Gold has certainly glittered again this year. Bullion prices have reached new highs but investor demand for gold has seemingly not yet fully translated to gold mining shares. Their performance lagged the gold price on the way up after catching the full force of the 2008 fall. As Evy Hambro, manager of the BlackRock gold & general fund, explained to me a few days ago, there are sometimes phases where gold stocks simply fail to follow the gold price and it is not always possible to rationalise these moves.
One explanation he put forward was that investors are sceptical of the sustainability of the gold rally. It is also true that many mining companies have poor records of capitalising on high gold prices, tending to reinvest profits poorly, a particular problem when rising inflation drives up the cost of extraction. Additionally some firms have been caught out by taking on too much debt at the wrong time.
However, this lack of financial discipline could be a thing of the past, especially for the major producers. Companies are in better shape than previous cycles with minimal debt and record amounts of cash flow. So far, comparatively little of this has been passed to shareholders by way of dividends, although some companies are improving on this front. Newmont Mining, for instance, has tied its payouts to the gold price itself. Evy Hambro believes they should be paying even more but anticipates it could at least act as a catalyst for others to follow suit with this type of dividend policy. In time, this could mean investors receive far more income from the sector as a whole.
With large amounts of cash on their balance sheets, dividends represent one obvious route for gold mining companies. Alternatively, there is scope for significant merger and acquisition activity as bigger producers look to snap up the assets of smaller rivals. This has been shown recently by Newcrest Mining’s bid for Lihir Gold, Kinross’ bid for Red Back Mining and Goldcorp’s bid for Andean Resources and is certainly something that could help underpin valuations of firms that become targets.
The most important factor for the sector remains the supply and demand equation. Production is about the same level as it was in 2001, yet demand is rising. Central banks, in the past big sellers of gold, have become net purchasers. This is particularly the case with emerging nations. China buys nearly all of its own domestic production and Mexico, which recently bought a massive 100 tons over two months, is set to be a regular buyer. Retail investors have got in on the act too with the launch of numerous exchange traded funds aiming to provide returns in line with the gold price. Many of these ETFs are backed by the physical metal and have been in popular demand.
The dynamics of the gold market have clearly changed but there can be no quick response from the mining industry as it takes several years to get a new gold mine up and running, so the case for gold remains strong. For me, Western currencies cannot be trusted and gold remains the ultimate store of value which cannot be devalued by politicians. Moreover, demand is resilient from emerging markets looking to diversify their reserves.
A fund such as BlackRock gold & general is an excellent means of profiting from the rise of gold and other precious metals. As well as gold producers, it holds companies such as Fresnillo, the world’s biggest silver producer. There is also platinum exposure where there are supply constraints and growing demand from the auto industry, notably in the US, where a switch from petrol to diesel cars means greater demand for its use in catalytic converters.
Significantly, investor appetite for mining shares has fallen behind that of the metals themselves, in my view, a potential opportunity to increase exposure in this fund for the long term.
Mark Dampier is head research at Hargreaves Lansdown