There are some very good reasons why it is difficult to value gold miners, according to Royal London Asset Management’s Peter Rutter, given how different the precious metal is to other commodities.
The price of gold has soared in recent months as investors sought to add more of the traditional ‘safe haven’ asset to their portfolios while the Covid-19 pandemic caused greater uncertainty in markets.
As the chart below shows, the Bloomberg Gold Sub is up by 24.63 per cent (in US dollar terms) so far this year and recently breached the $2,000 per ounce level, although it has fallen back since.
Performance of Bloomberg Gold Sub YTD
Source: FE Analytics
Given the popularity of the yellow metal, it might be safe to assume that valuing the miners responsible for extracting it from the ground would be an easier process.
Over the past six months (to 20 August), the Nasdaq Philadelphia Stock Exchange Gold/Silver index – a closely watched benchmark of 30 precious metals miners – has risen by 40.41 per cent, in US dollar terms.
Indeed, Rutter, Royal London Asset Management’s head of equities and manager of the £2.5bn Royal London Global Equity Diversified fund, said the valuation process should not be any different from any other company.
“If you can find a business you understand, are confident it is a superior shareholder wealth creator and it appears cheap relative to its current share price then you have found a legitimate investment opportunity,” he said.
“When it comes to understanding a gold miner it is a relatively simple thing to understand.”
He explained: “A mine contains some gold embedded in ore that needs to be dug up and processed with as low a capital and operating costs as possible, and then sells this into the gold market at the prevailing – or a previously hedged – price.”
However, Rutter said the yellow metal is different than other metals and other commodities.
“In terms of valuation, there are genuinely cases and environments where even the world’s best gold mines are simply a liability and worth nothing to shareholders, and there are other environments where their potential valuation could be truly enormous,” the Royal London manager said.
“In a bearish valuation scenario as a shareholder you might own a set of mines that have a lot of gold ore, but if it will cost $1,000 an ounce to extract that ore, and the gold price is worth $800 then you do not actually own anything of value. It is just some soil and/or rocks.”
Usually, markets ensure that commodities do not fall below the costs of production for extended periods of time, said Rutter, but this isn’t the case when it comes to gold.
“Gold is not consumed like food or oil or copper,” he explained. “So, when the price falls below the cost of production there is no significant loss of the underlying commodity from the system, which in turn guarantees supply-demand dynamics force prices back up.
“So, this liability ‘trap’ is a risk for gold that is fairly unique.”
However, the Royal London Global Equity Diversified manager warned that in a world of zero interest rates, low bond yields and huge monetary stimulus there is no real anchor for gold prices.
This is because the opportunity cost of taking cash out of the bank or bonds to buy gold “is the lowest it has ever been”.
Rutter said that should momentum grip gold prices or inflationary fears take off then gold “could capture the world’s imagination and speculative desires”.
“All this means it is hard to know what the limit to the upside is in any period, particularly when the world is vulnerable to asset bubbles like never before with zero interest rates,” he said.
“Given the significant operating and financial leverage in gold mining stocks and alongside the fact that some of them have a lot of gold in the ground there is the potential for tremendous upside when it comes to valuations.
“Gold stocks are effectively very geared plays on the gold price which itself might have limited anchors to the upside.”
As such, Rutter said valuation for gold stocks “is quite unknowable” without knowing the long-term gold price – something which is also unknowable.
And, as a result, there are just too many potential outcomes for gold stocks for the manager.
“For us, that doesn’t particularly constitute an ‘investment’ case, but for benchmark- and index-focused investors it does have risk management implications,” he said.
“And for the wider world it is perhaps an opportunity for what the famous investor and investment theorist Benjamin Graham highlighted as ‘intelligent speculation’, depending on your view of the gold price.”
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
The Royal London Global Equity Diversified fund has made a total return of 26.88 per cent since launch in October 2017, compared with a 25.38 per cent return for the MSCI World benchmark and a 21.43 per cent gain for the average IA Global peer. It has an ongoing charges figure (OCF) of 0.41 per cent.