May 11, 2013

Three Reasons to Buy Gold Equities Today


By Frank Holmes
CEO and Chief Investment Officer

A strong stomach and a tremendous amount of patience are required for gold stock investors these days, as miners have been exhibiting their typical volatility pattern.

That’s why I often say to anticipate before you participate, because gold stocks are historically twice as volatile as U.S. stocks. As of March 31, 2013, using 10-year data, the NYSE Arca Gold BUGS Index (HUI) had a rolling one-year standard deviation of nearly 35 percent. The S&P 500’s was just under 15 percent.

I believe the drivers for the yellow metal remain intact, so for investors who can tolerate the ups and downs, gold stocks are a compelling buy. Here are three reasons:

1. Gold Companies are Cheap.
According to research from RBC Capital Markets, Tier I and Tier II producers are inexpensive on historical measures. Based on a price-to-earnings basis, RBC finds that “shares are currently trading not far from the recent trough valuations observed during the 2008 global financial crisis.”

And on a price-to-cash-flow basis, gold stocks are trading at bargain basement prices. The chart below shows that average annual cash flow multiples for North American Tier I gold companies have fallen to lows we haven’t seen in years. Since January 2000, forward price-to-cash-flow multiples have climbed as high as 26 times. This year, we see multiples at the high end that are less than half of that.

On the low end, today’s price-to-cash-flow of 6.5 times hasn’t been seen since 2001.


Tier I and Tier II companies “offer investors an attractive entry point from an absolute valuation perspective with respect to the broader market,” says RBC.

2. Gold companies are increasing their dividends.
With the Federal Reserve suppressing interest rates, investors have had to adapt and reallocate investments to generate more income.

That’s where gold companies come in. I have discussed how miners have become much more sensitive toward the needs of their investors as they compete directly with bullion-backed ETFs and bar and coin buying programs.

In response to shareholders’ desire to get paid while they wait for capital appreciation, gold companies have rolled out dividend programs and increased payouts. “The growth in dividend payout has been spectacular when looking at the industry as a whole,” says my friend Barry Cooper from CIBC World Markets. His data shows that over the past 15 years, the world’s top 20 gold companies have increased their dividends at a compound annual growth rate of 16 percent. By comparison, gold only rose 12 percent annually.


Not only are gold companies increasing their payouts, the yields offer a tremendous income value to investors compared to government bonds today. Whereas investors receive a 1.5 percent yield on a 10-year Treasury, the stocks in the Philadelphia Stock Exchange Gold and Silver Index (XAU) are paying a full percentage point more!

This is a significant change from the past: In April 2008, the Treasury yield was nearly 3 percent more than the dividend yield of the XAU. In addition, the yields of gold stocks have been climbing over the past year while the 10-year Treasury remains low.


3. Enhanced returns in a diversified portfolio.
We have long advocated a conservative weighting of 5 to 10 percent in gold and gold stocks because of the inherent volatility you are seeing today. But despite the extreme moves, there’s a way to use gold stocks to enhance your portfolio’s returns without adding risk.

Take a look at the efficient frontier chart below, which creates an optimal portfolio allocation between gold stocks and the S&P 500, ranging from a 100 percent allocation to U.S. stocks and no allocation to gold stocks, and gradually increasing the share of gold stocks while decreasing the allocation to U.S. equities.
The blue dot shows that from September 1971 through March 2013, the S&P 500 averaged a decent annual return of 10.34 percent.

What happens when you add in gold stocks? Assuming an investor rebalanced annually, our research found that a portfolio holding an 85 percent of the S&P 500 and 15 percent in gold stocks increased the return with no additional risk. This portfolio averaged 10.96 percent over that same period, or an additional 0.62 percent per year, over holding the S&P 500 alone. Yet the average annual volatility was the same.

Although 0.62 percent doesn’t seem like much, it adds up over time. Assuming the same average annual returns since 1971 and annual rebalancing every year, a hypothetical $100 investment in an S&P 500 portfolio with a 15 percent allocation in gold stocks would be worth about $7,899. This is greaterthan the $6,246 for the portfolio solely invested in the S&P 500 while adding virtually zero risk.

Case Study: Alamos Gold (AGI)
Not all miners are worthy of your investment, and the task of picking quality gold company candidates isn’t simple. One company we currently like is Alamos Gold, which reported first-quarter 2013 results last week.
To the delight of many mining analysts, the company beat analysts’ expectations on both the top and bottom line. Alamos grew its production to 55,000 ounces of gold from 40,500 ounces in the same quarter last year.
In addition, AGI boasts an 8.76 percent free cash flow yield, allowing executives to build the business through paying off debt, making acquisitions or returning money to shareholders. In Alamos’ case, the company announced a stock repurchase of 10 percent of its float over the next 12 months. 
While the company trades at a premium to most junior producers, it may be well worth the extra coin, as its low cost profile, cash generation and self-funding capabilities, as well as its discipline in returning capital to shareholders fit our growth at a reasonable price (GARP) model.

Happy Mother’s Day!
As we honor and celebrate mothers this weekend, we thank them for their unconditional love and support. Alfred Lord Tennyson wrote, “Love is the only gold.” That may be true, but it wouldn’t hurt to stop by the jewelry store on your way to see Mom.


Gold Market SWOT Analysis


 For the week, spot gold closed at $1,448.20, down $22.55 per ounce, or 1.53 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 0.47 percent. The U.S. Trade-Weighted Dollar Index rose 1.24 percent for the week.

Strengths

  • At the risk of sounding like a broken record, there is yet more evidence of the unprecedented demand for physical gold. Christopher Wood in his Greed & Fear report this Thursday notes that Chinese gold imports from Hong Kong in March more than tripled from a year ago, from 62.9 metric tons to 223.5 metric tons. Similarly, India is heading for its second-straight month of 100 plus metric tons of gold imports according to the Bombay Bullion Association. There is only one way to view this data, and it is bullish for gold.
  • Franco-Nevada announced that it has acquired a 1.2 percent NSR royalty on Pretium's Brucejack project for $45 million. The royalty covers both the Valley of the Kings and West Zone and becomes payable after approximately 500,000 ounce. The investment by Franco-Nevada is certainly a vote of confidence in the project and serves to remind investors that there is value in junior mining stocks.
  • Timmins Gold reported first-quarter results this week; the company’s operating earnings beat analysts’ expectations reflecting strong gold sales and lower than forecast costs.With production ramping up in the course of the year and a decline in capital expenses as the drilling season ends, the company is in a strong position and will likely see rising free cash flow and cash balances through the remainder of the year.

Weaknesses

  • India’s silver imports slid 80 percent in 2012 and have continued falling in 2013. Despite producing sizable silver, unlike gold where the country is totally import dependent, the fall in demand is almost fully attributed to a decline in purchases for investment purposes, according to data from the All India Gem and Jewellery Trade Federation. Unlike gold which attracted massive physical buying after its historic fall mid April, silver has failed to garner any buying interest in India.
  • Investors pulled $8.7 billion from gold exchange traded products (ETPs) globally in April, Blackrock's data showed, after bullion plunged half-way through the month. It appears the strong demand for coins, bars, and jewelry has not been enough to arrest the levels of institutional selling. In fact, ETP investors are net sellers into May, which Ole Hansen, head of commodity strategy at Saxo Bank, continues to attribute to institutional accounts. Wealth managers have been rotating out of commodities and into high-dividend equities and bonds as they look for yield.
  • Despite having unbundled some of its labor-intensive, wildcat strike-prone mining assets earlier in the year, Gold Fields reported earnings per share 5 percent below estimates and 66 percent lower than last quarter. Production from the company’s mines came in 11 percent below last quarter at 477,000 ounces, making the once controversial split even more unappealing to investors.

Opportunities

  • Drew Mason of St. Joseph Partners noted in his Weekly Gold Review how equity investors are holding on to the single most negative viewpoint on gold in the market today, which is that central banks are on the verge of ending their money printing and again becoming responsible. However, the first days in May brought a broad amount of economic data which showed how weak the economy continues to be. At some point the consensus will remember the Fed has repeatedly broken its exit promise.  The view will shift from the Fed “will be exiting QE any minute now” to the realization the Fed is trapped and cannot exit which should be very positive for the metals.
  • The question on when is the right time to step into the gold market and pick up stocks has been asked too frequently. The quantitative analysts at GMP Securities provided an interesting view this week. When the ratio of gold bullion to gold stocks is falling, it means gold stocks are appreciating at a higher rate than bullion, and that is exactly when you want to be in stocks. The ratio of gold relative to stocks as measured by the HUI Index has been rising constantly since early 2011 and is now at 5.65. From a statistical standpoint, the current level is above the two standard deviation level—despite the current gold weakness—implying a correction is imminent. During the correction you want to be long gold stocks.
  • Peter Schiff, outspoken author of The Real Crash, permanent bear, and head of Euro Pacific Capital, is now an official gold supporter. On Friday Schiff released a video stating that the same unprecedented negative sentiment in the space will provide the “wall of worry” gold needs to climb back. In his opinion, he is now convinced the fundamentals have never been better for the yellow metal as the pace of currency debasement only accelerates, regardless where you are looking at.

Threats

  • This month, the South African Chamber of Mines will sit down with unions to hammer out its next set of wage agreements. Despite recent questioning of the role of unions by workers themselves, who are worried that leadership has lost touch with its members, the National Union of Mineworkers spokesperson asserts they are prepared to fight for double-digit figure raises, leveraging on their opinion that companies acted in bad faith following negotiations last year. Costs have increased to a point where further, significant wage hikes are just not an option if the sector is to stay above water.
  • The province of Quebec has defined the new hybrid royalty tax model applicable to mining companies. The levy will require producers to pay the greater of two amounts: a royalty on output, also deemed the minimum mining tax, or a tax on profits, deemed the progressive mining tax on profit. Minimum taxes will range from 1 percent to 4 percent depending on the size of the project, and profit taxes will range from 16 percent to 28 percent. Although the plan appears less damaging than initially thought, it adds pressure at a time when falling metal prices have already cut into the tight margins in the mining sector.
  • The Colombian government has officially postponed a highly anticipated auction for 50 million acres of strategic mineral concessions. Thom Calandra reports that mining regulators in Colombia appear to need more time to gather information about the properties, which were to have gone to bid later this year. Other properties, known as concession applications, which have long been delayed, appear thus far not to be at risk of postponement.

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