At first glance, the firing of Aaron Regent, Barrick Gold’s CEO, last June seemed unremarkable. The company’s share price had stalled amid concerns around cost overruns at its Pascua-Lama mine in Chile. While his dismissal was abrupt, it appeared to be a simple case of a company shakeup. But take a closer look at the gold sector and you’ll see that Regent’s ouster fits a pattern.
The list of laid-off CEOs is long. Kinross Gold’s Tye Burt, Centerra Gold’s Stephen Lang (he’s now chairman) and Great Basin Gold’s Ferdi Dippenaar are just three of the many gold company executives who found themselves out of a job or kicked upstairs.
Why the turnover? Because for the past few years, many gold companies have nearly run their businesses—and their investors’ equity—into the ground, despite an incredible rise in gold prices. Between 2008 and January 2013, gold prices climbed 82%—yet somehow, over the same period, the S&P/TSX global gold index fell about 15%. Thanks to cost overruns, labour inflation, misguided acquisitions and bad decisions, many gold companies have seen their stock plummet. Barrick’s share price has dropped 33% over the past 12 months. Kinross is down 29%.
The negative news has made the sector cheaper than it has been in years. Vincent Roy, BlackRock’s managing director of scientific active equity, points out that the S&P/TSX global gold index is trading at 16 times earnings, about half of where it traded in 2009. The inexpensive valuations, plus a gradual change in company attitudes, have made this sector attractive again. “We’re coming back to the view that it’s rational to have investments in gold equities,” says Onno Rutten, a precious-metals-focused portfolio manager with Mackenzie Investments.
Three major issues have weighed on gold equities since 2009. The first is that many management teams figured that the dramatic rise in gold prices would insulate them from climbing labour and equipment costs. It also made many overpay for assets. Chris Beer, vice-president and senior portfolio manager of global equities for RBC Global Asset Management, points to Kinross’s $7-billion purchase of Red Back Mining in 2010. It was the biggest deal in the company’s history, but last February it announced a $2.49-billion writedown after finding out that the gold at Red Back’s Tasiast mine was of a lower grade than previously thought.
Capital cost increases have also hurt miners. The inflation rate in the sector, mostly driven by labour costs, is around 15%. That’s destroyed rates of return. “We had thought returns on projects would be between 15% and 30%,” says Beer. “But they’ve come in at close to zero.” Firms’ inability to manage costs has shattered investor confidence. “The market does not trust management expectations on profitably because their production forecasts have been wildly off the mark,” he says.
The third reason gold stocks have underperformed is the advent of the gold exchange-traded fund (ETF). For most of history, the only way to buy the actual commodity was to purchase a bar of yellow metal. Now, you can buy a share of a big bullion reserve without the expense and risk of having to store it yourself, and sell it on a whim. Those who held gold stocks as a proxy for gold therefore no longer have to do so.
If gold companies continue to reinvent themselves, though, investors could see even better returns on stock than on bullion. One positive change is that many of these operations have started paying or have increased dividends. The yield on the S&P/TSX global gold index is now 1.6%, up from just 0.5% in 2010. Frank Holmes, CEO and chief investment officer with U.S. Global Investors, likes to see dividend payouts because it forces companies to be more prudent with their cash. “They can’t just buy anything they see,” he says. “It shows that a company has more fiscal discipline.” Income also distinguishes gold stocks from ETFs. Stocks can still generate some return for investors when gold prices are stable, as they’ve been the past year. Bullion can’t.
Gold producers should be able to continue raising their dividends too. Industry payout ratios—the share of profits returned to shareholders—are only 10% to 20%, says Rutten. He thinks the ratio could rise to 30%.
Companies are also improving their financial transparency. For years, the industry used a “cash cost per ounce” number, which tabulated the cost to produce an ounce of gold at a particular mine. It failed to take into account exploration and financing costs, taxes and other expenses. Using the cash cost per ounce metric, typically around $500, made it seem as though companies were making money hand over fist. Now, the industry is moving toward an “all-in” model, which factors in the company’s total costs. Use that metric and the cost for mining an ounce is typically around $1,500. With gold trading at $1,650 an ounce, it’s easier for investors to see who is making money and who’s not. Holmes would like to see companies have a gross margin of around 30% or an all-in cost below $1,100 per ounce.
Finding the right company still takes some work. With the problems the industry is facing, you want to make sure you’re buying a good business. Start by looking at the management team, says Rutten. The company should be shareholder-friendly. That means it should pay a dividend, and it must be listening to its investors. The team should have a record of delivering on projects and wisely deploying capital. “A truly good team can, through efficiencies, milk returns out of more difficult assets,” he says. Holmes also likes management to own a big stake in the business. Having skin in the game is crucial.
The most important number to consider, says Rutten, is free cash flow. The more free cash flow a company has, the better. It can use that cash to pay dividends or invest in new projects. He wants to see companies in riskier areas (like Africa) have a higher free cash flow than companies in less politically sensitive locations (like North America). “We need to handicap the country risk that we’re taking on,” he says. Investors can also look at the enterprise value-to-EBITDA ratio, says Beer. Today, companies are trading at between five and eight times EV/EBITDA, which is lower than the historical mean.
It’s likely investors will experience volatility this year as companies continue to work out their issues, but expect more ups than downs. With gold prices expected to stay where they are, or perhaps climb a little higher, these stocks have room to rise as costs come down. At this point, Rutten thinks investors should have at least half of their gold allocation—about 5% of a portfolio—in gold stocks and the rest in bullion.
Rutten is likewise optimistic. “Profits are coming back, return on assets are coming back, and we think the gold price will continue to rise,” he says. “We keep believing that companies will find even more efficiencies.”
The CB hotlist
Rangold Resources Ltd. (NASDAQ: GOLD)
P/E: 20.3 | Yield: 0.40% 1-year total return ($): -16.2%
This Channel Islands–based miner reinvests its free cash flow into existing projects, says Mackenzie’s Onno Rutten. Some are in high-risk locales.
Goldcorp Inc. (TSX: G)
P/E: 19.2 | Yield: 1.48% 1-year total return ($): -23.2%
Vancouver’s Goldcorp recently downgraded its production numbers for 2013, but RBC’s Chris Beer still thinks it’s a buy.
Eldorado Gold Corp. (TSX: ELD)
P/E: 25.8 | Yield: 0.79% 1-year total return ($): -20.3%
This Vancouver-based mid-cap trades at a high multiple, but that doesn’t worry Beer. The company recently bought a “world class” asset in Greece.
Detour Gold Corp. (TSX: DGC)
P/E: n/a | Yield: n/a 1-year total return ($): -22.3%
Toronto-based Detour has a project in northern Ontario on the cusp of production. Rutten’s confident of a smooth transition from explorer to producer.
Timmins Gold Corp. (TSX: TMM)
P/E: 13.6 | Yield: n/a 1-year total return ($): -2.5%
This Vancouver-based small-cap has strong free cash flow, says Beer. It should have no problem financing expansions.