A boutique investment fund with Old Mutual Investment Group SA (Omigsa) sees South African gold shares as destroying value and that the underlying metal no longer offers a safe haven for investors, writes Allan Seccombe in an article posted on miningmx.com.
Neil Brown and Richard Hasson, who head Select Equity Investments at Old Mutual Investment Group SA (Omigsa), issued an opinion piece explaining why they avoided putting money into South African gold shares.
A number of gold sources Miningmx spoke to reject the reasoning put forward by these fund managers, who could be regarded as contrarian in the face of a long-running bull market for gold.
The sources pointed to the exponential growth in gold investment instruments and, in some cases, the large margins posted by mining operations in South Africa. There has been a change in the leadership at most of South African gold firms, which is bringing in fresh and positive dynamics too, they argued.
Judging from the tone of the note from Brown and Hasson, they will not deviate from their chosen course of shunning gold, which is seen by a wide range of investors as a hedge against inflation and a weak dollar.
“However, we strongly believe that this ‘safe-haven’ status has fallen away now that gold no longer acts as any form of anchor in the global financial system,” the fund managers said.
“Today, gold mainly serves as a commodity used in the manufacture of jewellery, with limited industrial uses,” they said.
CENTRAL BANKS
A couple of market watchers, conceded the “anchor” point, but suggested gold is rising in importance for the global economy as central bank sales slow and others buy the metal to diversify their reserves. China, for example, has increased its gold holdings by 75% since 2003 to 1,054 tonnes.
Paul Walker, chief executive of metals consultancy GFMS, said in early April that gold prices will be “a lot lower” than they are now in the next four to five years, which raises the possibility of the Chinese government diversifying its massive reserves to incorporate gold.
It is thought to have largely held off doing so because of the high gold price and for fear of disrupting the gold market, he said. The market has long maintained that a serious entry by China into gold would drive prices sharply higher.
Not only are the central banks reassessing gold, but investors have piled into the metal, buying exchange-traded funds, which are instruments backed by physical gold, as well as coins and bars because of their concerns about the state of the economy.
The World Gold Council reported first quarter total investment, including inferred flows, grew 173% year-on-year to 711 tonnes.
Gold pushed through $970/oz on Friday as the dollar fell to a five-month low against a basket of currencies as investors tucked into equities and other riskier investments. Oil prices rose to $66, a six-month high.
If the global economy recovers – some watchers are seeing signs of tentative growth in data around the world – there is a real concern there could be a flood of gold onto the market as investors ditch their physical gold holdings in favour of equities and other investments.
DANGERS LURK
This would push gold prices down hard and fast given the glut of metal that wouldn’t have another demand outlet, apart from the embattled jewellery sector, a traditional pressure valve.
Brown and Hasson said they analyse gold like they would any other industrial commodity where the fundamentals of supply and demand determine the price. They argue there is an ample above-ground supply of gold, which will offset declining primary production.
“We therefore believe that the gold price should remain at a level which enables the majority of gold mines and companies to earn a fair operating profit margin on their sales, without earning too high a margin, as this in turn leads to excessive central bank and other investor gold sales and the entry of new marginal gold mines,” the fund managers said.
“As a result of this market equation, we believe that the gold price should trade around the $800 per ounce level.”
They see gold as similar to other assets such as equities and it should be valued against these kinds of alternatives, prompting one source to say gold has been the only asset class over the past six months to yield a positive return.
A BAD IDEA
Turning to South African shares, Brown and Hasson see them as a really bad investment idea.
“While SA gold companies are expected to deliver strong growth in earnings over the next year or two, the gold companies will still not be able to cover their cost of capital at these cyclically high gold prices,” Brown and Hasson said.
“Due to the increasing difficulty and cost of deep level mining in SA, as well as the increased focus on employee safety, this is an industry that we believe over the long term will not earn returns on capital above its cost of capital and therefore will destroy value to shareholders on a sustainable basis.”
They singled out AngloGold Ashanti as a company that has “continually” issued shares and yet its “gold output per share has continually declined.”
One of the funds sure to disagree with the Brown and Hasson view of South African gold miners is Paulson & Co, which has bought Anglo American’s 11.3% stake in AngloGold Ashanti for $1.28bn.
“We believe AngloGold is one of the best managed and undervalued of the major global gold mining companies. We look forward to the implementation of their global expansion strategy,” John Paulson said in mid-March.
Paulson, arguably one of the more successful hedge funds, is a holder of $2.8bn in gold-backed ETFs in the first quarter of 2009.
Brown and Hasson said earnings for the overall market were forecast to fall 6% in 2009.
“Gold company earnings growth should substantially exceed that of the rest of the market in 2009 and into 2010. However, over time these companies earnings growth has been very poor, and we believe that their earnings will continue to disappoint in the medium- and longer term,” they said.
“We believe gold shares in South Africa are extremely poor quality businesses that will battle to earn returns above their cost of capital. Their valuations are slightly expensive and therefore we have zero exposure to SA gold shares in the funds we manage.”
In another article on miningmx.com Ines Schumacher says that according to RBC Capital Markets major South African gold companies could suffer an 80% drop in quarter-on-quarter earnings unless the gold sector experiences a major upturn in the dollar price of the metal or a weakening of the rand.
RBC has increased its gold price forecast and predicted the rand would move stronger against the dollar. This translates to a weaker rand-gold price, which will significantly decrease South African gold companies’ share valuations.
We suspect the dramatically reduced forecasts will come as much as a surprise to the market as it did to us when we did this exercise, RBC said in its commodity assumption revision published on 5 June.
AngloGold Ashanti earnings could drop 78% quarter on quarter (q/q), Gold Fields could see earnings down 77% and Harmony Gold could deliver an 87% earnings plunge. RBC expects DRDGOLD to make a small loss after its record cash earnings in the previous quarter, which would result in a 138% earnings fall.
