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All That Glitters...
Posted by: Gordon Pape (IP Logged)
Date: January 20, 2014 10:46AM
Contributing editor Gavin Graham joins us today with a look at the recent rally in the price of gold and the outlook going forward for the precious metal. Gavin is the president of Graham Investment Strategy and an expert on international securities. He is the co-author of the new book Investing in Frontier Markets and his new newsletter, Emerging and Frontier Markets Investing, will be launched next week. Here is his report.
Gavin Graham writes:
In 2013 the price of an ounce of gold fell by 28% as bullion finished at US$1,202 per ounce, its worst performance in over 30 years.
It was the first year since 1999 that the price of gold had not risen. That period included two 50% falls in the major stock markets, in 2000-02 and 2007-09.
Gold miners did even worse last year, with the exchange-traded fund (ETF) that tracks the S&P Global Gold Index down 47.4%. The falling gold price meant that the profits of mining firms fell much faster than their revenues and a large percentage of their gold reserves became worthless, as it was no longer profitable to extract gold from their acreage at the lower price.
Making forecasts about the likely direction of gold or other precious metals is one of the more useless activities that market commentators indulge in. Unlike industrial commodities such as the base metals, coal, oil and gas, or paper and pulp, gold and silver are not especially influenced by global economic growth, rising demand from the emerging markets, or increasing use of technology. Instead, the price of gold, and to a lesser extent silver, is driven by investors' worries over the outlook for inflation, economic crisis, or worries over the collapse of the financial system, rather than by simple supply and demand. As skeptics never cease to point out, virtually all of the gold ever mined is still in existence, given its indestructible nature, and higher prices have the effect of bringing hoarded supply back into the market.
When gold doubled in price between 2008 and 2011, reaching an all-time high of US$1,920 per ounce in September 2011, it was reflecting concerns over the safety of the global banking system, the introduction of widespread quantitative easing (QE) programs by central banks around the world, and the outbreak of the eurozone crisis. Investors wanted disaster insurance, something that could not be rendered worthless by the collapse of their local bank or at the whim of a government. Gold, which has acted as a store of value over the last four millennia, was felt to be a suitable refuge from the financial storm.
The fact that the opportunity cost of holding gold was virtually zero, due to central banks reducing short-term interest rates in North America, Japan, and Europe to 0.5% or below, addressed one of the major negatives to holding gold: the fact it pays no income. Also, the introduction of ETFs such as the SPDR Gold ETF (GLD), each share of which represents one-tenth of an ounce of gold, allowed investors to own the metal with a click of their computer mouse.
Why did gold fall so sharply last year? The principal reason appears to be that, five years after the Lehman Brothers bankruptcy, investors' need for insurance has fallen. The economies of the U.S. and Canada had GDP growth of over 2% in 2013, the U.K. and Japan were over 3%, and even the eurozone has finally emerged from its double-dip recession. The central banks have made it plain they are now targeting unemployment as well as inflation, but also that they feel sufficiently confident that they can begin withdrawing some of the stimulus they were injecting.
The emerging markets, led by China, are also showing signs of recovering from the slowdown that affected them in 2012-13, and thus the outlook for global growth in 2014 looks brighter.
Lastly, one should not forget that stock markets in the U.S. and Canada, the U.K., and Japan have doubled over the last five years. Nothing makes investors feel more confident than a long running bull market.
One effect of the fall in gold mining stocks is that they are now looking pretty cheap. The price/earnings (p/e) ratio for XGD is 10.3 times 2013's earnings, the price/book (p/b) value is 0.9, and the trailing dividend yield is 1.6%.
As I have mentioned several times when discussing gold miners, the management of the better-run companies are now linking their dividends to the price of gold, so that shareholders are no longer merely dependent upon capital gains. In fact, my recommendations Franco-Nevada (FNV), Agnico Eagle (AEM) and Goldcorp (GG) all pay dividends which are much higher than the return on cash. Franco Nevada yields 1.7%, Goldcorp 2.7%, and Agnico Eagle 2.9%.
Goldcorp Makes Its Move
Goldcorp evidently believes this is an attractive time to be buying gold assets. On Jan. 13 it made a hostile $2.6 billion cash and shares offer for Osisko Mining (TSX: OSK), whose principal asset is the Malartic gold mine in western Quebec. It came on stream in 2011, contains 10.1 million ounces of gold, is expected to have a 16-year life, and produced over 500,000 ounces of gold last year. Having attempted to merge with Osisko several times over the last five years, at one stage owning a 10% stake in the company, and making three offers around $7.50 a share in 2009, Goldcorp CEO Chuck Jeannes decided to bypass the board and make a $5.95 offer directly to Osisko's shareholders. That's a 15% premium to its pre-offer trading price.
Goldcorp's strong balance sheet allows it to offer a mixture of $2.26 cash plus 0.146 of a Goldcorp share for each Osisko share. The deal would be funded by Goldcorp's $600 million in cash, a $2 billion undrawn credit line, and a $1.25 billion credit facility from Scotiabank. The acquisition is expected to boost Goldcorp's production by 17.5% and its probable and proven resources by 15%.
Malartic is a higher cost producer than Goldcorp, with cash costs of US$725 per ounce against Goldcorp's US$500. This would raise Goldcorp's average cost per ounce by 7.5%. However, Mr. Jeannes believes that Goldcorp could reduce its costs by operational improvements and synergies with its Quebec Eleonore mine.
The market is evidently expecting Goldcorp to raise its bid, as Osisko is trading around $6.47, a premium of almost 9% to the offer. However, it is hard to see many other bidders coming in to the fray, despite the long life nature of Malartic and its location in a politically stable jurisdiction. Few gold miners have a stronger balance sheet than Goldcorp; in fact Barrick Gold (TSX, NYSE: ABX) had to resort to a deeply discounted rights issue to raise $3 billion before the end of 2013, and most of the other large players such as Kinross and Newmont have issues of their own.
While the price per ounce that Goldcorp is offering for Osisko at US$240 is double what Gold Fields paid Barrick for three Australian mines a few months ago, it is well below the cost of transactions during the industry's acquisition spree in 2010-11, and less than half of what Osisko was selling at two years ago. While a small increase in the bid by Goldcorp should not be ruled out, it looks like the company will be getting a bargain. Its own share price barely moved, showing the confidence shareholders have in the management's judgment.
Action now: Goldcorp remains a Buy, as do Franco Nevada and Agnico Eagle.
Stocks Discussed: GLD, FNV, AEM, GG,
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