All that glitters might not be gold.
On the face of it, gold has been on a global bull run for the best part of a decade now, setting a slew of new price records. At $1,415 per troy ounce at pixel time, the gold price is now brushing up against its its $1,432.50 all-time high in December. Most sell-side analysts, for their part, are gold bulls for 2011, citing mounting inflation risks, the structural weakness of the dollar, and gold's status as an insurance against a global financial and economic collapse.
However, the last 6 years have been great for gold bars, but awful for gold stocks, especially in South Africa. Between November 2004 and February 11th 2011, a $100 investment in the spot gold price would have yielded $310 while South African-listed gold mining stocks in AngloGold Ashanti and Gold Fields would be worth around $100-$120, according to a Johannesburg-based gold mining analyst at US bank. Meanwhile, South African-listed Harmony is worth just $80 compared with the initial $100 investment, in dollar terms, back in November 2004.
Sure, global equities largely failed in the last decade compared with bonds. But there are two structural reasons why gold stocks have consistently underperformed gold ETFs globally, according to the same Johannesburg-based gold mining analyst:
- Companies have ramped up production of low-grade ore in recent years, as the trade is profitable only during periods of high gold prices. At the same time, the easier-to-mine high-grade ore is generally preserved for periods of low gold prices when higher-quality gold output is needed for companies to maintain profitability. However, shareholders, expecting huge returns during a gold price bull run, have cried foul and fled gold mining stocks.
- Mining companies have also tended to over-pay for acquisitions to boost output -- but at the cost of diluting shareholder value.
And therein lies the trade-off between risk and reward for gold investors. Gold stocks, in theory, offer outperformance thanks to the potential to ramp up sales volumes and to embark on cost-cutting and financial engineering. All these factors generally boost returns on equity, over and above the share price boost, triggered by the nominal jump in gold prices. But the downside risk for investors is just as significant: companies face operational risks in politically volatile territories and/or might take poor decisions while exchange rate volatility threatens cash-flows.
For these reasons, many investors have opted to snap up gold ETFs in recent years at the expense of mining stocks, especially as such funds are seen as a cheap and efficient play on the gold price.
"A gold ETF allows one to gain exposure to gold in a liquid way and unwind positions much easily, rather than being forced to liquidate one's positioning," Nick Moore, head of commodity strategy at the Royal Bank of Scotland told FT Tilt.
South African gold
The biggest driver for gold mining stocks in South Africa this year is macro-economic rather than sector-specific. The strength of the rand in 2010 reduced the equity value of dollar earnings and increased costs. For example, gold rose 29 per cent in 2010 -- bettered only in the last decade in 2007 when it jumped 32 per cent -- but in rand terms, gold prices rose by a more modest 13 per cent because the rand/dollar exchange rate appreciated 13 per cent during the same period.
As a result, South African gold mining stocks (.JGLDX), with the exception of Gold Fields, underperformed the world's largest gold ETF, SPDR Gold Trust (.SGLD.SI), in 2010, rising 10 per cent in rand terms compared with the latter's 20 per cent jump in dollar terms. What's more, South African gold miners underperformed the broader Johannesburg All-Share index.
Source: Thomson Reuters Eikon
Gold Fields was the best performing SA gold major in 2010 with a 19 per cent rise, matching its gain in the previous year, followed by Harmony, which notched a 9 per cent gain after slumping 19 per cent in 2009. AngloGold Ashanti underperformed its peers after it posted a strong rally the previous year. But 2011 could be a game-changer.
"Since South African companies are starting off from a lower base compared with the ETF bull run, these stocks could outperform the ETF market this year," concluded Moore, the London-based analyst at RBS.
The expected weakness of the rand this year, which will boost dollar cash flows, and stronger organic growth will drive gold mining stocks to outperform ETFs, said the Johannesburg-based analyst.
As always, the unpredictability of the rand, the increasing risk of state intervention, safety-related mining interruptions and high electricity costs all cast a shadow over the sector.
But the stakes are bigger than you think. If the country's gold stocks outperform, the development would trigger a broader repricing of South African equities. That's because gold stocks represent 12 per cent of the Johannesburg Stock Exchange, the second-highest weighting for the sector in the emerging world, after Peru at 32 per cent. These charts tell the story:
Source: Citigroup
Here's a company by company breakdown of South Africa's gold index:
Source: Thomson Reuters Eikon
See also:
Glittering African producer profits may not be gold - FT Tilt
Coverage of gold in Tilt markets - FT Tilt
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