A gold mine, according to Mark Twain, “is a hole in the ground with a liar on top”. The history of gold mining is so littered with stories of reckless optimism, fraud and ruin that the sector is often ignored. Yet investing in gold miners can be hugely profitable when gold prices are rising.
Real gold bugs, misers and the end-of-the-world crowd are invariably sniffy. Gold miners are stockmarket investments, vulnerable to market sentiment, economic factors and operational uncertainties. For real security and diversification, say the purists, nothing beats the shiny metal. The life of a gold mine is finite, but physical gold has retained its purchasing power for thousands of years.
Gold miners: a consolidating sector
George Cheveley, the manager of Investec’s Global Gold Fund, puts the case for investment in gold mining stocks in less emotional terms. He argues that economic factors underpin a rising price for gold, while mining companies are focused on improving returns. “Even at flat gold prices,” he says, “companies are generating good free cash flow; further consolidation in the sector is likely; and companies are being very careful about capital spending after the excesses of recent years. With less financial leverage, the volatility of equities as a whole has halved in the past three years.”
Cheveley has built up a solid record, lagging competitors and the benchmark gold miners index in the boom year of 2016, but performing much better in the difficult conditions of 2018. The annualised three-year return is 17.5%, with five-year returns at only 2.6%, though those numbers are a steadier 7.9% and 5.1% in sterling.
The volatility of dollar performance largely reflects the gold price, which reached a record $1,890 an ounce in 2011, but fell to $1,100 in 2015. Recoveries to $1,350 in 2016 and again in 2018 were not sustained, but subsequent corrections were modest, and the price is currently hovering around $1,300. Cheveley expects the price to go higher in an environment of low-to-negative real interest rates and dollar weakness.
Gold: virtually indestructible
Annual mined supply of gold is about 3,000 tons, but this is dwarfed by the 190,000 tons that the World Gold Council estimates has been mined throughout history, two thirds of it since 1950. Since gold is virtually indestructible, nearly all the gold mined is still around. Mined supply, which accounts for about 70% of total supply, is augmented by scrappage, while demand comes from jewellery, central-bank purchases and the technology sector as well as from investors. The supply and demand picture is complicated, but a rising price generally encourages demand.
This in turn should have a disproportionate effect on the profitability of gold miners and hence their share prices. The historic rule of thumb was that the return from the mining sector was three times that of the gold price, but this is too simplistic. The rising cost of exploration has made the replacement of mined output expensive, and ore grades are falling, meaning that more rock has to be blasted for the same gold content.
In addition, gold miners are subject to the same cost pressures on labour, equipment and fuel costs as the rest of the mining sector, and it is easy for management to fritter away the advantages of higher prices on over-ambitious expansion. Hence the importance of investing in a diverse fund with moderate operating costs, good ore grades and ample reserves.
The ratio of the gold price to the total-return index for ten-year US government bonds is moving steadily higher, pointing to a shift to an era of structural inflation, says Charles Gave of research house Gavekal. Sooner or later, he will surely be right, making gold an attractive store of value – and gold mining stocks a good investment.