Gold Mining Stocks An Inconvenient Truth

Daniel Gschwend, Vice President, Diem Client Partner AG Goldhaldenstrasse 23, 8702 Zollikon, Switzerland Tel: (0041) 43 888 55 88, eMail: d.gschwend@clientpartner.ch, www.clientpartner.ch

Markets are down sharply, investors are frightened and gold is rising. Thus are gold mining stocks rising as well? The performance of gold mining stocks was so far very disappointing. While gold has risen since 2001 from USD 250 to over USD 1900 or more than 600% gold mining stocks on average have only appreciated by approx. 200% (XAU Index). This extremely disappointing performance is even more frustrating in the time between September 2008 and August 2011: gold has risen from USD 800 to USD 1900 or by over 130% and gold mining stocks (XAU Index) have only risen by roughly 60%. Compared to the S&P 500 Index performance of -6% for the same time, gold mining stocks still did pretty well. From an investors point of view, owning gold and also gold mining stocks was strategically the right decision, but owning gold mining stocks and hoping to benefit from a leverage effect was tactically wrong. So what is the problem? Terribly incompetent management and leadership! I dont know of any other sector in which so many, also often completely wrong timed, bad decisions operationally and strategically have been executed as in the gold mining field. Barrick Gold in my opinion is one example: just recently, Barrick Gold decided to take over Equinox Minerals (copper miner) for over USD 7 billion in a tight bidding war. This was before the commodity complex, already in a completely overbought situation, corrected sharply along with the global equity markets. There were enough warning signs at least from our perspective that the global recovery was loosing steam and expectations were far too optimistic. Why should a gold mining company such as Barrick Gold move more towards copper? Does this strategically make sense? I dont think so. In 2008 Barrick Gold acquired an oil company, Cadence Energy for USD 350 million. Again, that takeover happened very badly timed, oil was trading at USD 140 and shortly after collapsed to USD 40. Unfortunately, such behaviour is very common in the gold mining industry. The inconvenient truth in the gold mining industry is a completely incompetent management and leadership in the way of constantly over-promising and underdelivering. Nevertheless, I strongly believe that there could be some kind of a tipping point for positive changes. But let us first talk about the two main problems: Management and Board of Directors are always too optimistic and have a clear lack of making profits and reducing costs as primary objective Focus is mainly on reserves and resources and not on profits and cash flows

So what should be changed to unlock the huge upside potential in gold mining stocks: Focus on NET PROFITS and stop talking about reserves and resources IN the ground. It doesnt matter how much gold you have in the ground, it only matters how much profit you make with the gold OUT of the ground! Net Profits should be distributed to shareholders in the way of DIVIDEND PAYMENTS and/or SHARE-BUY-BACKS NO FIRST PRIORITY on adding reserves and resources for the near term NEW MANAGEMENT: we need people with a clear focus on profits and only profits! NO HEDGING going forward until the real bubble in gold appears (still years away) NO BIG ACQUISITIONS, net profits must mandatorily be distributed to shareholders and/or used for substantial share-buy-backs. Currently, the only bull market is gold there are no other bull markets. Im wondering how long activist investors such as Carl Icahn, Bruce Berkowitz or any bigger private equity company can resist? Gold mining stocks are offering the biggest upside with likely the lowest risk. The game plan would be like this: PRODUCTION SURPRISE: mine the HIGH grade zones and keep the low grade zones for even higher gold prices. Since there is a limited amount of ore every mine can process, the higher the grade the more gold ounces you produce. COST CUTTING: unfortunately the gold mining industry is very inefficient, primarily because of too much overhead costs and slow execution FOCUS ON DIVIDENDS AND SHARE-BUY-BACKS: no more stupid, expansive takeovers, just distribute the profits to shareholders. Im sure the tipping point will be reached when the first activist investor buys a big chunk in Goldcorp, Newmont, Barrick Gold, Kinross Gold or any other common name and AGGRESSIVELY turns the company around to generate a maximum amount of profit and distribute it to shareholders. In a low yield and low growth investment environment, investors and particularly pension funds are hunting for payouts. In my view, hoping for a bull market in equities and therefore substantial capital gains is pretty illusionary thus dividends are even more important. As long as gold mining companies lag on dividend yields, many deep pocket investors simply will keep ignoring this sector. In a recent research report (see Figure 1), RBC Capital Markets predicts that cash margins could rise from approx. USD 800 to USD 1200 over the next 12 to 24 months.

Figure 1

In other words: Profit margins are going to explode to the upside. Which other sector has currently an acceleration on profit margins? In our macro-scenario, we expect global growth to be at best moderate, interest rates low, consumption very depressed and commodities such as oil vulnerable for some more downside pressure. Ergo: gold should do exceptionally well and profit margins should therefore remain high. A well observed barometer about the gold mining stocks valuation is the Gold/XAU Ratio (see Figure 2). Historically gold mining stocks were cheap if the ratio was > 5 and expansive if the ratio was < 4. This ratio was working exceptionally reliable up to the financial crises. In the post financial crises period, gold mining stocks stayed cheap, way too cheap. The question remains: is gold too expansive or gold mining stocks too cheap? I think, gold mining stocks are far too cheap.

Figure 2

As an aside: the gold bull market is far from over, gold is still a completely under owned asset class (see Figure 3) less than 1% of global financial assets are invested in gold) and central banks around the world are inflating the system at full speed.
Figure 3

Source: CPM Group, Gold Yearbook 2011

The gold bull market will find its end, when the deleveraging process is completed and when real interest rates start to rise. But honestly, that is years away.