The Bullish case for Aussie Gold Shares


Equity markets seem to be taking a slight breather from their relentless rise. The Dow Jones and the S&P 500 both fell around 0.5% overnight. Europe on the other hand had a good session, with all the main indices continuing to levitate on nothing more than blind faith in central banking.

Gold continues to try and find a short-term bottom here, at least in US dollar terms. It closed the US trading session just over US$1,200 an ounce, an area it’s hovered around for a while now.

If the US market corrects lower from here, it might be time for gold to have another shot at moving higher.

In Aussie dollar terms, the recent gold price correction looks healthy. After reaching a peak of just over AU$1,650 an ounce in late January, the price has corrected back to around AU$1,535. But as you can see in the chart below, the price is still above the moving averages (red and blue lines), which indicates the upward trend is intact.

This is why I continue to be bullish on Aussie gold shares. Not simply because the gold price remains above its moving averages. That’s only one piece of the puzzle.

The more important piece is the outstanding valuations on many local gold stocks…valuations that will only become more attractive if I’m right about Aussie dollar gold being in a new emerging uptrend.

I’ll give you just one example. On Monday, I sent my subscribers a special report on a local gold stock I have been following for some time. Positive price action triggered a buy recommendation.

Communicating how attractive a company’s ‘value’ is can be a difficult task sometimes. The shorthand way is to talk about price-earnings ratios or dividend yields. These are useful, but they don’t tell the whole story.

A far better way to really understand the value of the business is to look at the price-to-book ratio and the return on equity (ROE).

Let me show you the example of the company I recommended on Monday to give you an idea of how you can assess ‘value’.

According to forecast earnings for 2015, this company trades on a ROE of around 11.5%. That’s not spectacular but it’s not bad either. But the market price is so depressed this company trades for less than half of its ‘book’, or equity, value.

The ‘price-to-book’ ratio is around 0.4. That means the market is giving you the opportunity to buy this company’s assets at a 60% discount to their book value.

What does all this mean?

Well, assume you buy the whole company at a 60% discount to its equity value. And assume that the company delivers a return on its full equity value of 11.5%. The actual return to you would be much higher than that though, because you bought at a discount.

As a rough rule of thumb, to find out the potential return, you divide the ROE by the price-to-book ratio. In this case, it’s 11.5% divided by 0.4, which equals 28.75%.

That is the return to the business owner and has nothing to do with the returns the stock market could deliver. In a world of QE and zero interest rates, this is an incredible reward that the market is offering.

Of course, there’s no reward without risk. And the risk is that the gold price will keep falling in the years ahead and make this potential reward disappear.

For this type of return though, it’s a risk I’m prepared to take. Provided you have stop losses in place and know when to accept that you might be wrong, a good investor should embrace this risk/reward scenario every time.

Which is exactly what I’m doing. If you want to find out about these opportunities, and join me in finding more, click here.

Getting back to the markets, Aussie stocks are holding up pretty well considering the dire economic outlook. They’re clearly betting on more rate cuts from the RBA. Yesterday’s GDP release pretty much guarantees it.

Economic growth came in at 0.5% for the December quarter, seasonally adjusted. That’s a 2% annual rate and virtually ensures unemployment will continue to creep higher.

The main driver of the result was strong household consumption (which added 0.5 percentage points) and net exports (adding 0.7 percentage points). Inventory drawdowns took 0.6 percentage points off the growth rate.

Let’s have a closer look at the numbers…

Net exports made a strong contribution in part because of rise in exports but more importantly because of a large 2.5% fall in imports (10% annualised). How does a big decline in imports take place while household consumption is so strong?

Probably through the decline in inventories, as businesses run down their stock levels. The point is that, if household consumption remains strong, you’re not going to continue to see a drop in imports, so this contribution to growth is fleeting.

Turning to the household sector, ‘final consumption expenditure’ for the quarter was 1.3%, or a very strong 5.2% annualised. This is despite wages growth of just 0.2%, or 0.8% annualised.

What accounts for the difference? The ‘wealth effect’ and increased leverage, which feeds back into the ‘wealth effect’.

The upshot of all this is that household consumption is holding the economy up right now. And it’s doing so because of the power of lower interest rates to fire up asset prices and encourage more borrowing.

Doesn’t sound like smart policy, does it?

This means the RBA is trapped. Lower rates are causing increased leverage and booming assets prices, which is helping the consumer to spend money they think they have.

But the increased leverage means higher financing costs for the household sector too. Despite record low interest rates, interest expense for households was the highest it’s been since the first half of 2013.

Now the RBA wants to see the heat taken out of the property market before cutting rates again. That means a potential hit to the ‘wealth effect’ and possible future consumer spending.

Slower growth in household consumption wouldn’t hurt, given its strong rate of growth recently. But what else is there to take its place? Nothing.

The RBA has plenty of balls in the air right now. Interest rates will stay low and will go lower. But what good are lower rates really doing? They’re not creating sustainable economic growth or business investment.

The truth is that we’re on a treadmill. Running faster and faster just to stand still…

Greg Canavan,
for The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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