Will Junior Gold Miners Rally or Bust?

Contrarian investors everywhere often look to 52 Week Rolling Low Lists for buying opportunities.  This is a strategy fraught with considerable risk, as even if the market sentiment is wrong about a particular stock or sector, buying into a company on a downward trajectory can lead to an investment that keeps falling and falling.

Early in this trading week the 52 Week Rolling Low list included 13 Junior Miners with seven of them qualifying as pure play gold miners.  Considering the price of gold reached a record high of over $1900 an ounce as recently as July 2011, do these shares represent a high risk speculative buying opportunity?  Gold prices have weakened since the new record was set but are still positive year over year, as evidenced by the following chart from goldprice.org:

However, the share price of gold mining stocks has diverged dramatically from the price of the commodity.  One of the world’s largest gold miners is headquartered right here in Australia – Newcrest Mining (NCM).  Here is their one year share price performance chart:

Taken by itself, one might be tempted to interpret this chart as evidence of some problem with Newcrest.  However, one of the major indexes of gold stocks used by investors worldwide – the AMEX ARCA HUI – shows the same pattern.  Here is a one year chart for that index:

Junior gold miners have suffered the same fate.  Here is a table of the seven shares from the recent 52 Week Rolling Low List:

At the heart of contrarian investing is the belief market participants are ignoring the real fundamental value of a company and eventually the share price will rise to reflect that value.  To determine whether gold stocks may be in for a rally at some point in the future one first has to look at some fundamentals.  The problem with companies still in the exploration stage of their stgelopment is there are no performance numbers to evaluate.  One has to rely on potential, not performance.

However, it is reasonable to assume if the market continues to ignore the fundamentals of a well established company like Newcrest, it would take a momentous discovery to rally the share price of a junior.  So let’s look at Newcrest to see what the market may be missing.  Here then is a 5 Year Performance table for Newcrest showing revenue, net profit after taxes, and operating margins:

Note that net profit has come close to doubling every year.  The company reported half year results in December of 2011 and the stellar performance remains intact – revenue increased 19% year over year and profit increased 50%.  From these numbers it certainly appears the share price is not fully reflecting fundamental performance.  Operating margins, however, may provide a clue as to why gold mining stocks have been so badly beaten down.

While the investing community has been focusing on the rising price of the commodity, some have ignored a fundamental fact known to all miners – the cost of mining gold has risen almost as much as the cost of the commodity itself.  Here is a chart showing the rise in the cost of producing gold globally:

Global Gold Production Cash Costs

While Newcrest’s operating margin of 50% is impressive, note that over the five year period margins have been relatively flat.  Check the analyst reports for Newcrest and you will learn they are one of the lowest cost producers in the industry.  Costs are rising for a variety of reasons, most notable among them energy and labor costs.  Despite this fact, miners as a whole have been able to maintain respectable margins because of the high price of gold.  In 2011 average profit margins increase almost 38%.  The following chart tracks the rise in margins:

Average Gold Miner Producer Profit Margin

In theory, one would expect a fairly close correlation between the share price of a commodity producing company and the price of the commodity from which it derives its profits.  Clearly, the share price of companies producing gold has lagged behind the price of gold, despite their solid performance.

Addressing that question is the province of experts, but from the point of view of an ordinary individual investor the gap might be explained by looking at the reasons investors buy gold as a commodity versus why they buy gold equities.

Perhaps more than with any other commodity, fear drives the price of gold.  Fear that paper assets may lose their value on a massive scale sends the price of hard assets, most notably gold, skyrocketing.  That same fear of a cataclysmic collapse in global economies sends investors fleeing equities in droves.  There is the disconnect.  When times are really terrifying, investors go for the gold while at the same time dumping the shares of companies that produce the gold.  To exemplify the point, look at the following five year chart of the price of gold:

As you recall, the collapse of US Investment Bank Lehman Brothers in late 2008 plunged the world into a global credit crisis.  Although this is subject to debate, there are many experts who believe only the actions of the US Government in bailing out their financial institutions prevented a complete collapse of the global financial system.  It is easy to forget that at that time few realised how tangled international finance had become.  Now let’s look at what happened to Newcrest Mining and the ASX 200 during the same period:

While the price of gold as a commodity was going up during that crisis, the price of gold equities was plunging, as were equity markets everywhere.  Despite its recent moderate weakness, as long as there is fear of paper assets losing their value, the price of gold is not likely to collapse.

However, there is considerable debate as to whether gold will continue to go up or stabilise into a consolidation phase.  A recent report by CPM Group – one of the world’s largest commodities research firm – entitled Gold Yearbook 2012 – sees prices stabilising.  The principal reason they offer is investors no longer fear a collapse of the global financial system.  A very short time ago the investment community watched in horror as the potential for a collapse of the European Union grew in scope with the approaching possibility of a Greek default.  While there is still the potential for additional problems on the horizon, the combined actions of the European Central Bank, European Governments, and Private Investors are good indicators that potential is no longer with us.  The ECB put up the money; Governments instituted austerity measures; and Private Investors were willing to accept dramatic decreases in the value of their bond holdings.

CPM Group sees gold prices remaining about $1500 an ounce for the remainder of this year and above $1400 over the next few years.  Others disagree.  Goldman Sachs in its own report states gold prices are too low in relation to real interest rates.  Other experts see the price of gold rising to $2000 an ounce and even beyond.

Interest rates are a key driver in the price of gold and recent unexpected strength in the US economy has raised the prospect the US Federal Reserve will raise rates sooner than expected and forego anymore “quantitative easing” through buying more debt.  That belief was discarded when US Federal Reserve Chairman Ben Bernanke commented recently weak US employment may require more monetary easing.  The price of gold rallied in response.

No one can predict with any certainty what will happen here.  Those who cite historical trends ignore the fact in many ways we are in uncharted waters here, with global economies intertwined in unprecedented ways.  However, despite some encouraging trends in the US, there are still trouble spots aplenty.  Chinese growth is slowing and the price of oil is rising.  European growth potential is highly suspect.  Taken together, it appears unlikely investors will flee gold, although they might settle into more of a “buy the dips, sell the rally” mode.

As long as the price of gold holds or rises, the possibility of a rally exists, both in established gold mining stocks like Newcrest and in junior miners with potential.

As of July of 2011, Ambrian Capital, a London based firm specialising in corporate finance, stock brokering and commodity trading services to institutional and corporate clients, placed a Speculative Buy Rating on two of the Australian Junior Miners that graced the recent 52 Week Low List.  The companies are AusGold and Aviva Resources.

Aviva has a promising gold prospect in Kenya.  AusGold has assets in Australia’s Boddington South Project, one of Australia’s few remaining under-explored gold provinces, in Ambrian’s view.  Ambrian is particularly bullish on AusGold as an “early investment” due to the potential of the resources in Boddington South.

Ambrian offers perhaps the best advice available on a catalyst that could drive gold prices into bear territory.  In their view, investors need to track interest rates when they turn positive again and rise above inflation rates.  Considering the myriad of real macroeconomic concerns we face, this is not likely to happen anytime soon.

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