ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Follow us on

    Last 14 days

Most Popular Articles


Most Popular Commentaries

    Last 12 Months

Most Popular Articles


Most Popular Commentaries



More by the Same Author

Economic Insights
   Inflation
Equities
   Growth
   Value
Global Markets
   Africa
   Global
Investment Strategies
   General
Investments
   Investments
Specialty Investments
   Gold

Are Gold Stocks Oversold?

April 19th, 2013

by Steve Land

of Franklin Templeton

Gold bugs have been bugging out over a sharp decline in the price of gold, which hit a two-year low in April. Many gold-related stocks felt the sting. Steve Land, CFA, portfolio manager and research analyst with Franklin Equity Group© , thinks gold-related stocks could be oversold, and that there are still compelling reasons to own them.

Steve Land, CFA, Portfolio Manager and Research Analyst

FRANKLIN EQUITY GROUP®

Factors Driving a Recent Slide in Gold Prices

Though they had somewhat stabilized by mid-week, gold bullion prices underwent a sharp slide in recent days for which the main drivers appear to be selling of gold-backed exchange traded funds (ETFs) and physical gold investments. There has been a dramatic reduction in the amount of gold held in global gold ETFs since February of this year that has effectively moved a sizable quantity of gold out of the investment market. We think the potential triggers for these liquidations include:

  • Fear of Cyprus Spreading: Rumors intensified last week that the Central Bank of Cyprus may have to sell gold reserves to help raise capital. While Cyprus’s total gold holdings in tonnes is quite small compared to other countries, the news seems to have spooked the gold market and fueled concerns that other heavily indebted eurozone countries may follow suit.
  • A Strengthening US Dollar: Although US growth is still weak, the US economy has continued to recover at a measured pace, and the outlook appears better than that of many developed countries.
  • Bearish Comments from Sell-Side Analysts: Sentiment from a number of prominent investment banks has turned increasingly bearish on gold.
  • Improving Equity Markets/Global Economy: In broad terms, the backdrop of a strengthening global economy has raised the confidence of many investors to take on more risk and that has helped lift the equity market at the expense of alternative assets such as gold.
  • Profit Taking: As of year-end 2012, gold prices had risen for 12 consecutive years, and bullion outperformed many asset classes in that time frame.
  • Limited Signs of Inflation Globally: Similar to the US, growth globally is fairly moderate, which has helped keep a lid on inflation worries for the time being. Concerns remain around the long-term impact of the significant global stimulus programs implemented over the past several years, but in the short term, inflationary forces have generally remained at bay.

The Impact on Gold Equities

A decline in the price of gold is typically bad for gold equities, and we saw that relationship during the recent pullback over these past few days. As gold declines, margins for gold producers decline faster. As an illustration, for a company with $1,000 in costs, when gold drops from $1,600 to $1,300, the metal’s decline is 19%, yet margins go from $600 to $300 ($1,600-$1,000 to $1,300-$1,000), resulting in a 50% drop in cash flow. However, the math works equally well on the upside, and supports the historical relationship that gold equities tend to be more volatile than the metal.

Shares of mining-related companies have significantly trailed gold in recent years, with several factors contributing to the performance divergence. Some mining companies overspent during the gold boom, with many developing reserves that turned out to be much less profitable than originally expected as costs rose. Partially as a result, five of the world’s 10 largest precious metals mining companies have appointed new chief executive officers in the past year alone. We are encouraged by the fact that these new management teams seem focused on cost control and returns to shareholders. Additionally, although gold has become more expensive to mine and harder to find, countries continue to demand higher royalties and taxes.

“Amid a selloff in stocks of gold miners in recent years, the market seems to think that there will be no positive surprises for these companies.”

Amid a selloff in stocks of gold miners in recent years, the market seems to think that there will be no positive surprises for these companies. Our investment process has tended to favor smaller, development-stage mining companies, and we have maintained our positioning in smaller-capitalization gold exploration and development companies with a belief that the reduced exploration spend for larger companies is likely to drive increased interest in mergers and acquisitions as they look to replace depleting reserves. We have, however, focused more recently on companies with assets that have moderate capital costs and operating costs that are forecast to be below industry averages, with a view that these assets should remain attractive even in a lower gold price environment.

Historically, platinum, palladium and copper mining companies have generally benefited from strong economic environments given their use in industrial applications, but these companies have struggled in the current environment given labor concerns in South Africa, where most of the world’s platinum and palladium are produced, and the fact that copper is expected to see significant supply increases over the next two years. Despite the near-term challenges, we have maintained this type of commodity diversification with a view that it should help reduce overall portfolio volatility.

We have also maintained a focus on companies that we think are able to sustain a period of lower gold and other precious metals prices and reduced our exposure to higher cost producers in response to falling gold prices. Based on valuation metrics such as price-to-cash and price-to-forward earnings, a number of gold mining companies were trading below their longer-term historical averages and at a discount to major gauges of the US equity market as of March-end.

Our Current Outlook on the Sector

Although gold prices are nearly impossible to forecast, we believe there are still compelling reasons for having exposure to gold through related equities in the current environment. Gold acts as a store of value in times of uncertainty and may act as a potential hedge against a weak US dollar or rising inflation. Regardless of the direction of gold prices, we remain focused on identifying what we regard as the best-positioned companies to potentially create shareholder value by developing new projects and discovering more gold through those companies’ exploration efforts. While the recent extreme downward volatility is disappointing, most gold companies remain profitable at current prices according to our analysis, and we continue to believe that exposure to gold equities can serve as a valuable diversification tool as part of an overall portfolio. We continue to position our strategies in companies that we believe have attractive opportunities to grow their business while offering leverage to higher commodity prices that may come in the future.

© Franklin Templeton

www.franklintempleton.com

Website by the Boston Web Company