“Diamonds are a girl’s best friend,” sang Marilyn Monroe in the 1953 film Gentlemen Prefer Blondes. And who, regardless of gender, wouldn’t want to own the renowned Pink Star diamond? This stunning 59.6-carat (the industry’s diamond weight measurement unit: one carat equals 200 milligrams) gemstone sold at auction in 2017 for $71m, the highest price ever paid for a jewel. However, stockmarket-listed diamond shares could also be a great friends for investors. To understand why, let’s start at the beginning.
Diamonds began to form in the ground around three billion years ago and are the hardest natural material known to man. They are highly effective at conducting heat, and expand only slightly in high temperatures. They’re also resistant to most acids and alkali.
Around two-thirds of diamonds come from Africa, with Angola and Botswana the top suppliers. But the largest individual producer is Russia – a fact that has assumed more significance for the supply outlook since its invasion of Ukraine, as the US has imposed sanctions on Alrosa, the state-owned diamond company. Open-pit mining – digging out diamonds on the earth’s surface – accounts for most of the industry’s output. Much of the rest is derived from mining underground to a depth of at least one kilometre. Ore containing rough diamonds is then crushed and processed to enable extraction. Alluvial mining of deposits of sand, gravel and clay along river banks, shorelines or the ocean bed can also produce diamonds.
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Rough, or raw, diamonds vary in size, shape and quality. About 30% of diamonds are gem quality, and are cut and polished for jewellery manufacture. The other 70% are sold for industrial applications, including cutting, drilling and grinding. In total, global rough diamond output is worth $13bn a year and the industry that employs about ten million people from mining to retail, says the World Diamond Council, an industry group. Annual diamond jewellery sales have trebled within the last 25 years. Include the cost of precious metals and other gems, and this has become a $72bn market, of which the US accounts for half, followed by Japan (15%), Italy (5%), India (3%) and China (2%).
Tackling the stain of blood diamonds
Not only are diamonds big business, their economic contribution can be substantial, especially in Africa. For example, diamond mining represents a third of Botswana’s GDP. It makes a pivotal contribution to that country’s healthcare and education funding. Yet the industry also has a dark side. “Blood” (also known as “conflict”) diamonds are mined in war zones and sold to finance military activities, as depicted in the 2006 film Blood Diamond, which was set during civil war in Sierra Leone in the 1990s.
This came to present a major reputational risk for the diamond industry. After the Sierra Leone war, the industry set up the United Nations-backed Kimberley Process Certification Scheme, which is intended to verify the origin of rough diamonds and stop conflict diamonds entering the supply chain. Each diamond receives a certificate verifying that it comes from legitimate sources. The industry says this has led to a substantial drop in sales of conflict diamonds and associated crimes, although some human rights organisations say that it does not go far enough in preventing human-rights abuses and financial crimes.
Alternatives to mined diamonds are the other obvious potential risk. Historically, the cheaper substitute to natural diamonds were “simulants” – substances such as cubic zirconia (CZ), which is manufactured from zirconium dioxide and which has been commercially produced for the jewellery market since 1976. Nobody worried much about these. “Although popular in its own right, CZ is easy to recognize as a diamond simulant,” says diamond marketplace RapNet, “because it is more brilliant and sparkly than a real diamond and has no tint or inclusions [small imperfections in the structure].”
However, “synthetic” or “laboratory-grown” gems are a different proposition. These are composed of the same materials and share identical chemical and physical properties. Two main techniques – high-pressure high temperature (HPHT) and chemical vapour deposition (CVD) – were developed in the 1950s, although it took until the 1970s for them to produce gem-quality stones and only within the past decade have these become cost-competitive with natural diamonds. The synthetic diamond market was worth $14bn in 2021, according to Data Bridge Market Research. It’s expected to grow by 7.5% a year to 2029, by which time its value would exceed $25bn. Much of this is for industrial purposes, but lab-grown diamonds are increasingly used in jewellery as well – and the best ones can only be distinguished from natural diamonds with specialised equipment.
Lab-grown diamonds now account for roughly 5%-10% of jewellery diamond sales, according to estimates by industry analysts, and are used by mass-market jewellers such as Pandora and Signet. This could pose a threat to demand for natural diamonds, so the mining industry is pushing back by positioning its product as rare and unique, in contrast to mass-produced, potentially unlimited supplies of lab-grown diamonds.
The fact that diamonds already come certified, and that certification specifies whether they are mined or lab-grown, should make this possible.
The post-Covid bounce will endure
The compound price return for top-quality diamonds from 1960 to 2019, measured in US dollars, was around 4.3%, according to Ajediam (the Antwerp Jewels & Diamond Manufacturers group). Granted, that’s not a spectacular performance as US consumer-price inflation was averaging 3.7% over this period. However, at least it’s been on the right side of the ledger – and in any case, we are not looking for opportunities to buy and hold diamonds themselves, but rather in diamond miners that may be underpriced.
Diamond prices initially dropped in the pandemic, but recovered well from their mid-2020 lows and the outlook remains auspicious. Now the supply/demand balance for gemstones could lead to average prices for natural diamonds climbing by up by 15% in 2022, according to analysis released last month by Bank of America. “[There] is a lack of substitutes for luxury spend amongst consumers, with tourism unlikely to rebound to pre-Covid levels amid ongoing travel restrictions,” says the report. So “demand will remain buoyant” with diamond sales forecast to grow by 10% this year. Strength in Asia and the US is expected to more than compensate for weakness in China.
However, the real kicker is that global diamond production is at its lowest since the 2008 financial crisis. Overall supply will stay flat over the next few years, as no major new projects will open up, reckons Bank of America. Despite possible output rises in Angola and Botswana, production drops are expected in South Africa and Canada, while sanctions on Russia could hit supply further. The bank anticipates shortages in small diamonds, given the rebound in the watch industry.
Meanwhile, diamond-exploration budgets have been reduced. “A diamond project now takes between ten and 15 years from exploration to first production, largely due to the need to deliver projects in an ESG [environmental, social and governance]-friendly manner.” The corollary of less exploration is a smaller increase in supply over the next decade.
Of course, a recession could cause near-term damage to demand. But the longer-term outlook for the sector is looking increasingly bullish. Below we recommend an overlooked stock that will benefit from rising diamond prices.
Petra Diamonds could prove a major moneymaker
Petra Diamonds (LSE: PDL) is a London-listed independent diamond miner. It holds 74% stakes in four production operations (three underground kimberlite mines in South Africa and a large high-volume opencast kimberlite mine in Tanzania).
These sites include the Cullinan Mine in South Africa, which was the source – in 1905 – of the world-famous Cullinan diamond. At 3,106 carats, this was the largest rough gem diamond ever found. It was cut to form the two most important gemstones in the UK’s Crown Jewels. As at 30 June 2021, Cullinan’s gross resource was 150 million carats, meaning that its life could be much longer than the current target of 2030.
Last year Petra undertook a restructuring which, along with the sale of several exceptional blue and white diamonds from Cullinan, cut net debt by around two-thirds to $228m (despite its London listing, the group reports in US dollars). The Tanzanian operation (Williamson) was temporarily closed owing to Covid-19. Meanwhile, Petra is planning to sell one of its South African sites (Koffiefontein) and has received expressions of interest from several interested parties. If a buyer is not found, the group will continue to operate the mine before starting a decommissioning and closure programme. In total, Petra’s resource base is 230 million carats.
In its trading update last month, Petra says that it “continued to deliver safe, robust operating performance into the fourth quarter… total revenue increased to $585m [amid] supportive diamond market fundamentals and a 41.5% increase in like-for-like diamond prices year-on-year... Strong free cash flow generated in [the
year to the end of June 2022]… has delivered an 82% reduction in consolidated net debt to $40.6m.”
The board is unfazed by inflation. It reckons that “relatively low fuel consumption, disciplined cost management, three-year labour agreements to June 2024 and exposure to a weaker South African rand will assist us in better absorbing these cost pressures.”
Petra is confident enough to provide forward guidance for its potential production on a mine-by-mine basis until 2025. Although there may be some volatility in the short to medium term, the company says that “structural changes to the supply and demand fundamentals in the diamond market remain unchanged”, and it expects more of the same in the future.
Petra’s market value is £196m. By contrast, sterling-equivalent sales for the year to 30 June 2022 were around £480m. On a price-to-earnings (p/e) ratio of just over six for the year to 30 June 2023, according to analysts’ forecasts compiled by the Financial Times, this little-known stock looks cheap. Against the backdrop of a fast-improving diamond market, it could prove to be a major moneymaker.
David J. Stevenson has a long history of investment analysis, becoming a UK fund manager for Oppenheimer UK back in 1983.
Switching his focus across the English Channel in 1986, he managed European funds over many years for Hill Samuel, Cigna UK and Lloyds Bank subsidiary IAI International.
Sandwiched within those roles was a three-year spell as Head of Research at stockbroker BNP Securities.
David became Associate Editor of MoneyWeek in 2008. In 2012, he took over the reins at The Fleet Street Letter, the UK’s longest-running investment bulletin. And in 2015 he became Investment Director of the Strategic Intelligence UK newsletter.
Eschewing retirement prospects, he once again contributes regularly to MoneyWeek.
Having lived through several stock market booms and busts, David is always alert for financial markets’ capacity to spring ‘surprises’.
Investment style-wise, he prefers value stocks to growth companies and is a confirmed contrarian thinker.
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