Outlook for Gold and Gold Stocks

Transcription

1 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaMcLeod Senior Portfolio Manager, with responsibility for advising the Anchor June 1 st, 2013 Stock Market Outlook Outlook for Gold and Gold Stocks Once more, nothing has changed sufficiently to alter our conclusion on North American equity markets in our April 1 Stock Market Outlook Note - namely that: we believe there is still some potential for further gains for North American equity markets over the next quarter or two. We have to recognize that this cyclical bull market started in March 2009 and thus, because of its longevity, we are likely in the latter innings of this cycle. The one change that we have noticed that bears watching is that, in post Memorial Day trading, North American long term bonds had a large sell off perhaps mimicking to a more modest degree what happened to the Japanese bond market in the preceding week. In our view, this rise in longer term bond yields could persist for a month or two. However, we still believe that North American economic activity will disappoint in the second half of 2013 and that 10-year Canadian and U.S. government bond yields will be back below 2% in the latter part of the year. This sharp rise in longer term North American bond yields quickly manifested itself in pullbacks in the pipeline, utility and infrastructure equity groups as well as in REIT s. We have been gradually reducing our exposure to these sectors over the last few months on valuation concerns. Chiefly we have been modestly increasing exposure to the banks, which we regard as relatively cheap reflecting the significant shorting by U.S. hedge funds, and to selective cyclical issues chiefly in the natural gas sector and in certain special situations such as in the gold sector, which we are highlighting in this Strategy Note. Outlook for Gold and Gold Stocks Four weeks ago, we were in the East, in Toronto and Montreal, on one of our semi-annual visits to visit managements of companies in our universe. Although Q1 results for gold miners were only just starting to be released, we were able to interview the CFO s of Barrick Gold and Yamana just after their results were released. Of course, April has been a month when the price of gold bullion and shares prices of major gold mining companies had plunged precipitously. There has been a lot of commentary in the financial press to the effect that there will be no bottom to the gold price until it reaches $1,200 per ounce or even $1,000 per ounce and that gold stocks should generally be avoided. Our perception is somewhat different and we believe that there is a decent prospect for the bullion price to stabilize between $1,300 and $1,400 per ounce and, if that were the case, the valuations of some of the major miners could be regarded as extraordinarily cheap. This Strategy Note develops our reasoning for this belief.

2 a) Q1 demand changes per the World Gold Council The recent Gold Council Quarterly report, reviewing the first three months supply/demand picture highlights the strong demand for physical gold in the form of jewelry and from gold bar and coin demand and the contrasting liquidation of gold ETFs. Gold jewelry demand in Q1 was concentrated among Asian buyers (Chinese consumer demand grew 19% year-over-year in the quarter and Indian demand by 15% with both countries accounting for 62% of total Q1 global jewelry demand) and resulted in incremental demand of 29 tonnes over Q4 levels. Gold bar and coin demand was up 42 tonnes. Demand for gold from the technology sector grew modestly in the quarter by six tonnes over Q4 levels while central bank purchases fell by 37 tonnes (109 tonnes versus 146 tonnes in Q4). All of these net changes were dwarfed by the decline in ETF demand. In Q4, there was net increase of 88 tonnes while in Q1, there was liquidation of 177 tonnes. The bulk of the drawdown appears to have come from institutional investors as hedge funds and other investment funds turned negative on bullion. The pace of ETF liquidation accelerated in April by 174 tonnes, which was almost the equivalent to the decline in all of the first quarter and was the major factor behind the $130 an ounce drop in the bullion price in the month of April. The selling of gold from ETFs was at its most intense in the middle two weeks of April, which saw weekly declines of over 60 tonnes for those two weeks. The pace of liquidation slowed in the last week of April and first three weeks of May according to Bloomberg s daily tracking of total gold holdings in all ETFs as the weekly liquidation averaged 29 tonnes a week over that period. For the last week of May, the liquidation was only 16 tonnes and the bullion price moved back above $1,400 an ounce. If the weekly liquidation pace continues to drop over the next few weeks, our confidence in the price of bullion having found a bottom at or above its intraday low of $1,321 an ounce on April 16 will increase commensurately. In terms of seasonality, May/June tends to be a seasonal low point for gold and gold stocks. Performance of both is often robust between July and September/October. Evidence of slowing gold ETF liquidation over the next while would give us an increasing sense of confidence that the metal and stock prices of the miners could have seen their bottom. b) The new gold company management emphasis on profitability and cash flow generation Certainly, our interviews in Toronto with Barrick Gold and Yamana underlined the changed emphasis on the part of all the managements of the major gold miners to stress profitability rather than production growth as a result of investor pressure to improve returns. Evidence of this can be found in the trend of these companies now providing guidance around all-in costs per ounce not just operating cash costs but also G & A, debt service, exploration and sustaining capex costs. On this basis, for example, ABX s all-in cash costs are estimated at $950 an ounce with operating cash costs of about $620 an ounce and G & A, debt service, exploration and sustaining capex costs of about $330 an ounce ($100 an ounce estimated for debt service). The $950 an ounce compares with an estimated $1,300 an ounce for the overall gold industry. Furthermore, 20 of ABX s 25 mines with 40% of its production have all-in costs of $1,200 an ounce. On average, each of these mines represents, therefore, about 2% of ABX s production and, in a worsening gold bullion price scenario (i.e. down to $1,200 an ounce), ABX would look to shutter these mines. What would it be left with? The remaining five mines at a bullion price of $1,400 an ounce would

3 generate cash flow of about $4.25 billion ($4.25 per share). Recently, it was announced that ABX (and its partner Goldcorp) have an agreement in principal with the Dominican Republic for revised fiscal conditions for Pueblo Viejo. If that were the case, at $1,400 an ounce gold, there would be incremental cash flow of at least $250 million. With sustaining capex of $2.5 billion, that would give free cash flow of $2.0 billion before dividends at the current rate of $800 million. The net free cash flow of $1.2 billion a year would be sufficient to cut ABX s $12 billion of debt in half in five years. If, and when Pascua Lama were to be in full production, that would add a further $1.0 billion of cash flow after all-in costs. Last week, ABX said it was studying the implications of Chile s Superintendence of the Environment s resolution requiring it to complete Pascua Lama s water management system in accordance with the project s environmental permit before resuming construction activities in Chile. In sum, using $4.50 CFPS and a P/CF multiple of seven times, we get a price target of $ This assumes the closure of 20 of ABX s mines and no cash flow contribution from Pascua Lama. Other than in the event of further significant bullion price deterioration, we would regard this as a worst case scenario. A seven times P/CF multiple is lower than any experienced by the company in its history (prior to this year) and so we would regard that as a very conservative assumption. In addition, in this scenario, the stock yields 3.8%. As for Yamana, similar discussions with the company as with Barrick Gold, showed a determination on the part of management to reduce all-in costs by $ an ounce over the balance of the year. This would indicate a potential all-in cash cost target of between $700 and $775 an ounce one of the lowest cost structures in the industry. This assumes a copper price of $3.20 per pound (versus the current level of $3.31). Despite its concentration on profitability through cost control, Yamana also has an excellent growth profile with production to exceed 1.5 million ounces of gold in 2015 excluding any subsequent contribution from Cerro Moro where the feasibility study is yet to be completed (likely by mid-2014). At $1,440 an ounce gold and $3.20 per pound copper, we estimate 2015 CFPS in the area of $1.60. For 2013, based on $1,400 gold for the balance of the year, we are using a CFPS estimate of $1.33. YRI s valuation has not been hit to nearly the extent of ABX s this year so that its P/CF multiple on our 2013 estimate has not fallen below eight times considerably higher than ABX s P/CF multiple at its low of 3.7 times on estimated CFPS of $4.85 for This combined with a current dividend yield of 2.2% versus 3.8% for ABX currently explains why we only added ABX in our portfolios earlier in May (we also previously held Goldcorp in our Advantage Equity portfolio and continue to do so). c) Valuation methodology to move towards greater use of cash flow multiples versus NAV. Historically, we have found the use of P/CF multiples to be a more reliable valuation metric. However, precious metals analysts have generally preferred to use NAV as the basis for their valuations of stocks in the sector. With gold miner managements placing greater emphasis on cash flow and profitability versus production growth, we think that the analysts will likely lean more heavily towards the use of P/CF multiples in the future. A stock like ABX would thus show up as much better value on this basis than relying solely on its NAV valuation.

4 Portfolio Changes We explained in our May 15 Notes how we had just added Just Energy in the Anchor Dividend Growth fund. We noted that we had previously sold Just Energy after its dividend cut from $1.24 to $0.84. However, since our sale, the stock had dropped a further 15%. Again, on our Eastern trip, we had been able to interview senior management of JE at length and our confidence had been bolstered that the dividend payout percentage on FFO would fall modestly below 100% in this fiscal year and could decline further to the targeted 60%-65% range within the following two fiscal years. With a market cap below $1 billion, JE was at that stage only eligible for purchase within the Anchor Dividend Growth fund. However, Q4 results for fiscal 2014 (JE has a March 31 year-end) were in line with previous guidance and increased investor confidence in the Company s forecast of its dividend pay-out ratio two years down the road. This saw the stock rise in price from the mid $6 area to the mid $7 area. As a result its market capitalization increased to well over $1 billion, thus making it eligible for the Anchor High Income and Defensive Income funds. We, therefore, repurchased JE in each portfolio. In the Anchor High Income fund, we thus added a new position in JE but also added to our holding of Boardwalk REIT, where AFFO growth continues to be robust and the Company maintains a very conservative balance sheet. These purchases were funded by sale of Manitoba Tel. The stock had provided a good yield but little in the way of capital gains to that point. The combination of the JE and BEI.UN additions had the effect of increasing the overall yield on the portfolio as well as adding the potential for higher future capital gains than we thought might be available from MBT. We believed that a sale of Allstream at an attractive price was unlikely in the short term although that was quickly proven to be wrong shortly after our sale of MBT. The net proceeds of the announced sale of Allstream to Accelero Capital appear to be in the middle of the range of expectations and on the strength of greater assurance that the dividend will be maintained at current levels, the shares rose post sale. We still hold the stock in our Anchor Dividend Growth and Defensive Income funds. In our Anchor Defensive Income fund, we added Just Energy funded by small sale of our IShares Short Term Bond ETF. Nick Majendie, CA Director, Wealth Management Senior Portfolio Manager

5 Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of Scotia Capital Inc., is the manager of the Anchor. ScotiaMcLeod, a division of Scotia Capital Inc. is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaMcLeod, provides portfolio advice to the Funds. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaMcLeod or on This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaMcLeod, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice.