factors adequately explain why the whole sector has done so poorly.

Some industry sources have another theory: that the analysts themselves are pricing in numbers that are much too low when they calculate what these companies are worth. While most analysts are using a gold price of roughly US$1,500 an ounce for 2011, their long-term targets are closer to US$1,000, which affects their earnings estimates.

“I think what happens is that people rely on net asset value [to value gold companies], and the calculations don’t seem to rise so dramatically because the long-term gold price [used by analysts] is at a deep discount to the current price,” says Peter Marrone, chief executive of Yamana Gold Inc. “So I think there’s a tendency to say, ‘I’m not taking advantage of the equities because they’re not reflecting the current gold price.”

If gold miners want to convince investors that their stocks are a better investment than bullion, they have one obvious ace in the hole: yield, which you can’t get from physical gold.

Every significant gold producer in the world has either introduced or increased its dividend in the past year. It is genuinely the first time in history that these companies, which made no money for decades, have spare cash to burn. Their theory was that paying dividends would suddenly make gold stocks appealing to value and income investors, but experts say that it still has not happened to a significant degree.

Part of the problem is that the yields are still very puny – 1% is well above average for the sector. And that isn’t good enough to attract new investors, Mr. Marrone says.

After listening to the Street, he decided that a 1.5% yield represents a threshold at which income-based investors will start to take a gold company seriously. Yamana thus hiked its dividend 50% earlier this month to get it into that range.

As gold miners continue to accumulate absurd amounts of cash, Yamana’s rivals will also be hiking dividends in the months to come. The question then becomes, will that be enough to convince investors to buy these stocks?

The views from inside the industry are mixed. Ian Telfer, the chairman of Goldcorp Inc., says that one of the unique things about commodity stocks is that a dividend or cheap valuation is not necessarily enough to make fund managers jump in. Ultimately, they’re only going to do so if they believe the price of the commodity is going to go up.

And that might explain in part why the gold stocks are underperforming. When gold was trading at US$250 a decade ago, investors could imagine the price doubling to US$500, which made the potential earnings growth very attractive. Today, it is probably a little tougher for people to get their head around a price of US$3,000. Thus, multiples can decrease even as earnings dramatically increase.

“People pay more for these stocks when they see the chance of a big run-up. Once that run-up happens, there’s going to be fewer people seeing that high upside ahead of them,” Mr. Telfer says, though he himself believes that the price will move far higher than it is now.

History shows that these trends do not last forever, and at some point the tide will change and the equities will start to outpace gold again. But it seems that some catalyst is going to be required for that to happen.

Ironically, many experts think that catalyst might be a cool-down in the price of gold itself. If owning bullion suddenly becomes a little less attractive and investors want to put money to work elsewhere, Barrick’s nine times earnings multiple might catch some attention.

“I’ve always believed that as the metal price continues to appreciate, there’s a higher probability that people will gravitate to the metal than the equities. But as the gold price stabilizes, that’s when the equities begin to show cash flow, earnings, and improvements in margins, and the result is that people begin to invest in the equities,” Mr. Marrone says.

The gold miners can only hope he’s right, or the not-so-good good times could continue for a while.