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Not all that glitters...

Created:

18 September 2007

Updated:

27 January 2008

Written by:

Daniel O'Sullivan

Gold recently cleared the psychologically-significant $700 per ounce (oz) price level and is currently trading at $717 per oz on the back of continuing dollar weakness and the traditional autumn resurgence of bullion buying in countries such as India. As reflected by investors' recent enthusiasm for gold ETFs (see Dollar Damage), demand is also being driven by an apparent rediscovery of the yellow metal's allure as a safe haven during times of turmoil. But gold’s most recent rally, which has seen it gain just over 9 per cent since 17 August, is also significant for another reason: it marks the first time in many years that gold equities have managed to outperform a rising gold price.

However, investors who have only followed the UK's gold-focused mining plays are unlikely to have noticed this outperformance. In fact, the only stand-out performers from the London market through this period are Randgold Resources and Peter Hambro Mining, which are up 26 per cent and 16 per cent respectively. But the FTSE Gold Mines Index, the most widely-followed gold equity index worldwide, shows the effect clearly. It is up by 24 per cent through the same period. Contrast this with the period from 1 January this year to 17 August, during which time gold rose 3.5 per cent but the index was actually down 14 per cent.

Performance of key gold indicators and shares

Sources: FTSE Group, Thomson Datastream

The first thing to note is that the outperformance of the Gold Mines Index is actually consistent with just Randgold and Peter Hambro being the notable gainers in the UK market - Randgold is actually an index constituent. The index only comprises mining companies that are mining significant amounts of gold, whereas most of the UK-listed gold companies are plays on future gold production, with mines yet to be built or expanded and relatively insignificant current production. Randgold Resources and Peter Hambro Mining are really the only two noteworthy London-listed producers right now. Therefore, only they have benefited in the same fashion as the index and from the market's belief that rising gold prices will increase profit margins on current production.

The second thing to note is that shares in significant gold producers are finally behaving as they should. Logically, they should always outperform rises in the gold price because they are unavoidably geared to it through their operating costs. That is to say, if the cost of mining an ounce of gold is fixed, the percentage movement in the gold price per ounce should equate to a larger percentage movement in profit per ounce. So the mystery isn't why gold equities are outperforming gold right now - rather, it is why they have failed to do so for so long, not just in the year up to 17 August but for several years before this.

Evy Hambro, a mining fund manager at BlackRock Merrill Lynch, has a theory. He thinks that when gold was in the doldrums and trading at $250-$300 per oz through 2000-01, many mining companies were reporting operating costs per ounce of around $250. However, Mr Hambro says many companies would have cut back production to only mine the most lucrative 'high grade' veins in order to achieve this just-profitable operating cost. Gold has recovered slowly but surely since then, and through this period gold miners themselves have also gradually recovered confidence. But, as they have done so, they have returned to their 'true' operating costs, because operations are running at full capacity and a spectrum of grades are being mined.

Added to this is the general inflation in mining costs, which is now running rampant throughout the natural resources industry in everything from labour to machinery to truck tyres. So the story during the past few years has been one of gold companies disappointing investors by continually declaring that any increase in the sale price for gold has been gobbled up by soaring operating costs. But Mr Hambro has thought for some time that most of the potential increases have now fed into mine operating costs. So, more and more, increases in the gold price should drop straight through to company profits. In fact, the sudden spurt of outperformance by significant gold producers in the past month suggests the market at large has started to think the same way.

So, how should investors play this? Mr Hambro himself believes in buying into gold producers with current production and plans to expand this even as world gold production overall is in decline. And as a fund manager, he unsurprisingly thinks investors should hedge exposure to one particular operating environment by investing in a basket of such shares, most easily accessed through a gold mining fund. But as a single UK-listed stock pick, we're still happy with Randgold Resources, despite it gaining 30 per cent since we tipped it as a buy at 1,087p () and the downside risk of a gold price decline. Randgold should grow production from around 400,000 oz per year now to 600,000 oz in 2010 and is also a prime takeover candidate.

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