Citigroup: Don’t be tempted to buy gold stocks

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After getting slaughtered last year, gold mining stocks are showing modest gains in 2014 and are also outperforming gold by a narrow margin. That's the good news. The bad news? Gold miners are still burning through cash, making them unattractive investments.

"Understandably, many shareholders are toiling with the idea of buying into gold equities given the past 12-month's decline in share prices," said Johann Steyn, an analyst at Citigroup, in a note. "We continue our theme of 'don't be tempted.'"

But rather than condemning all gold miners, Mr. Steyn holds out some hope for a select few that show more promise than their peers. These rare opportunities include Goldcorp Inc. and Barrick Gold Corp.

His negative assessment of gold miners in general comes at a time when the sector has been bloodied beyond recognition. Gold had been seen as an ideal hedge against rising inflation, central bank policy experimentation, political instability and collapsing currencies in the years immediately following the financial crisis. The price doubled between 2009 and 2011.

But with the global economy looking relatively stable and the U.S. dollar in decent shape, gold has lost much of its allure over the past few years. When the price of gold fell 29 per cent in 2013, the NYSE Arca Gold Bugs index of 18 global producers plunged nearly 55 per cent, approaching 10-year lows.

According to Mr. Steyn, the decline didn't merely reflect the skittishness of investors but rather the "intrinsically bad fundamentals" of the industry – which is probably why he subtitled his report "A Leopard Cannot Change Its Spots."

Gold itself isn't the threat here. Indeed, he argues that the price of gold should average $1,337 (U.S.) an ounce in the second half of the year, marking an improvement from the current price of $1,257 an ounce, due in part to geopolitical risks and demand from China. He expects gold to rise modestly again to $1,365 an ounce in 2015 – down from the high of $1,900 an ounce in 2011, but at least stable.

Nor are companies spending freely these days. The top 10 producers have cut capital expenditures by 25 per cent, exploration expenditures by 33 per cent and corporate expenditures by 8 per cent.

But rather than leaving gold miners looking leaner and meaner and worthy of investor attention in the event of an upturn in the gold price, Mr. Steyn estimates that 75 per cent of the industry is still burning through cash – and additional cost-cutting is going to be hard to do without closing mines.

"The fact that gold companies tend to burn cash in good or bad markets, to us, accentuates the industry's poor fundamentals," he said.

"There seems to be no easy way out," adding that even mergers are acts of desperation that tend to destroy value for shareholders.

The industry, he argued, is stuck with a short-term approach – expanding operations when conditions are strong, only to cut them when conditions turn. This is a problem, given that lead times for new production are between five and 10 years, meaning that companies are out sync with the cycle.

The better approach, he said, is to strengthen balance sheets and maintain capital spending throughout the cycle.

"In addition to bad industry fundamentals, we argue that the short-term focus of gold companies is one of the key reasons for their long-term economic suffering," Mr. Steyn said. "The value destruction cycle is being repeated."

However, if you have a strong stomach and can stick with an investment for the long-term, then Barrick and Goldcorp are your best bets among major producers.

They are low-cost producers and the stocks look attractively priced based on discounted cash flow. But management is going to have to strengthen their balance sheets to spend capital on projects throughout the cycle.

"History suggests investors should not expect too much," Mr. Steyn said.