Today we have a guest post by Michael Bradshaw, CFA, portfolio manager with expertise in investing in gold, other precious metals, and gold-related stocks.
The price of gold was affected more than usual by concerns over reduced U.S. Federal Reserve (Fed) bond-buying activity and broader macroeconomic concerns in 2013. However, investors interested in precious metals are not limited to just the metals themselves; they also can invest in gold-related companies and there, I believe, the picture seems brighter.
The metal itself had a tough year. Gold declined 28% in 2013, the worst calendar-year performance since 1981. This drop in the price of gold was the first decline in 13 years. Much of the decline resulted from investors selling gold exchange-traded funds (ETFs) who feared that an imminent tapering of economic stimulus by the Fed would be bad news for gold. By year’s end, much of the resulting effects from the Fed’s tapering seemed to be reflected in the price of gold. Gold ETF sales, primarily from individual U.S. investors, continued through the fourth quarter but at a slower pace than in the first half of 2013. Much of that gold has found its way to China, where there have been increased gold imports.
Speculators may continue to put downward pressure on gold in the near term. However, a floor for gold prices seems to be developing. In the future, gold appreciation is likely to be driven mostly by physical demand. I anticipate significant purchases of gold jewelry, coins, and bars from China as well as other emerging markets nations. Central bank purchases should also help bolster gold prices. While gold prices won’t likely be driven by retail investor demand, the U.S. government’s lack of attention to its debt issues should be supportive for gold price trends. The U.S. federal debt was projected to hit $17 trillion by the end of 2013 and to continue to rise from there. Additionally, the Fed might have difficulty scaling back its quantitative easing program without upward pressure on interest rates. Longer-term, dollar depreciation, higher inflation, or both may result from future U.S. fiscal and monetary strategies. Gold has historically had a negative correlation to the U.S. dollar and a positive correlation to significant inflationary pressures.
Source: Bloomberg, Wells Fargo
Gold equities may make up for a slump in gold prices
Looking into 2014 and beyond, I think there is materially more appreciation potential for gold equities than the metal itself. The relationship between gold and gold equities can best be measured by the beta (or market sensitivity) of gold-related companies. Gold equities have historically overshot movements in the underlying gold price—an unfavorable characteristic when investors expect the price of gold to decline. Many investors have viewed precious metals equities through a pessimistic lens. Some analysts are still concerned that mining companies may not be profitable with gold prices at current levels. Investors have also begun to discount the perceived value of investing in precious metals as a hedge against other portfolio risks and have taken advantage of tax losses by selling precious metals stocks at depressed prices toward the end of the year.
Despite recent trends, I still believe that there are gold-mining companies that can demonstrate solid profitability and have notable appreciation potential. Stock selection will likely remain important, though, as company fundamentals tend to drive stock prices. Higher-quality companies with internal growth catalysts, such as effective execution of business plans and mining and production successes, are likely to outperform. I also continue to favor production companies over exploration or development firms because they are more established, generally have positive cash flow, and have less risk of needing to raise capital in the current environment.
Mining and production companies aren’t helpless in the face of falling prices
Precious metals companies can make numerous modifications to adjust for depressed gold and precious metals prices. They can cut exploration and related expenses, general administrative expenses, and salaries. They can also alter mining plans to realign with economic profit potential, cancel plans to grow production, and defer new development. So, while there are many mining companies whose profits are at risk, there are actions they can take to improve profitability. Declining costs often lead to margin improvement for mining firms.
In the near term, costs have already begun to decline for gold producers due to:
- New initiatives by mining firms to focus on free cash flow and margin improvements
- Declining currency values in commodity-rich nations
Based on the most recent data available, for third quarter 2013, the cost of gold production (per ounce) fell modestly. If history is a guide, mine production costs could continue to fall for some time. During the last down cycle for gold, which was in the late 1990s, the industry was able to cut costs an average of 8% per year for four years.
Many of the anticipated actions by mining firms mentioned above are likely to limit future gold supply. Meanwhile, the amount of recycled scrap gold in circulation is also likely to decline since people have less of an incentive to sell gold at today’s low market price, which also could restrict overall supply. A more limited supply of gold in tandem with persistent physical demand could mean attractive appreciation potential for gold equities, particularly considering their currently depressed market values.