Window of Opportunity in Gold

September 3, 2012 at 17:56

truthing

Investors with risk appetite may want to look at gold stocks, particularly those of companies ripe for takeover, analysts say.

A gap between the price of bullion and gold-mining stocks has emerged, and history shows that it likely won’t last long. Equities should catch up to gold prices and close the valuation gap.

The NYSE Arca Gold Bugs Index, which tracks 16 miners, has underperformed the front-month gold contract on the Comex division of the New York Mercantile Exchange by 16 percentage points since the beginning of the year. This is attributable to a combination of factors, including broader risk aversion toward equity investments, lower gold output among certain miners for various reasons, and the emergence of exchange-traded funds, or ETFs, that have wooed traditional retail investors away from gold-mining stocks and toward direct gold investment.

Such funds are considered less risky because investors can buy and sell shares in a fund that buys and holds gold on their behalf. Gold-mining equities, on the other hand, not only provide exposure to gold prices but also fluctuations in cost and production levels, which could either enhance or hamper investment performance.

The current gap between the price of gold and gold equities has lasted longer than the previous one in 2008-09, largely because of Europe’s protracted sovereign-debt crisis, which has pushed gold prices higher but made equity markets more volatile.

“Unfortunately, we believe the overall equity markets may face some difficult times ahead, at least until the euro zone crisis is resolved,” analysts at RFC Ambrian said. “But we feel that in most cases the market has significantly oversold gold equities and this has presented some attractive investment opportunities.”

The valuation gap hasn’t gone unnoticed. While retail stock investors may be apprehensive about jumping into gold equities, acquisitive mining companies have demonstrated interest in scooping up gold companies on the cheap.

Accountancy and consultancy firm Ernst & Young reported this summer that gold mergers and acquisitions accounted for the highest share of the global mining and metals deal volume during the first half of 2012. Out of 470 M&A deals, 160 were in gold, although the average size of those deals was $40 million compared with $62 million a year earlier.

“It’s a buyer’s paradise” when gold stocks underperform gold prices, said mining analyst Asa Bridle of Seymour Pierce Ltd.

The resource base of West African gold developers, for instance, is now valued at an average $30 a troy ounce, compared with $100 12 months ago, said Adam Kiley at RFC Ambrian.

RBC Capital Markets analyst Jonathan Guy said investors could stand to reap more rewards from investment in small-to-midtier gold producers than from the top-tier gold producers that have more stable production profiles.

Such small-to-midtier miners, mostly exploration and project development companies, may offer more attractive returns, in part because the relatively credit-constrained market environment means they may have to seek partnerships to develop their projects, making them potential M&A targets.

“We have not seen a large amount of activity flow through to the explorers/developers as of yet, but as their valuations remain at such distressed levels that we believe it will not be long before producers will look at raiding and cherry-picking the best from this sector,” RFC Ambrian analysts said.

Mr. Guy of RBC Capital said that one of his top picks would be U.K.-listed Centamin, whose valuation has fallen due to production setbacks stemming from labor issues and sovereign risk associated with political unrest in Egypt.

Mr. Kiley highlighted Australia-listed Papillon Resources Ltd., given the company’s discovery of a high-grade ore deposit in Mali. The company could be of interest to U.K.-listed Randgold Resources Ltd., because Randgold is interested in high-grade ore deposits and already operates in Mali, he said. Randgold signaled last month that it was interested in pursuing opportunities in the junior mining sector.

Investing in small-to-midtier gold miners, however, comes with its own risks. Miners could struggle to finance their projects in the current market environment. And mining costs are still rising while gold prices have been range-bound recently, pressured to the downside by a stronger U.S. dollar and a low-inflation environment. Investors tend to buy gold to protect their investments from risks associated with a weaker dollar and inflation.

But the price of gold could surprise to the upside if central banks around the world continue buying gold at current rates and countries implement stimulus measures. U.S. Federal Reserve Chairman Ben Bernanke said Friday that the central bank was open to the possibility of further action to stimulate the economy, prompting spot gold to rise 2.2% to $1,691.40 an ounce, a high last seen just over five months ago.