Gordon Barratt: Market Watch, March 2013
Last month’s note aired my frustration about momentum and herd mentality dictating market terms, rather than cold hard facts. Hence, being able to advise, or predict, the direction of resource equities is at best difficult; at worst a mug’s game.
This week I’m going to take a “devil’s advocate” view and drill down to determine if markets might be, at least somewhat, justified in their present negative view of the resource sector.
Many investors will be able to empathise with the frustration that the vast majority of gold company share prices have not tracked the strong performance of the underlying physical gold price. In fact, every time the gold price hits what should be construed as bonanza levels, in the mid US$1,700 per ounce, gold stocks seem to sell-off in what could only be construed as anticipation that the gold price will fall from those heady levels.
Why is this?
A close-up look at the sector reveals that, by and large, gold producers’ profits and the gold price have little correlation. This has been a function of the sector for quite some time. It seems that, for most, the rising gold price has been negatively offset by poor operational performance, rising costs and/or poor productivity. Investors seem to be “browned off” by the situation that the companies they have been investing in should be swimming in profits. However, year in year out, seemingly decent projects turn in losses.
With the advent of various derivatives products that give the average punter the ability to invest directly in the physical, there is no need to try to pick your way through the equities mine field in order to gain exposure to the sector. This has resulted in a complete lack of support for the sector leading to the bulk of listed gold companies trading at historically low valuations, on a number of different measures, such as capitalisation per ounce.
If this persists, which is likely if the sector can’t show a return for shareholders, a number of scenarios are likely to emerge including:
- Increased M&A activity as the stronger companies take advantage of the ability to add ounces through acquisition at much cheaper rates than through exploration; and
- The sector becomes capital starved as investors resistance to supporting poor performance become endemic. This will lead to two issues, an exploration drought and fewer mines being developed through lack of funding. Ultimately this will lead to a number of other scenarios for the sector. The sector will become more concentrated, with fewer opportunities to back grass roots or developing plays. Fewer new mines will be developed, which, on the basis that demand remains strong, will provide underlying support for the price of the physical.
The gold sector isn’t the only sector guilty of this scenario. The price performance of BHP and RIO, while ridiculously low, and I’m sure represents outstanding long term buying at these levels, is telling us that shareholders are sick to death of being ignored by companies. What appears to be a habitual propensity to destroy shareholder wealth by investing in value destroying businesses, and a steadfast refusal to pay shareholders a decent dividend return as a reward for investing in higher risk investments, has been weighing heavily on the market.
It’s now time for the industry to step up and listen to what the share prices are telling them. The market needs to see evidence that they are tackling costs and productivity and they need to be able to see that if companies chose to reinvest “their” money that they get an acceptable return on those funds employed.
Fortunately we are seeing evidence of this through the appointment of more operationally focused MD’s at Rio and BHP. We are currently hearing of mines closures and cost cutting initiatives in order to increase returns. I do believe were on the cusp of a new dawn in the sector. However I’m hoping that commodity prices will hold so that long suffering shareholders might be rewarded for their patience.
Gordon Barratt is an authorised Representative and financial adviser with RBS Morgans. He is not a Director or Employee, of Market Cap and does not receive any fees or remuneration from the company. Any comments that are made are General Advice purposes only and do not take into account any persons personal circumstances. Any views expressed by the author do not necessarily represent the views of RBS Morgans
20 March 2013