As a sector, gold mining stocks have taken some beating in recent years.
Frankly, it’s been justified. When the price of your key product just keeps on rising, it really shouldn’t be that hard to make money off the back of it. But somehow, the management teams of many gold miners have proven more than capable of squandering their good fortune.
Shareholders are fuming. And with the gold price faltering, and the future less certain, miners can no longer rely on an ever-rising product price to keep them afloat.
But the good news is that this squeeze could be just the thing that gold miners need to kick them into shape.
Here’s why now could be the time to buy…
Gold Miners: Engineers, Not Entrepreneurs
One consistent complaint about mining stocks in general, and gold miners in particular, relates to the standard of management in the sector. Put politely, it’s not very good.
Those who found and run mines have a tendency to fall in love with the process. That might seem odd to those of us who don’t have much interest in geo-engineering. But it’s a good thing they do. Otherwise mines would never get built.
Mining is risky, and it involves lots of travel to remote and largely inhospitable locations. If you’re going to spend months or years in the Canadian wilderness, or a South American jungle, you need to really enjoy what you’re doing.
The problem is that, as Evy Hambro of BlackRock’s Gold & General Fund points out, this passion for the job can go too far. Making money ends up taking a back seat to the process of mining.
As a result, mines have failed to control costs and have been all too willing to splash out too much money on the latest equipment. At the same time, the quality of seams is in general decline – which means you get less ore out of each seam.
So despite the rapid gains in the gold price from 2001 to 2011, costs have kept pace, squeezing profit margins.
As well as poor cost control, badly timed sales decisions haven’t helped the industry. In 2001 – around the bottom of the market – many gold miners chose to sell their future gold production to raise revenue (this is called ‘hedging’).
You can see why they did it, having suffered a horribly long bear market. But while it meant the big miners secured a guaranteed income, it also meant they could only watch from the sidelines as the gold price surged.
Finally, the industry experienced a wave of mergers and takeovers. Some of this was sensible, enabling companies to take advantage of economies of scale.
However, in many cases it was simply a case of one miner trying to boost its reserves by buying a rival. And in most of these cases, the acquirer paid too much. Miners have also abused their shareholders by constantly issuing new shares to raise money, thus diluting existing holders.
Gold Shareholders are Striking Back
The good news is that shareholders are now fed up enough to do something about it.
Shareholder activism has been a bit of a dud, by and large. The much-heralded ‘shareholder spring’ has so far resulted in few victories in the quest to rein in high pay and punish poor performance in most industries, but the gold mining sector looks like it might be an exception.
Investors in Centamin and Central Rand have both forced their boards to scrap pay rises. And most of the major companies have seen top executives lose their jobs this year.
Thanks to this, things are starting to change. Hambro notes that gold miners are taking more of a hard-nosed approach to technology. They are asking for, and getting, large discounts from suppliers. Given the slowdown throughout the mining sector, this should continue as demand for equipment falls, putting buyers in a far better negotiating position.
Firms have also started to increase dividends and share buybacks. In some cases this is simply about protecting the share price. But other companies are finally starting to recognise that investment can destroy value if it doesn’t deliver returns that are above the cost of capital. Again, the need to keep paying a dividend should help maintain this spending discipline.
Finally, the last of the disastrous hedging contracts expired, meaning that gold firms can fully benefit from higher prices (although it also means that they are more exposed to drops).
Contributing Editor, Money Morning
Publisher’s Note: This article originally appeared in MoneyWeek
From the Archives…
Why Small-Cap Resource Stocks Beat Blue Chips Hands Down
10-05-2013 – Dr Alex Cowie
Can Australian Stocks Defy Gravity if The Australian Dollar Falls?
9-05-2013 – Murray Dawes
Build Wealth Fast through the Resource Sector
8-05-2013 – Dr Alex Cowie
36% Potential Upside for Australian Stocks Over the Next Two Years
7-05-2013 – Kris Sayce
The Key to Becoming a Successful Investor
6-05-2013 – Kris Sayce