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Is There a Golden Lining?

A review of gold market and related stocks

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Gordon Pape
Dec 07, 2015
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We are joined this week by contributing editor Gavin Graham, who provides an update on the sagging gold sector. Graham has had a long and successful career in money management and is a specialist in international securities. He held senior positions in financial organizations in London, Hong Kong and Toronto. He currently is chief strategy officer at Integris Pension Management, a provider of personal pension plans for incorporated individuals. He divides his time between Toronto and the U.K. Here is his report.

Gavin Graham writes:

The price of gold hit a new low last week in its four-year bear market, dropping to $1,052 an ounce (all figures in U.S. dollars) at the time of writing (Dec. 2). That's down about 10% this year and 44% from its all-time high of $1,885 in September 2011.

After trading in a range between $1,150 and $1,380 for the two years between mid-2013 and July this year, gold then slipped briefly below $1,100 at the beginning of August in the turmoil caused by the Chinese stock market crash and the devaluation of the renminbi before recovering to $1,175 in mid-October.

The recent decline seems to be driven by a renewed belief that the U.S. Federal Reserve Board will finally raise short-term interest rates at its meeting in mid-December, making cash a more attractive alternative to the nonincome producing precious metal.

As I've noted in previous commentaries, investors tend to regard gold (and to a lesser extent silver) as insurance against financial crises. Gold hit its all-time high in 2011 when the Standard & Poor's 500 had fallen sharply on fears of GDP growth accelerating and interest rates rising. As recently as the beginning of 2013, gold and the S&P had performed equally well since the world emerged from the Great Recession in 2010, with both up almost 20%.

Since then, the prolonged period of exceptionally low interest rates has resulted in fears of an economic pullback fading away. The S&P is up 70% plus dividends over the last five years, while gold is down almost 25%.

Whenever economic uncertainty rises, as occurred this past summer, gold enjoys a revival of interest, with its price rising 5% while the stock market fell 15% in August. With concerns over global economic growth on the rise due to political uncertainty in the Middle East, the terrorist attacks in Paris, the refugee crisis in Europe and a potential slowdown in North American growth, the possibility of unpleasant surprises is rising.

The developed world has enjoyed an economic windfall with the halving of the oil price to $50 a barrel over the last year. However, the response of most consumers has been to save the extra cash rather than spend it, as witnessed by the disappointing retail sales in the U.S. over the last few months.

Many developing economies that depend on commodity exports are in trouble, such as Brazil, Russia, South Africa, and Indonesia. That's due in part to the fact the major commodity importer, China, has cut back on its inflow of raw materials as it attempts to rebalance its economy away from capital investment and exports to domestic consumption. The situation has been exacerbated by a crackdown by the Communist Party on corruption, which has hit imports of luxury goods.

But the one commodity that the Chinese have continued to buy is gold. The World Gold Council (WGC) noted that, while total gold demand rose 8% to 1,121 tonnes in the third quarter of 2015, Chinese bar and coin demand was up 70% to 52 tonnes, while Chinese jewelry demand rose 4% to 188 tonnes. China overtook India as the largest market for gold in 2013, taking in 1,132 tonnes in that year following the former Indian Congress government's ill-advised import duties on gold.

Rising incomes and urbanization combined with concern over the devaluation of the renminbi are helping drive Chinese demand, but the fall in the gold price in the third quarter also saw demand in the U.S. and Europe jump sharply. Demand for coins in the U.S. was up 207% to 32.7 tonnes, and demand for gold Eagle coins was the highest since the financial crisis in 2008.

In the third quarter, overall consumer demand for gold (jewelry, bars and coins) was up 13% in both China and India to 240 tonnes and 268 tonnes. In the U.S. and Europe the increases were much higher, by 62% and 27% to 60 tonnes and 73.6 tonnes.

In the meantime, central banks continue to add to their reserves, with purchases of 175 tonnes, down only 3% from the all-time record of 179.5 tonnes in the same quarter last year. China added an additional 50 tonnes to its 1,658 tonnes of reserves at midyear, making it the sixth-largest central bank in terms of gold reserves, a 57% increase from 2009. Russia remained the largest buyer at 77 tonnes.

The major source of selling for gold has been from investors through ETFs such as the SPDR Gold ETF (

GLD, Financial), with 54 tonnes sold in the third quarter. However, we saw a sudden switch at the end of July as ETF outflows of 71.8 tonnes in July turned into small inflows in August and September. To the end of October, ETF outflows in 2015 are only 54 tonnes. That compares with 785 tonnes in the same period of 2013, the year the gold price fell most sharply, and 133 tonnes in 2014.

Investors, especially the emerging middle class in Asia and the Middle East, are reacting logically to the six-year lows in the gold price. Supply rose by only 1% in the third quarter to 1,100 tonnes, as higher production costs and the lower gold price deters miners from opening new operations. Meanwhile, older South African and U.S. mines exhaust their reserves.

It's reasonable to expect a flattening of supply around this level for the next few years while higher incomes and heightened tension should offset the drag from higher interest rates in the U.S. Elsewhere, central banks appear willing to continue expanding the money supply through Quantitative Easing, whether it's Mario Draghi at the European Central Bank, Shinzo Abe working with the Bank of Japan or Mark Carney at the Bank of England.

Finally, as I have mentioned several times when updating my three gold mining picks, companies with low mining costs and expanding production can grow their earnings even when the price of gold is falling. So far this year, Agnico Eagle is up 22.7% and Franco-Nevada 12.2%. Only Goldcorp, down 26.6%, is lagging the gold price and that is largely due to the market over-reacting to a superficially disappointing third-quarter result. In addition, all three stocks provide healthy and sustainable dividend yields: 1.2% for Agnico, 1.7% for Franco-Nevada, and 2% for Goldcorp. Detailed updates follow.

Goldcorp (

GG, Financial)

Originally recommended at C$46.45, U.S.$45.42. Closed Friday at C$17.03, U.S.$12.73.

Goldcorp's gold production in the third quarter increased 41% to 922,200 ounces from 641,700 ounces last year. This year's numbers were boosted by the Eleonore mine in Quebec and the Cerro Negro mine in Argentina, which came on stream in April and January. Revenues, even with the lower gold price, rose 31% to almost $1.1 billion (currency figures in U.S. dollars).

All-in sustaining costs fell 20% to $848 per ounce from $1,066 per ounce while operating cash flows more than doubled from $192 million to $443 million. Goldcorp generated positive free cash flow before dividends of $243 million compared to an outflow of $355 million in the same quarter of 2014.

However, the share price tumbled 10% as the company reported a net loss of $192 million (-23 cents per share) against a loss of $44 million (-5 cents per share) in 2014. After allowing for discontinued operations there was an adjusted net loss of $37 million (-4 cents per share) against a $70 million (9 cents per share) profit in 2014. Much of this was due to Cerro Negro and Eleonore coming on stream and starting to incur depreciation charges, as well as lower gold prices and write-downs on the value of reserves due to the lower gold and silver prices.

Goldcorp sold its remaining 26% stake in Tahoe Resources for a $264 million profit at midyear and its wharf mine in the first quarter. In August, it bought New Gold's 30% stake in the El Morro project in Chile for $90 million and a $400 per ounce royalty on future production. It also combined El Morro with Teck's Relincho project 40 kilometers away in a 50/50 joint venture.

Goldcorp remains a Buy for its strong growth in output, falling costs and pipeline of new projects in politically stable countries in North, Central and South America.

Agnico Eagle (

AEM, Financial)

Originally recommended at C$55.39, U.S.$55.80. Closed Friday at C$38.93, U.S.$29.13.

Agnico Eagle also delivered an excellent set of results for the third quarter. The company reported record gold production of 441,124 ounces, up 26% from 349,273 ounces last year. The all-in sustaining cost was $759 per ounce, down substantially from $1,059 per ounce in 2014 (currency figures in U.S. dollars). Revenue was up only 10% due to the lower gold price, but cash flow doubled to $144 million from $71 million. Agnico reported net earnings of $1.3 million (1 cent per share) against a loss of $15 million (-7 cents per share) in the same period of 2014. Adjusted earnings after foreign exchange and noncash charges on the value of reserves were $37.2 million (18 cents per share).

For the nine months to the end of September, Agnico had earnings of $40.1 million (19 cents per share), down from $104.3 million (55 cents per share) on production of 1.249 million ounces. Revenue was $1.5 billion, up from $1.39 billion a year ago. Cash flow was essentially flat at $475 million versus $504 million in 2014. The lower earnings were due to increased depreciation at the Malartic mine and higher production costs.

The company raised forecasts for 2015 to total production of 1.65 million ounces from 1.6 million at all-in sustaining cost of $840 to $860 per ounce, reduced from previous guidance of $870 to $890 per ounce.

Most of the increase in production comes from the Malartic mine in Quebec, which Agnico bought in concert with Yamana Gold (

YRI, Financial) last year. Also, doubled exploration has increased inferred reserves at the Amaruq deposit in Nunavut and extended a parallel zone at the Kittila mine in Finland.

Agnico Eagle remains a buy for its strong growth in production, low cost base, excellent pipeline of projects in politically stable countries and sustainable dividend.

Franco-Nevada (

FNV, Financial)

Originally recommended at C$31.69, U.S.$30.45. Closed Friday at C$68.01, U.S.$50.85.

This is by far the best-performing gold stock of the bear market. Gold and precious metals royalty company Franco-Nevada reported production of 85,637 Gold Equivalent Ounces (GEOs) from the royalties on gold, platinum and silver mines and $7.8 million in oil and gas revenues (currency figures in U.S. dollars). Net income was $15.2 million (10 cents per share) and adjusted net income after excluding foreign exchange and impairment charges was $19.4 million (12 cents per share). This compared to 70,071 GEOs and $20.5 million of oil and gas revenues in the same quarter of 2014, which resulted in net income of $33.2 million (22 cents per share) and adjusted net income of $34.5 million (23 cents per share). The difference was largely due to lower gold prices and impairments of investments.

Franco-Nevada invested $648 million in late 2014 in a gold and silver royalty stream from the Candelaria project in Chile, owned by Lundin Mining, funded partially by a $480 million equity issue. More recently, the company invested another $610 million in a silver stream from the Antamina mine in Chile, operated by Teck Resources. The deal closed at the end of the quarter and is expected to generate 12,300 to 15,000 GEOs for Franco-Nevada in the fourth quarter. Franco-Nevada also invested $337.9 million in the Cobre Panama copper/gold project with First Quantum in November, part of a $1 billion commitment for a mine that will start producing in 2018.

Franco-Nevada has $330 million in net debt and an undrawn credit facility of $270 million, allowing it to make further additions to its portfolio. While it has invested almost $1.3 billion in Latin American assets over the last year, Franco-Nevada remains well diversified by geography, with royalty and stream incomes from politically stable countries in North, Central and South America, Australia and South Africa.

Investors may wonder why Franco-Nevada has performed so strongly since being recommended five years ago, doubling in value while the price of gold has fallen 25%. The reason I selected FNV as the initial exposure to gold and precious metals was its low risk royalty structure, which founders Pierre Lassonde and Seymour Schulich had established when setting up the original company in the early 1980s. By receiving a royalty of between 2% and 4% on each ounce of gold or the equivalent produced by a mine or a collection of mines, the company has exposure to the price of the precious metal but not to the costs of producing it or the environmental liabilities. Other royalty/stream companies have followed this model, such as Silver Wheaton and Freehold Royalties.

The original royalty on Barrick's Goldstrike mine on the fabulously productive Carlin trend in Nevada meant that Franco-Nevada's predecessor company went up several hundred percent while the price of gold fell by two-thirds before the company was bought by gold giant Newmont Mining in 2002.

When the royalties owned by Newmont were spun out into the "new" Franco-Nevada in 2009, investors once again had the chance to invest in this low risk way to play the gold price. The resurrected company offered a well-diversified portfolio of gold, silver and platinum royalties and some oil and gas royalties as well, almost all in politically stable and mining-friendly jurisdictions.

They also had the chance to benefit from the experience and track record of Pierre Lassonde and his new CEO Ian Harquail, who have successfully added a number of major new royalties, such as the Candelaria, Cobre Panama, and Antamina deals in the last year.

As the largest royalty/stream company by market capitalization, Franco-Nevada has the ability to do deals of a substantial size and take advantage of miners who may need the cash from such deals when the price of precious metals is depressed. Doing royalty or stream deals is often the cheapest form of financing and in many cases the only one available if the miners cannot raise money through equity issues or borrowing.

While Franco-Nevada looks expensive on traditional valuation metrics, it has the ability to substantially increase its earnings with a single move, such as the 15% to 20% addition to its GEOs provided by the Antamina deal this quarter.

If investors want exposure to one precious metals stock, which nearly all experts agree deserve a place in an properly constructed portfolio, they should own a well managed royalty company, of which Franco-Nevada is best diversified and most successful.

Franco-Nevada remains a buy for its low risk exposure to the gold price, excellent geographic and operational diversification, and highly regarded management.

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