Gold: no froth here

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— Gold is a long-time investment favourite here at the Daily Reckoning. We’re not the most optimistic bunch of economic observers. We think the people running the shop are running it slowly into the ground. So, as a hedge against human hubris and idiocy, we take refuge in gold. And as you’re no doubt aware, we suggest, constantly, that you do too.

— First and foremost gold is a wealth-preservation asset. The very essence of investing, the first thing you are trying to do above all else (whether you know it or not) is to preserve your purchasing power. That’s what gold does better than any other asset.

— Gold’s bull market has been going on for a decade. At every new peak, a bunch of people come out and say gold is in a bubble. There are so many reasons why that is not the case, but one we haven’t really touched on before is the performance of the gold shares.

— If gold was anywhere near a bubble, it has certainly forgotten to inform the gold stocks.

— Let’s face it; more people probably own gold equities than gold bullion. Bullion is a wealth preserver, but the listed stocks provide the potential for wealth creation.

— Unfortunately the gold stocks haven’t been creating much wealth for their owners, despite a record-high US dollar price for gold and a near-record high in Aussie dollars. Despite the nominally high dollar price of gold, the reality is the companies that mine the stuff are not very profitable. Even at these seemingly high prices, they can’t generate decent returns on capital.

— Profitability is not rising because costs are rising just as fast as the gold price. We get a doctored price of inflation every quarter, but in reality inflation is much worse and the gold sector proves it.

— We wrote about this a few weeks ago in our Sound Money. Sound Investments publication:

The languishing gold stocks signify that the gold price is not high enough to enhance profitability and create additional value across the sector. Unlike government statistics, you can’t hide the huge inflation that the gold sector has experienced.

Take Newcrest for example. Back in 2005, its total costs were $245 per ounce of gold produced. In the 9 months to 31 March 2011, total costs were $679 per ounce. That represents 177 per cent cost inflation in just six years.

And Newcrest has the benefit of scale (its mines are generally large) and of mining copper, which lowers total costs because the copper sales are applied as a by-product credit.

Smaller companies with relatively small, low-grade deposits and no by-product credits will have experienced cost inflation far greater than the above example.

Now over the same timeframe the gold price (in US dollars) has risen by around 230 per cent. So while the gold price has indeed done very well, cost pressures have not been too far behind. Therefore, the profitability of many, if not most, gold miners have not benefited from the rising gold price.

From a fundamental, analytical viewpoint, weak profitability means balance sheets don’t expand and value isn’t created. The only other way share prices can rise substantially in such a situation is via speculation – and we’re seeing little of it in the gold sector.

— The conclusion? Gold is nowhere near bubble territory. It’s not even frothy. To make the sector much more profitable prices would have to double from here.

— For comparison, take a look at the iron ore sector, which is arguably in a bubble. BHP generates a return on equity of around 100 per cent in its iron ore division. Granted, BHP’s Pilbara iron ore assets are amongst the highest quality in the world, but that is still a very high return. Even lower quality ore bodies would be doing very well at current prices.

— Now look at Newcrest, Australia’s premier gold miner. Its return on equity is around 12 per cent. It has a decent chunk of capital tied up in growth projects so that figure will increase by a few percentage points but is hardly inspiring.

— One of the most profitable gold miners we know of is Medusa Mining (ASX:MML). It owns a very high-grade gold mine in the Philippines and churns out a return on equity of more than 40 per cent. But quality high-grade mines are an exception. Most Australian gold stocks struggle to meet their cost of capital and that’s why share price performance has been so indifferent.

— The biggest gains in the gold sector usually come from pure speculation. Gold explorers who find a good ore body attract early interest. Then, throughout the drilling campaign, the share price continues to soar as the ore body increases in size.

— But watch what happens when the company then looks to move into production. It’s here that the really hard work starts. BFS studies, capital raisings, construction, ramp up, problems etc.

— Investors then realise that the gold in the ground is worth much less than initially thought if it can’t be extracted profitably. A gold miner must earn its cost of capital to add any value. And as we mentioned, there are plenty of miners out there struggling to meet their cost of capital.

— One of the most important attributes to seek if you’re looking to own a gold company is quality of management. It’s a rubbery concept but a good management team can add many millions to a company’s market cap while bad managers will reduce it. Running a gold mine is not an easy business. It’s not like banking.

— So you should expect to see even mediocre companies generating strong returns on equity and assets before this bull market runs out of steam. It’s another signpost to watch for and one that very few people consider in the debate.

— Speaking of signposts, the ASX200 has slipped slightly below Slipstream Trader Murray Dawes’s ‘point of control’ at 4700. Not good action. If it doesn’t recover shortly, expect a sharper downward move.

— Until next week…

Greg Canavan
For Daily Reckoning Australia

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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3 Comments on "Gold: no froth here"

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Lachlan
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True Greg. If things progress slowly though at least we can accumulate more metal and metal shares before she blows….the aud gold price that is. Having said that, the old chart is getting a little cramped.

For bugs we get to watch with interest the opening of the HKMex (Hong Kong Metals Exchange) on the eighteenth of this month. It looks like the key man in charge is a wall streeter so I’m guessing we’ll see nothing new for the upside in pm’s and lets hope nothing new in downside action.

Lachlan
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Lachlan
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Then who wants the bull market to blow off next week anyhow. A steady climb over another ten years might do nicely thanks. Keep up the shorting fellas ;)

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