“Things can go from the impossible to the probable, without stopping at the possible”. It’s a quote we use here at Morphic quite often, as it’s remarkable to see how the human brain adapts to the cognitive dissonance of finding out it was wrong – it rationalises after the fact that it always thought it was going to happen, otherwise people would walk around depressed each day. A recent example for Australian investors would be Qantas. A team member can remember chatting to other industry participants as recently as October of last year and being told categorically why Qantas was not going to go up, despite mounting evidence that the competitive environment was improving and oil was falling. Now, having tripled, it’s accepted that this was “obvious” (alas the debarkation was painfully early for Morphic in hindsight, with us committing our own mental sin – selling winners too early)
We write this, because Gold is a topic we have devoted little attention to since we launched in 2012. We’ve really been neither long nor short in any size– the general opinion at Morphic being that with an US recovery underway and cheap stocks relative to other asset classes, equities were likely to be a better investment, as was the US Dollar itself. Both of these have largely played out and may have more room to run.
But what is remarkable to us, is just how the view that gold was a “must have” asset class has now disappeared, without much discussion as is usual for these changes. A quick check on Google Trends shows this.
Searches for “Gold ETF” peaked in 2011/12 after coming from very low levels in 2005. This mirrored the move in the gold price up from $400 to $1700 over that time, peaking in the period highlighted in green with the search terms. Gold has now falled 35% since that point, with probably only the diehard gold bugs and those who refuse to accept a loss in their investment (another mental failing investors suffer from – holding losers) still in there.
Chart 1: Gold Price in USD 2004-2015
Having said that, the purpose of this blog isn’t to focus on why gold has gone down or up, or even where it is going to go this year. Rather we point out: a) a lot of the speculative froth has been washed out of the sector; and b) some “babies have been thrown out with the bathwater”. In particular, one of the peculiarities of the gold sector is that stocks globally trade off the USD gold price, yet their revenue line and cost bases are local currency based. So if we covert the gold price to AUD, we see a different picture - prices received are down, yes, but about 15% lower than their peak. This compares rather favourably to Iron Ore (down 60% from its peak in AUD) or Oil (down 40%). Chart 3 is from UBS shows the strong correlation of Australian gold miners to the USD price
Chart 2: Gold Price in AUD 2004-2015
Chart 3: Correlation between Australian gold miners and gold price in USD
So when we put the gold price moves in Australian dollars alongside the stock price (here we are going to focus on our preferred play -Evolution Mining), you can see how the stocks got sold down substantially more than the revenue line of their business. As a result most of the handful of surviving Australian gold miners look very cheap, even if you assume that the US dollar gold price does not go up much.
Chart 4: Gold Price and Evolution Mining, normalised, since 2010
And for gold miners there is a silver lining to the fall in the iron ore price. Costs are falling for gold miners as they have had to compete with iron ore and coal producers in WA and Qld respectively for labour and services, and in both these cases their costs of production are going to fall, along with lower oil prices leading to cheaper fuel costs on site. As a result many companies are generating a great deal of free cash, even after funding exploration and development to maintain or even increase resources for future mining.
Our favourite is Evolution Mining which produces gold from six different operations and is trading at just seven times consensus earnings for June 2016, even after a 20% plus rally in recent weeks. This week UBS initiated coverage with a bullish, but to us not unreasonable call that the company will earn nearly 24 cents a share in 2016, which would put Evolution on a P/E of less than five times.
We especially like Evolution because of the quality of its management – not something you can say about most gold mining companies, where the record of value destroying investment decisions is sadly legend. Evolution Chairman, Jake Klein, has built and sold a mining company in the interests of shareholders before - Sino Gold - and has shown great discipline in not over-paying as he builds up Evolution.
However, the stock has run hard in the last few weeks, far more swiftly than we expected, so we would be looking to add to our existing position on any significant pullback. Our expectation is also that there will be another wave of consolidation in the Australian gold mining sector, including exploration minnows, and possibly including more corporate activity from mid-cap Canadian gold miners which trade at considerably higher multiples, as the industry globally is forced to move from a frothy sector in mania mode to one focused on returns to shareholders.
And that’s one of things about investing – sometimes your next winner doesn’t need the obvious to change (in a paradox, high gold prices led to very little value creation for gold equities owners as costs soared on the back of competition for resources), rather benign neglect can present opportunities.