12 March 2020
Gold often glitters brightest when other risk assets lose their sheen. So far, the metal has proven an effective hedge against recent market volatility amid the global Covid-19 coronavirus outbreak, with prices topping $1,600 per ounce in recent weeks. Looking ahead, we see more potential support for gold as investors price in plans among policymakers to roll out additional fiscal and monetary easing measures.
But it’s not just the metal. Gold miners have also been outshining the broader market, but the higher price of gold is not yet fully baked into share prices, in our view.
We think Australian miners are uniquely positioned within this space because dynamics in the currency market tend to amplify their returns: when global investors shy away from risk, the Australian dollar tends to depreciate, while gold prices rise in US dollar terms. This boosts the gold price, and the miners’ returns, in Australian dollar terms. This dynamic runs counter-cyclical to trends in mining for other metals, which have mostly seen demand plummet due to the impact of the coronavirus outbreak on industrial activity in China.
At current gold prices, exploration can generate very high returns. With an industry discovery cost of around $50 per ounce, miners generally earn more than $1000 per ounce of EBITDA (earnings before interest, tax, depreciation and amortization), when they eventually mine those discovered ounces. And most of the fertile ground is underexplored because the gold price was much lower the last time miners had the balance sheets to allow them to invest.
How then to explain why gold miners have tended to underperform gold prices, when instead they should have outperformed from having operating leverage to an upswing in prices of the metal? One reason is simple: Mines are hard to run well. Poor capital allocation is another reason.
Historically mining company management teams have been pro-cyclical. In other words, they invest more in their assets when the gold price is high. But this leaves them vulnerable when the gold price falls and they find themselves unable to justify those investments.
Rather than owning a basket of gold miners, investors need to be selective. This means identifying companies with good assets, and management teams that are focused on creating value rather than volume. In other words, companies with a track record of making savvy acquisitions and then knowing how to maximise cashflow streams from them.
Some miners are becoming better operators and capital allocators, having learnt their lessons from the past decade’s boom and bust. Some are redefining mine site productivity while others are religious about not repeating the capital allocation mistakes of the past.
Value can also be created through industry reorganisation, consolidating mismanaged assets, and executing turnarounds. We see ample space in the sector for more of this. The supermergers of Barrick-Randgold and Newmont-Goldcorp set the scene for a new form of disciplined capital leadership.
When it comes to environmental, social and governance (ESG) factors, the broader mining sector tends to be fraught with risks. One way we seek to navigate these and identify the better ESG performers is by looking at company-level initiatives around conservation.
In Australia, for example, the main challenge for gold miners is water usage. The country suffers from frequent draughts and bush fires, and some mining operations are close to population centers. If the miners use shared water resources, they may have to forfeit their water allocation and stall operations to prioritize firefighters or drought alleviation. We have a close eye on relative water risks between companies.
Supply and demand
Supply is another consideration. The gold mining sector must replace 17 per cent of its current supply by 2028 just to keep annual production flat, which would require around $5 billion of additional investment each year.
This supply constraint should incentivise greenfield developers, often called junior miners, which can earn large profits at current gold prices. But there’s a dearth of capital in the space to support greenfield projects, implying foregone opportunities and untapped value. Generalist investors and the bellwether passive exchange-traded funds tend to favour more mature producers and shun the risk of greenfields.
Valuations still attractive
Unlike many other sectors like technology, property, and infrastructure, gold miners valuations are optically cheap. GDX, the benchmark gold miners ETF, has yet to recover from the drop in 2012. It’s down 14 per cent year-to-date as of 12 March, compared with an 8 per cent run-up in the price of gold during the same period. Against the backdrop of the current market volatility, gold miners may still have more space to shine.
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