The bull (and bear case) for gold bullion as a safe haven investment could be heard all over the digital airwaves after Gold experienced its largest drop since 1981 falling 28% in 2013. What got relatively less press coverage is that investors in gold miners saw 55% of their investment wiped out in the same period as measured by the HUI Gold Bugs Index.
It’s been a painful 5 years for most miners
While the S&P 500 index has seen a 147% rise over the last 5 years, much of this has been driven by central bank monetary easing as opposed to a commensurate rise in corporate earnings. I say this not as a fleeting statement, but factually looking at the most recent earnings releases from McDonalds to Walmart a ringing theme from management in corporate America is that of margin pressure in the face of rising input costs and cash conscious customers. Unfortunately, gold miners have not been immune to these cost pressures and investors have seen a significant fall in the price of mining stocks. Measured by the HUI Gold Bugs index that tracks a basket of 15 of the largest unhedged gold stocks, investors have lost 14.7% over the last 5 years. Most of the losses were in incurred in 2013 when the HUI lost 55% as gold fell by almost a third; gold miners facing falling revenues and rising costs to extract gold from the ground are never a good combination.
The fall in gold while significant should have been expected for an asset class that spent 12 years consistently rising from its bottom in 1999. Nothing can rise forever without a minor pause or correction and similarly nothing can fall in perpetuity. There is always a bottom. Infamously, 1999 marked gold’s bottom with prices at a 20-year low when the Bank of England sold 400 tons of Britain’s gold reserves highlighting the truism that the best time to buy is when everyone else is selling.
A rare opportunity?
Some may argue that the truism today provides an opportunity to invest in the mining sector, which when measured by the HUI gold bugs index is at rock bottom valuations. While traditional equities can be measured by their price to earnings ratio, resource investors tend to focus on how much they’re paying for the reserves held by a mining company as opposed to metrics like NPV. Right now, the price to book value of the HUI stands at 1.06x meaning that investors are able to acquire all of the assets belonging to mining companies in the index for little over ‘book cost’ as recorded on the balance sheet. That includes all of the mines, reserves, cash, plant and infrastructure, while paying zero-premium for the staff and operational value that comes with these businesses.
Historically the index has traded at 2.64x price to book but even after a steady rise this year, the stock market today only just values the companies within the index at just over the assets listed on the balance sheet. The chart from KStar Associates shows that the last time gold miners were this cheap from a price-to-book basis, the index as a whole rose 150% in 1997 (miners were trading at 1.21x price to book) and then again by 89% in late 2008 (1.4x). For the index to return to its historic average of 2.64x, the price would need to increase 149% as today’s prices for mining businesses sit around 2008 crisis levels.
Significant risks exist
The mining sector is a scary place. The performance of companies in the last 12 months show just how quickly business performance can change and as mentioned production costs for mining companies to extract resources from the ground are on an upward trend. Unlike other businesses, there is also the unique problem that the more a mining company sells, the more it depletes its own asset base. This brings with it the challenge of continually having to find new mineral sources which is costly, risky and extremely difficult. Shareholders usually face dilution when miners have to raise funds by selling more shares to finance exploration efforts. These factors likely explain why famous investor Warren Buffett doesn’t understand people’s obsession with gold as an investment, let alone mining companies that explore and mine it.
After the three largest gold producers took at least $30bn in asset write downs, Barrick Gold CEO was quoted in Bloomberg as saying “gold production in the industry could start to decline more than people think.” Barrick is the largest producer of gold in the world by volume and in 2013 spent an average $1,050 per ounce to mine, extract and produce gold. The price of gold today has a premium of roughly 30% on the production cost for the largest producer in the world; this premium should rise as global supply is reduced and smaller / less efficient mining companies dispose of their assets.
It’s interesting to see the market price mining assets at close to the base cost of the metals in the ground but these are notoriously dangerous times when a number of mining companies have already gone into bankruptcy. History has shown that assets usually revert to their mean valuation and while nothing is guaranteed, the current negative sentiment certainly provides an opportunity to warrant further research into the area to identify those companies that are profitable but have simply been caught up in the torrent of negative sentiment within the gold mining sector. It will be interesting to see how the sector evolves over the coming years.