Gold: The Big Winner of Sub-Prime Slime?

Our principal specialist commodities advisers wrote at the end of December:

Gold posted its eighth consecutive yearly gain, ending the year at US$882/oz, up 6% as governments, led by the US and UK, continued their highly expansionary monetary and fiscal policies in their stated efforts to prevent their economies from descending into a deflationary spiral. The desperate measure.....by governments aimed at reflating assets by printing money is very positive for gold.

The strong performance of gold against the joint headwinds of rising bond prices (normally signalling deflation fears) and a strengthening US dollar (deleveraging and safe haven induced) indicates that the ramifications of such reflationary policies are dawning on investors and the public at large: demand for physical gold as coins and bars surged.

In the US alone US$3.2 trillion is sitting in money market funds which are now barely covering their running costs, let alone paying a return. If only a fraction of this trickled into the gold market the price would likely be multiples of where it is now, and there are strong arguments that the trickle ought to be a flood. At today’s gold price the total value of all the central bank stocks is only around US$1 trillion and the value of annual mined gold supply is barely US$70bn. Central bank foreign exchange reserves are around US$7 trillion held predominantly in US dollars (with China alone holding around US$1.8 trillion in US dollars). With the US Government projecting a 2009 budget deficit of over US$1 trillion and growing, the question is who will carry on buying all these dollars, particularly with zero interest rates on bank deposits. The ‘investment planets’ are better aligned for gold than they have been for a generation! Although gold did its job, gold shares were a major disappointment in 2008, given that gold prices were at, or close to, all-time highs in nearly all the major producing countries. With hindsight, we failed to appreciate the extent to which gold shares could be ‘carried out’ with the rest of the equity markets in the massive de-leveraging climax that took place as hedge funds dumped anything and everything in September and October. Even before the de-leveraging induced rout, the tide has been against gold shares over the last couple of years caused by the general lack of operational delivery, rising costs (steel, oil, reagents, labour etc), competition from the Gold ETF, and decreasing market appetite for risk, which has particularly impacted growth-orientated mid-cap gold shares to which the Fund has exposure.

We believe the tide has now finally turned and 2009 will be a far better environment for gold shares. On costs, the lower oil price will have a significant impact on margins, with oil price down some US$100/bbl from its high likely to reduce mining costs by U$40- 80/oz. For example, Oceana Gold tells us that the annualised fuel saving from the first half year will amount to close to US$16m, significant when one considers that its market capitalisation is only US$28m! Other costs are also falling including steel, reagents and even labour: the margin expansion could surprise a market that has yet to factor these changes. December saw a strong rally in many gold shares with the top 5 performers rallying between 27% and 76%, although still offering substantial upside just to reach the levels seen earlier in 2007/early 2008 when the fundamentals for these companies in a higher cost environment were not as strong as they are today. Many gold shares remain ridiculously cheap on replacement cost and price to cash flow metrics (we can only assume continued equity market risk aversion)..... Northgate, which has a market cap. of US$210m, expects to produce 390,000oz at US$400/oz in 2009. This implies EBITDA of over US$180m (or a price to EBITDA multiple of 1.2x) and yet the shares are barely off their year lows: we continue to buy.

2008 has seen equity markets driven by macro forces with little regard for the investment fundamentals of individual companies. We are a specialist manager that aims to provide investment returns through a stock selection process which involves detailed due diligence and analysis. We target undervalued gold companies with sound economic gold reserves which will deliver on their production and growth plans resulting in share price performance that should outpace both their peer group and gold. The current market is providing numerous investment opportunities as most equities have been mispriced by the market turmoil of 2008 – some ridiculously so......given our positive view on gold..... we anticipate that 2009 could be an exceptional year.