Analysis: Gold equities set to lag as yellow metal surges

By Atul Prakash

LONDON (BestGrowthStock) – The underperformance of gold mining shares against the price of bullion this year will be underlined in coming quarters as a spike in the yellow metal is largely discounted and the equities look expensive.

A falling dollar on signs of U.S. monetary easing is bullish not just for gold, but also for oils, a key component of the mining cost.

Analysts said that firm energy prices and a stronger local currency would crimp a rise in miners’ profit margins, though companies with ambitious expansion programmes and smaller miners could still be attractive picks.

Overall, since the last quarter of 2009, shares in gold miners (.XAU: ) have underperformed, and though they outdid bullion last quarter, analysts say underperformance will resume and last for more than six months amid a further rise in gold.

Gold hit a record high of $1,387.10 an ounce on Thursday. World No. 1 gold miner Barrick (ABX.TO: ) predicts the price will cross $1,500 in 2011, while a poll of delegates attending the London Bullion Market Association’s conference last month pegged gold at $1,450 by next September.

“Higher gold prices doesn’t always mean higher margins. It means higher revenues potentially, but you have to be concerned about management competence, operational cost efficiency and underlying inflation, amongst other things,” said Charles Cooper, mining analyst at Oriel Securities.

“We are also starting to see that in some emerging economies, a higher level of inflation is creeping back into the industry and that could limit the upside in profit margins.”

Analysts say that uncertainties over the global economic outlook and expectations of a weaker dollar, which makes gold cheaper for other currency holders and thus raises demand for the metal, should continue to support bullion, generally seen as a safe haven investment.

“But a weaker dollar also means potentially stronger Australian dollar, South African rand etc. which mitigate some of the performance on the cost side of the equation,” said Charles Kernot, gold analyst at Evolution Securities.

EXPENSIVE

Gold equities also look expensive to some other sectors, with the gold/silver index (.XAU: ) of top miners trading at 20 times its one-year forward earnings, against 9.7 times for the European healthcare sector (.SXDP: ), 10 times for the telecom sector (.SXKP: ) and 10.9 times for basic resources (.SXPP: ).

But analysts said that there are several interesting companies in the gold mining sector, with good quality ore reserves and impressive growth potential, and a carefully selected portfolio could yield strong returns.

“If you invest in gold equities, you are taking a lot of other risks through which you may be rewarded,” said Tom Gidley-Kitchin, analyst at Charles Stanley.

By investing in mining shares, investors also take a certain exposure to a particular country’s exchange rate, political risk, mining taxes and the management’s ability to deal with situations such as strikes, analysts said.

“Operational challenges for miners are always quite high, but you can still find some value in gold mining shares,” said Richard Greenwood, fund manager at Bedlam Asset Management.

Production costs differ from country to country and miners with lower costs and rich ore reserves are best placed to reap the benefit of rising gold prices.

The global average to mine one ounce of gold is about $600 an ounce, but in countries like South Africa, costs of some miners are $900 to $1,000 an ounce and they face operational challenges in terms of deep mines and low quality reserves, analysts said.

“Diversification is one way to protect against your risk,” Greenwood said, adding investors should look for gold companies with impressive volume growth potential.

Analysts picked Randgold Resources (RRS.L: ) and Petropavlovsk (POG.L: ) as examples of good gold mining companies to buy because of their aggressive programmes to substantially increase production over the coming years.

Investment firm Altus Resource Capital said valuations of selected smaller cap gold shares were not reflecting the increased price of gold and the gap between gold and small cap gold mining companies was sill wide.

“While we see some volatility ahead, there is further upside in gold producers and developers in the junior resources sector,” said Steve Poulton, co-investment manager at Altus.

(Editing by Sitaraman Shankar)

Analysis: Gold equities set to lag as yellow metal surges