Gold Shares - where has all the gearing gone?

Shaun le Roux of Alphen Asset Management writes that the attractiveness of gold in the current economic environment is well documented. In these uncertain times, gold comes to the fore as a 'safe haven' and 'store of wealth' and the price benefits from investment flows associated with investor jitters and aversion to risky assets and fiat currencies.

At some point in the future it is also likely to serve as an effective hedge against the inflationary consequences of excessive money printing . Hence, we continue to like the long term prospects for gold. For the past three years gold has been negatively correlated with risky assets like equities and we expect this dynamic to persist. This makes gold an attractive diversifier within an asset allocation portfolio - overall portfolio risk can be reduced (by including gold) without materially compromising future returns.

Much like cash in the developed world, an ounce of gold yields nothing. It has very limited industrial use and jewelry demand is difficult to predict. As a result, it is nigh impossible to determine a fair value for gold. The bottom line is that for the price to go up, investment demand needs to stay healthy or the dollar needs to fall out of bed.

We have long argued that the JSE-listed gold shares generally make very poor 'buy and hold' investments. The graph below illustrates how poorly the shares have performed during a potent bull market for the precious metal. The gold price in rand terms has more than doubled since the end of 2005 - it is up 169%. Over the same period, the large cap gold shares are all down!

The gold shares have underperformed for a number of reasons. Firstly, production volumes have declined over this period. Like many South African commodity producers, the gold industry has failed to capitalize on the upturn in the cycle. Deep, ageing mines have become increasingly problematic to mine and cost control has been very difficult thanks to strong pressure from the unions and rampant electricity prices. Appropriately, attention has been focused on the mines' poor safety records which has further impacted cost and production volumes.

Also, a company like Anglogold has had to unwind its very costly hedge books and that has had a massively negative impact on cash earnings over the past five years. As a result of poor volumes, high costs and hedge book costs, gold companies have delivered dismal earnings over the past five years. Despite this, at no stage have the shares offered compelling value over recent years - this is probably best demonstrated by the graph below. As readers will be aware, we are firm believers in the dividend yield as indicator of value. In the 1980s and 1990s, the dividend yield of Anglogold seldom fell below 4%. The yield is currently 0.4%.

In normal circumstances, gold shares should be geared to a rapidly rising gold price. This means that share prices should move up faster than the rise in the gold price. This is because there is a fixed cost element to the cost of mining an ounce and, more importantly, the reserves under the ground that the company has yet to mine become more valuable as the price moves up. Unfortunately, the poor operating performance of the SA producers has conspired to result in negative gearing to a rising gold price over the past five years as the graph above illustrates.

The good news is that we expect vastly better operating performance from the gold majors going forward - volumes should start increasing, and control over operating costs look like they have turned the corner. This bodes well for SA gold shares should the gold price keep rising. And, we have been encouraged by the fact that the gold shares have outperformed the gold price since the latter part of 2008.