Gold shares are undervalued

From a historical perspective, the 14% drop in the price of bullion in September is not unusual, Markova argues. “It’s not as dramatic as previous pullbacks, when we see it in percentage terms,” she says, noting that in 1983, there was a decline of about 20%.

“I view this as a short-term correction, driven partly by profit-taking,” says Markova, who shares duties with Bob Lyon, senior vice president with AGF. “To me, this is a buying opportunity. Even [with billion prices] at US$1,600-US$1,700 an ounce, gold stocks are very inexpensive. This is the sweet spot for the equities, which the market is slowly starting to embrace. It is still a long-term bull trend.”

The price of gold bullion could move higher than US$2,000 an ounce, although Markova admits that it’s hard to be precise about the timing. However, based on the fact that the previous historical peak was about US$2,500, on an inflation-adjusted level, Markova says, “It’s very realistic that we test that level again — and go beyond it. It will depend on what [monetary and fiscal] policies are put in place. This is the wild card that could push us to levels we’ve never seen before.”

“Growth at a reasonable price” investors, Markova and Lyon are a running a fund with more than 100 names. Ten per cent of the AGF fund’s asset under management is in gold and silver bullion, and 13.5% is in large-cap firms such as Goldcorp Inc. The remaining 76.5% is in a mix of mid-tier and small-cap firms that have the potential to become much larger.

One small-cap holding is B2Gold Corp., which has projects in Nicaragua, Colombia and Uruguay. The last, the Cebollati project, has the most promise, says Markova: “The management team has proven that they are very good explorers and can find good-quality gold ounces. They’re onto something big in Uruguay.” Bought in 2007, B2Gold’s stock is trading at about $4 a share, although Markova believes it could reach $5-$6 in two years.

Another favourite is Belo Sun Mining Corp. In 2009, Markova notes, the firm had a management change and began getting good exploration results from the Volta Grande project in Brazil. The stock is trading at about $1.15 a share. Markova’s target is $2-$3 within two or three years.

 

Charles Oliver, senior portfolio manager with Sprott Asset Management LP in Toronto and co-manager of Sprott Gold and Precious Minerals Fund, also points to the valuation gap between bullion and gold stocks: “Stocks have not performed well over the past four years. Look at Barrick Gold Corp.: its stock is very close to where it was in 2007, and yet its earnings have more than tripled; its margin per ounce has gone to US$900 an ounce from US$200. It’s quite a conundrum. Oliver notes that gold-mining companies’ valuations are in the single digits, in stark contrast with valuations in 2000-01, when they were 50 times earnings.

This valuation gap can be attributed to a couple of factors, says Oliver.

First, he points to the rapid growth of exchange-traded funds that allow investors to buy bullion directly. “With stocks trading at high multiples, a lot of individuals thought it was more prudent to buy bullion,” he continues. “But in selling [their] stocks, that depressed the price of gold shares. It’s overshot a little too far on the downside of stocks. In my opinion, they represent some of the best opportunities I’ve seen this decade.”

In addition, Oliver points to investors’ skepticism of high gold prices. “They are not willing to pay gold companies for valuations that have gone too far,” he says. “In a number of reports, analysts are using an average gold price forecast of about US$1,100 an ounce in 2014-15. But if you actually buy a forward contract in the same time frame, you could transact [bullion] at US$1,900. There is a huge variation in what analysts are projecting for earnings and cash flow.”

Oliver believes bullion could reach US$2,000 in the spring of 2012: “Gold is going a lot higher than where it is today. I don’t know how high; but if you asked me if it could hit US$5,000, I’d say it’s quite feasible. Ultimately, what will decide that is when governments of the world start to live within their means and stop debasing their currencies and printing money.”

Oliver and fund co-manager Jamie Horvat run a portfolio with about 150 names, split roughly equally among large-caps, mid-tier companies and small-caps.

One representative mid-tier company in the Sprott fund’s portfolio is Osisko Mining Corp., developer of the Canadian Malartic mine in Quebec. “In a very short time,” says Oliver, “[Osisko has] done a spectacular job of moving it forward and has opened Canada’s largest new gold mine.” Osisko stock is trading at about $14 a share, or at a price/earnings multiple of 11.4. Oliver has no stated target.

Another favourite is Barrick, the world’s largest gold producer, at about seven million ounces a year. “Normally, I don’t like the large-caps. But today, I look at them and say, ‘Wow, are they ever cheap!'” says Oliver, noting that Barrick’s forward P/E ratio is around 8.5 times. “They are very underbought.” The stock is trading at about $48.50 a share.

The valuation discrepancy between bullion and gold stocks can be attributed to several factors, argues Ari Levy, vice president of TD Asset Management Inc. in Toronto and manager of TD Precious Metals Fund.

“One of the top concerns was cost inflation,” says Levy, adding that investors became skeptical about gold producers’ ability to control costs. “But they didn’t realize that as inflation grew, the commodity rose even faster and was more than enough to compensate. And companies were taking steps to contain cost increases.”

Another concern was how quickly the bullion price moved within a fairly short time, rising to $1,920 an ounce in September from about US$1,400 in January. “[Investors] weren’t willing to factor in a higher gold price because they thought it was a short-term move,” says Levy. “Today, stocks are trading at fairly inexpensive valuations, with many at less than 10 times earnings. Companies have implemented cost containment, and their margins are growing very nicely.”

Meanwhile, Levy notes, the traditional inverse relationship between the U.S. dollar and gold bullion came under pressure this summer, mainly because of the European sovereign-debt crisis: “People looked at the US$ as a safe haven, and that had an impact on the gold price, too.”

And yet, the supply/demand relationship remains intact, argues Levy, who notes that central banks have been buying bullion again (rather than selling it), and retail buyers in China and India have continued to account for significant growth in bullion’s market share. “Overall, the fundamentals still support a higher price for the commodity,” says Levy. “It takes time for the market to believe it, though. “

A bottom-up growth investor with about 150 names in the TD fund’s portfolio, Levy has a bias toward large-cap names such as Goldcorp, a senior producer with about two million ounces in annual production. About one-third of its output comes from the Red Lake mine in Ontario, with the rest from mines in Mexico, Guatemala and Argentina.

But Goldcorp’s growth potential is what Levy finds attractive: “If you can find new zones in existing operations where the incremental capital cost is much less than a ‘greenfield’ [undeveloped] operation, that’s where you get the most leverage. Goldcorp fits that description.” The stock is trading at about $47 a share, or about 14 times 2012 earnings. Levy has no stated target.

Another top holding is Kinross Gold Corp., which has grown rapidly through acquisition, purchasing mines in Russia, Chile and West Africa. It produces about 2.6 million ounces annually, although Levy expects that to rise to about 4.5 million to 4.9 million ounces by 2015, mainly because of a new mine in Mauretania that has proven resources of about 20 million ounces. The stock is trading at about $15.40 a share, around 11.5 times forward earnings.

Says Levy: “The stock has a lot of upside.”  IE