If you’ve been invested in actual gold this year, you’re probably a happy little bug right now. But anyone who has invested in gold producers can only grumble: Good idea, bad performance. While gold has risen 30 per cent, gold stocks within the S&P/TSX composite index are down 1 per cent.
Tuesday’s action merely highlighted the frustration, with the price of gold down a little and gold stocks down a lot.
The disconnect has left many observers scratching their heads. Stephen Walker, an analyst at the Royal Bank of Canada, figures it is due to a general distaste for equities amid the market selloff, as well as concerns about rising operating costs for gold producers and some skepticism over whether the sky-high price of gold can hold. However, he and his colleagues outlined in a note why stocks should catch up to bullion.
Part of it has to do with cash flows. Historically, margins were thin until the price of gold started to rally in 2006. And despite the steady margin growth and rising free cash flow of the past five years, the high capital demands of mining have limited value creation. Until now.
“We believe we are at an inflection point in the industry and on the cusp of a substantial wave of free cash flow over the next 12-24 months,” he said.
At the moment, the top-tier gold producers he covers trade at just 8.3 times estimated 2012 cash flow, well below the range of 10- to 15-times cash flow of the past three years. He estimates that the stocks are assuming a gold price of about $1,100 (U.S.) an ounce – versus its current going rate of $1,870.
“If the gold price remains elevated and/or investors accept a higher long-term gold price we could see 25-50 per cent upside in the equities,” he said.
That said, he remains bullish on gold over the next year or two. Ongoing concerns about sovereign debt, ongoing low interest rates, strong physical demand for gold in China and India, and buying by central banks should support the price – while a sluggish economy should contain production costs. Indeed, there is a strong correlation between the price of oil and cash costs for gold miners over the long term.
According to his calculations, gold at $1,850 an ounce and oil at $82 a barrel translates into margins of about $1,300 an ounce. “To put this in perspective, many recently completed and proposed mines were deemed to be economic at a gold price of $700-$1,000 (per ounce) with margins of $300- $500 (per ounce),” he said.
He recommends focusing on large- to mid-cap gold producers that have recently invested in growth projects. Barrick Gold Corp. and Goldcorp Inc. have the best free cash flow profiles over the next 12 to 24 months, he believes. Among mid-caps, he recommends Centerra Gold Inc. , Eldorado Gold Corp. , Osisko Mining Corp. and Yamana Gold Inc.