Still Bullish on Gold

Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There has been a lot of bearish sentiment around gold recently. Citigroup analysts reported the metal may have hit its cycle peak and the SPDR Gold Shares ETF (NYSEMKT: GLD) was down around 14% from its 52-week high.

The pessimism is understandable. After a high of around $1900 an ounce in 2011, the gold price has fallen back and been slammed vigorously each time it’s tried to return. Yet, I'm still bullish on gold. My confidence rests mostly on the unprecedented easy money policy instituted around the world.

After decades of tepid growth, Japan threw in the towel and proclaimed that they would take aggressive steps to re-ignite inflation and boost the economy. This move indicates that just about every major economic power in the world is printing money and weakening its currency to jump start growth.

The thought is that gold is a barometer for the value of currencies. As more currency is created the relative value of that currency goes down and the value of gold goes up. The introduction of aggressive quantitative easing by all major central banks, an action that essentially floods the economic system with liquidity, should materially increase the value of gold if this theory is correct.

While feeling comfortable with this theoretical basis for being long gold, my strategic implementation has been far from successful.

Never quantitatively sure when the precious metal itself was undervalued, I've always favored investing in the gold miners where I could rely on basic discounted cash flow methods to value the business. Unfortunately, I ran into three of the major risks when investing with miners.

International Risk

A lot of gold mining is done in countries with unstable political environments and fragile societal dynamics. Problems within these countries can often escalate and decimate profitable mining opportunities.

South Africa has long been one of the key gold producing regions. South African miners AngloGold Ashanti (NYSE: AU) and Gold Fields (NYSE: GFI) have also been some of the cheapest on a valuation basis. I've experienced that these stocks can quickly jump when markets become enthusiastic about the prospects for gold, all things being equal.

Unfortunately, all things weren't equal last year. In August, there were news reports of a strike at an Anglo-American Platinum mine. Police at the scene fired into the crowd during a riot and killed a number of striking workers. Strikes are fairly common in the mining industry and usually not a major crisis. However, it seemed the level and circumstance of the violence could turn this mine strike into a greater societal issue. If it was a societal issue, any mining venture in South Africa could be at significant risk. I immediately sold my sizable South African miner stake and feel fortunate to have roughly broken even.

Mine Production Risk

The level of production is very important in assessing gold miners. Gold mining is a mature industry and most major gold discoveries have been exploited. Miners with meaningful production increases are rare and usually valued highly. Miners with falling production need to be looked at closely. If the production decline was expected and looks temporary, the miner might be a good buy. If the decline is a surprise and the reason looks ominous, it's often prudent to sell out.

I was pretty happy with my stake in IAMGOLD (NYSE: IAG), a gold miner with holdings in Suriname, Burkina Faso, and Mali until I saw its third quarter earnings release and noticed a surprising 7.7% drop in production with a 10.5% fall in one of their key low cost properties. Management's explanation that the shortfall was due to the processing of lower grade ore was not comforting. Though taking a small loss was unpleasant, especially after the shares were nicely higher a short time earlier, getting out and reassessing the situation is usually the best thing to do.

Operating Cost Risk

Gold mining is a labor-intensive business. Beside manual labor there is a lot of machinery that uses a lot of energy. Any rise in fuel, electrical and personnel cost can significantly reduce mining profitability even in the face of rising gold prices.

Barrick Gold (NYSE: ABX), one of the world's largest gold miners, reported all-in sustaining cash costs of $826 per ounce in the fourth-quarter of 2011. These costs jumped over 17% to $972 per ounce in 2012 and are expected to rise another 13% to $1100 an ounce in 2013.

This astounding increase in operating cost took me by surprise and has significantly reduced my Barrick fair value estimate. Originally calculating a fair value around $60 per share, the increased expense pushed my estimate down to $45 a share based on $14.0 billion in revenues and estimated cash earnings of $3.2 billion with a 14x capitalization multiple.

I'm still confident that the price of gold will eventually be noticeably higher than it is now and that my remaining gold miner holdings will realize fair value. But I have to admit that current gold mining circumstance and my market efforts have done little to bolster that confidence.

grahamsway (Bob Chandler) has a long position in Barrick Gold. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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