Gold Producers Aim To Raise Roe To Compete With Etfs
Ian M. Preston
TWST: Some people are looking for a rally in gold. Is that what we're going to see from here?
Mr. Preston: Look, I think the gold price is going to fluctuate really around sentiment in Europe, firstly. And then that I think flows into the U.S. dollar, euro and other currencies, depending on moves in exchange rates. I think if we continue to have a period of uncertainty around the debt crisis in Europe, then gold will do well in that sort of a climate. And every time people think that there is going to be some resolution, we start to see a little bit of strengthening in currencies, the appeal of gold dissipates a little bit.
And in particular, as you get people moving into the U.S. dollar as the best of the best in terms of fiat currencies, that is always a little bit negative on gold. But broadly I think gold - that there are more positives for gold than there are negatives. And in particular, the fact that central banks are buyers of gold now, individuals are voting with their feet buying gold. So I think that tells you that people are still concerned about preservation of wealth.
TWST: Central banks, for years, have been net sellers. What's changed that posture?
Mr. Preston: One of the arguments why central banks were net sellers was that gold had no real impact on foreign reserves held by central banks and it wasn't earning any interest as part of their foreign reserves, and so therefore, why would you want to continue to hold gold? Whereas really the reality now is that most currencies have got very low real interest rates, and so therefore the desire to hold currencies, in particular the U.S. dollar, has been waning. And if you look at the percentage of foreign reserves held by global countries or countries globally, they have all moved up overtime. Now they haven't necessarily been buying a lot of gold - I mean, the emerging markets have been buying gold, but because you've had a depreciation of the rest of the reserves relative to gold, the percentage of foreign reserves held as gold has actually gone up quite significantly. And I mean it's quite illustrative that if you think of the European Union, all the signatories to the so-called Washington gold accord, you know, 54% of their reserves are held in bullion.
TWST: Is that growing now?
Mr. Preston: Well, it's grown over time. It's grown not because they have been buying gold. If you go back to when the euro was set up, you know it was set up with 15% gold backing and it's now probably closer to 32%. That's not because the European Central Bank has bought or sold one ton of gold since it was setup, but the 15% has now moved to over 30% simply because of depreciation of other currencies, which is principally the U.S. dollar.
TWST: That doesn't sound like good news.
Mr. Preston: It's not, but the fact that you are not having any interest earned on currencies held by central banks has made the attraction of holding gold because of its ability to preserve value over a very long period of time. The real purchasing power of gold has been established over hundreds of years. You have more propensity to want to have gold as part of your foreign reserves and for an individual it's exactly the same. It's not necessarily about trying to create wealth; it's about trying to preserve wealth.
TWST: Is that the driving force for many people at this point?
Mr. Preston: I think, absolutely. I think if you live in Europe or you live in the U.S., I mean you've had some pretty tough times over at least the last five years, maybe a decade, whereas if you live in the lucky country, Australia, they have seen property values in Australia continue to appreciate. I mean, they might be coming off a little bit now, but you haven't had the same fear of losing your wealth that you've had in some of the major developed economies of the world.
TWST: For many of the majors, that's been more than fear: it has become more of a reality.
Mr. Preston: And that draws people to want to own some gold because gold has stood the test of time as being able to preserve value, and we haven't really got into an inflationary situation yet. We are talking about inflation, but ultimately if you start to get inflation coming back into the world economies, then again gold will do well in that environment, so you have a lot of people putting some of their wealth into gold, simply to try and protect what they have got, not necessarily trying to grow it.
TWST: And is that why we are seeing the success with ETFs and some of these other new vehicles?
Mr. Preston: In my mind, yes, it is. I think the competition for major gold companies is not between themselves. They have to give a bit of return than what you can achieve just simply having gold in an ETF. Remember the ETF, if its physically backed, you don't have any operational risk, you don't have any political risk, you don't have any fear of governments changing the legislation and the rules of operating. So if you as an investor are going to invest in a gold equity, you've got to have more than just gold leverage. You've got to be able to not only grow earnings in an improving gold price, but in our view you've also got to give a return to investors, and I think that's why you have seen some of the majors moving now to significantly lift the dividend that they have paid. I mean, historically gold companies have not been significant dividend payers, and in fact have not actually been significant preservers of the equity that's been invested in the companies. Return on equity in many gold companies has been very poor over a very long period of time.
TWST: So what we're seeing is a new management thought process. Is that going to become permanent?
Mr. Preston: It's a very good question. I do think you've had a change, whether or not it becomes permanent, I wish I had that crystal ball, but realistically all of the majors have materially changed the amount of earnings that they are paying out in the form of a dividend. And if you look at some of the majors - say, for example, have Newmont (NEM), where they have linked the dividend to where the prevailing gold prices - I mean, I think that's a clear signal that they want to make it very easy, very transparent for an investor to say, "Well, I have a view of where the gold price is going to be, therefore I can actually calculate what the dividend will be; I'm not subject to the vagaries of management saying, Ôwell, I'll only pay out a little bit this year.'"
And the share price response for Newmont post that announcement has actually been very positive. You've had a similar proposal from Eldorado (EGO), where some of the other majors have just simply lifted their dividends quite significantly. So whether you talk about yield, the lift in the dividend has been very, very significant. I think personally, I think you've got to have at least a 2.5% to 3% level of yield to really make people sit back and say, "yes, this is an alternative to an ETF."
TWST: Is that indicative of the fact that companies don't think they have the opportunities to invest and they would rather give it to shareholders?
Mr. Preston: No, I don't. I think it's more companies saying my competition actually is the ETF as a gold major, and therefore I have to balance the growth aspirations that I have with actually giving my current owners, my current shareholders a return on the money that they've invested. So I don't think it necessarily is that they don't want to do additional investments, but it certainly will make them lift the bar on what is an acceptable rate of return that they can get out of the project if they have competition for the cash flow generated by the company. I mean, if you are saying part of the cash I am generating has to go to providing the owners of the business with a return and then I also have to look at growing the business, I think it will force you to make better investment decisions - some of the more marginal projects might not get off the ground. Scarcity of capital in a company forces you to actually move to only the best projects being given the cash to be developed.
TWST: So management becomes more careful because of opportunities and capital constraints.
Mr. Preston: Yes, I think it forces them to say, "one of the things that I have to do as management is to provide a return to my shareholders." I mean, the underperformance of the gold equities relative to the gold ETFs certainly over the last 12 months or so really highlights to you that you have to do more than just simply be captive to the gold price.
TWST: With gold prices where they are, are the companies ramping up their development, exploration and development projects?
Mr. Preston: Well, I think, you've certainly seen a ramp-up in exploration, but we haven't had that many truly world-class gold discoveries. If you were to say more than 10 million ounces, you haven't really had that many major new gold discoveries yet. That will come with time, but yes, I think there's been a lift in exploration expenditure, but it's not yet being turned necessarily into a lot of new developments. I think the developments we've seen with all of the majors are projects they have known about for sometime already.
TWST: So they have been kind of sitting on them?
Mr. Preston: These things will take a lot of time and there's a lot of due diligence, environmental approvals, the regulatory process wherever you are in the world now is certainly extended from what it was maybe five years ago. It's much more rigorous. It takes a lot longer. It just takes time to develop new projects.
TWST: As we look out, ETFs have become an important vehicle. Are they going to continue to grow in importance in this space?
Mr. Preston: Well, I think, yes, they will as we have more and more private wealth looking to try and preserve some of their wealth. I think the interesting part of that question is, Would you see then if there is a $100 million of investment to go into gold, does $90 million go to ETFs and $10 million goes to equities, or does it reverse? Do we start seeing a greater share of the money that's being allocated to gold going into gold equities rather than gold ETFs? And I think that will only happen when collectively individuals look and say the return that I can make from investing in a gold equity is far superior to the ETF and offsets the increased risk because there is clearly more risk investing in a gold equity than there is investing in a pure gold ETF fund.
TWST: We started out the conversation talking about gold price relative to perceived economic risk. Has that really become the dominant driver here rather than old supply and demand?
Mr. Preston: I think, on the margin it is probably now more important. I mean, if you look at supply and demand at the moment, India will import record volumes of gold this year. So I mean, clearly because the gold price is higher, the actual value of gold imported into India will be higher. But actual physical volumes have been extremely good into India, coupled with which you've had very little recycling of old gold in India, which really would tend again to point to a country where the concern is about the value of the currency and trying to protect themselves against increasing inflation. I think China would be another case in point where the volumes of gold being imported are actually going up significantly, again, I think, because you have people there worried about the value of their currency and being debased over time because of increased inflation.
So I think supply and demand, you can never get away from, will be very important. And in particular, if you say what are the big changes that have taken place, central banks moving from being net sellers to being net buyers, huge change in terms of supply demand. But it's not just a supply demand equation, I think that's what sets gold aside. It is also a currency and ultimately if you lose faith in paper currencies, in fiat currencies, then you turn to hard assets, one of which is gold.
TWST: You mentioned recycling.
Mr. Preston: Just on that, I mean, it's quite illustrative. If you look at how well the gold prices have performed relative to platinum, both are precious metals; platinum at the moment is clearly suffering because of its industrial uses. So the auto industry globally hasn't really fully recovered yet. So the physical demand for platinum in terms of going into auto-catalyst manufacture is significantly lower than it was. So you actually have the platinum price trading substantially below the gold price. So gold is fulfilling that role of being an area to put some wealth as to preserve your wealth.
TWST: So it's got different characteristics.
Mr. Preston: Yes, I mean, we've always said, platinum at times acts as a precious metal and at times acts as an industrial metal. And right now, it's acting as an industrial metal, whereas gold is truly acting as a store of wealth.
TWST: What could change that picture other than unexpected economic stability?
Mr. Preston: Global growth. Somebody waving the magic wand and all of the global economic woes are resolved. Then you would think, as we move out of this period of instability economically, the desire to hold a percentage of your wealth in gold will reduce and on the margin that you would think would be negative for the gold price.
TWST: Given where we are, some may say that seems to be wishful thinking.
Mr. Preston: Well, I think it isn't all about the time frame. So in the very short term, I would agree with you. It seems to me coming back to where we started, there are more positives around the gold price at this point than there are negatives.
TWST: We've seen lots of new investors in gold, like hedge funds. Is that going to become increasingly important?
Mr. Preston: Well, I think, at the end of the day, hedge funds - like any other money manager - are looking for returns and looking for preservation of the funds that they have under management. If you truly believe that we could be entering a period of changing economic circumstances and perhaps the debasement of currencies and inflation could start to become an issue globally, well then, yes, you would want to have some exposure to gold.
TWST: As you look at this market, is the best behind us or is there still a lot more to go?
Mr. Preston: The gold bulls would say the best is still to come, and the bears would be that we've already seen the best. I think we would probably sit in the camp of saying we would see further upside in the gold price until such time as you start to see real interest rates in the U.S. turning. Now everybody would have a view as to when that really takes - that change takes place. I think that's a very, very difficult question to try and put a timeline on. I think, right now, there are more positives than negatives, an improving U.S. economic environment, and then you can come back and say how dependent is that on the rest of the world that to my mind would be a point when you would start to see U.S. interest rate starting to pick up. I think that would be a signal that perhaps the best might be over for gold, but I don't think we're anyway near that yet.
TWST: Yes, that seems to be "never-never land" at this point. With gold prices at these levels and if we see them kind of hang around these levels, are we going to see continued M&A activity in this space?
Mr. Preston: Yes, I think, inevitably. But probably more in the midcap and the juniors than necessarily for the majors. I think acquisitions by the majors will be of individual projects rather than necessarily wanting to get current productions, so it would be to replace the ore bodies that are going to be coming to close over the next five to 10 years rather than trying to bolster very near-term production. I think most of the majors at this stage would be quite comfortable with their current production profiles and all of them have some reasonable volume growth over the next five years. So they would be in my view probably looking more to what are they bringing from years five to 10 rather than years one to five. Whereas I think for the juniors, they are all trying to get to a sufficient scale that they actually become investible and the liquidity in shares is sufficiently high to be able to attract some of the funds and almost by definition they have much, much stronger near-term growth. If you're just ramping up your first mine and that comes into production and then you can get a second one that's starting in a couple of years, your volume growth is going to be much, much more substantial than a big diversified player. The risk is also much, much higher.
TWST: Despite the high profile gold has, is the industry size modest from a stock market point of view?
Mr. Preston: Absolutely. The observation there is, if you didn't have a gold ETF, if you had the funds that have flowed into ETFs, if they had flowed into gold equities, what would've been the share price reaction? Or alternatively, would you've had the same flow of funds given the lower liquidity that you have in gold equities relative to their overall market? I mean, the ETF has provided an outlet for substantial flows of funds.
TWST: Some numbers seem to suggest ETFs are larger than the gold equity side now.
Mr. Preston: I don't think that would be true in terms of total value, but there are certainly substantially - I mean, if you say gold ETFs are bigger than any individual gold equity, I think that might be true. I'd have to check the numbers on that.
TWST: But certainly they've become a significant force in here.
Mr. Preston: Absolutely.
TWST: We touched earlier a little bit on the supply side. What's coming out of mines? What's coming out of recycling at this point? Is it vastly different than a couple of years ago?
Mr. Preston: Well, I think we've come back to a point where there's some small volume growth in new mine production as I think we had sort of 2.5% growth in new mine production in 2010 over 2009. That's been the first time for a very long time that we've really had much growth. I think recycling is really a function of price to some extent. It's been quite remarkable that you've not had as much recycling out of India this year as you've had in the past, but it's an important part of that supply. I think inevitably if high gold prices in local currency terms, with exploration success, will lead over time to some increase in production, but there's always quite a long lead time and there's no guarantee of success from exploration.
TWST: With the gold price performing as well as it has, as you talk to investors, is there still an interest level in this space?
Mr. Preston: Absolutely. No question. I think increasingly starting to go across from gold funds per se but into generalist funds as well, into hedge funds as you mentioned earlier. There's no question that there is renewed interest in gold compared to what there was five years ago.
TWST: Is that likely to continue?
Mr. Preston: I think so. I mean, as long as the gold price is continuing to perform relatively well compared to other commodities or other investment opportunities, yes, I think it will continue to attract interest. I think we've been 10 years in a gold bull run now.
TWST: That is a long time.
Mr. Preston: It's a long time, and it certainly shows no signs of stopping in the near term. Nothing just keeps going up in a straight line. So we must always expect that there's going to be corrections, but very broadly, all participants in this market have taken a positive view on gold over a long period of time. I think until we get a changing global economic environment, that's likely to continue.
TWST: Given that, where are you pointing investors? What should they be looking at?
Mr. Preston: I think it always comes back in my mind to what the investors' own investment framework is, what's their tolerance for risk. I mean clearly multimine majors provide lower levels of operational risk compared to say, a pure-play junior. The junior clearly will offer much greater growth in earnings just given the nature that he's starting with a relatively a new producer. Starting production and coming to full capacity, he's obviously got a much stronger growth profile than an established major. However, I think as the global majors have lifted the returns that they are providing to investors in the form of a dividend - although none of them have done buybacks - I think there's a place for both.
But it really comes down, I think, to the individual investors' tolerance around risk. What's their risk/reward framework like? I mean if you're simply investing for wealth preservation, I think there's a strong argument to look at an ETF. If you want more than that, I think a gold equity provides it. Of the gold majors that are all looking at circa 25%-plus growth over the next five years in terms of volume, that's quite substantial. Doesn't all happen in one year, but if you continually are delivering operationally so you are not disappointing the market and you've got volume growth and you're increasing the return that you're making to shareholders, I think you will see people continuing to look at that as an investment opportunity, just as you will have the investor who has got a much higher risk tolerance looking at the exploration play, makes a discovery. The return is phenomenal, but so is the risk.
TWST: Who would be kind of at the top of your list among the majors at this point?
Mr. Preston: We only cover Australian-listed gold equities, but in a global sense I mean, Newcrest (NCM.AX) has good, if not better, growth than the other global majors and has very long life, low-cost operations, will reduce the gold cash cost of its operations over the next five to 10 years as they produce a larger percentage of copper, which is a byproduct from some of their gold mines. So they are very well placed as are Goldcorp (GG), Newmont, Barrick (ABX). They all have good growth, but Newcrest certainly has every bit as good a growth, if not better, on a longer-term basis than the other global majors.
TWST: How about on local names that you like?
Mr. Preston: The smaller part of our market, there are a number of really good companies in terms of growth. The one which is listed in North America and listed in Australia - Alacer (ASR.TO) as we would pronounce it - has, they're involved in the development of a new mine in Turkey, so lot of exploration potential. The mine is just coming into production, but they've got a stable production base in Western Australia. They look very attractive relative to their global peer group. The more junior companies who are growing volumes in Australia, they all have good volume growth, obviously higher risk. So companies like Kingsgate (KCN.AX), St. Barbara (SBM.AX), Teranga (TGZ.TO) in Senegal, Perseus (PRU.AX) in Ghana - I mean, they all have very good growth profiles. I mean, I think when you're trying to say which is the best of them, it really depends on individual investors' risk/reward tolerance and what are they really trying to find in that investment.
TWST: A couple of those are developing areas, which seem to have reasonable political risk. Is that something the companies are having to accept to find new production?
Mr. Preston: I think, at the end of the day, you know, for any kind of mining company you have to go where the ore body is. I think, it would be fair to say that, the Pacific Rim, where we operate from in Australia, that is a prolific area for mining. Not just gold - so Indonesia, Papua New Guinea, the Philippines - I mean, that's all highly prospective, and there are a lot of very large mining projects in that part of the world, and that seems to me that that's a different political risk, let's say, than Australia. Within Australia or Queensland, or there is different risks, even within Australia between the different states. But I think it would be fair to say that globally around mining there is an increased desire by governments to have a bigger part of the pie, and that's whether you're talking about Africa or you're talking about South America or you're talking about Australia, globally governments are desirous of having a bigger part of whatever pie is available.
TWST: Thank you. (TJM)
Note: Opinions and recommendations are as of 11/02/11.
Ian M. Preston
200 West St.
New York, NY 10282