Gap between spot bullion and mining shares near 30-year high, says JP Morgan AM

The manager of JP Morgan Asset Management’s Global Natural Resources fund admits gold mining share performance recently was “disappointing”, but notes the divergence in gold shares and bullion’s spot price is unjustifiably near its highest level since at least 1984.

Neil Gregson, who manages the JPM Global Natural Resources and JPM Natural Resources funds, says the difference in performance, in favour of gold, has been “particularly prominent since the beginning of 2011, and this trend seems to be continuing in 2012.”

The divergence is now near two standard deviations from its long-term historical average.

Gregson looks to historic valuation levels in an effort to understand the current de-rating of gold shares.

“In the 1960s and 1970s most of the listed gold equities were the South African producers and tended to be valued on dividend yields. In the 1980s an improvement in gold processing technology – heap leaching – allowed substantial growth in Australian and North American gold production.

“The same period saw the launch and growth of a number of dedicated gold mining mutual funds. Valuations increased as investors paid a growth multiple and a gold option premium for exposure to gold price movements. Direct investment in gold was either not allowed under investment guidelines or was not practical, gold ETFs did not even exist at that time.”

As a result of all this, valuations of gold mining companies trended increasingly higher through the early 1990s, and the sector’s shares traded on average at two to three times the value metrics of other mining companies. At the same time, many gold companies began forward-hedging much of their production.

But as gold rose in uncertain markets from 2001, some hedging often backfired, and left companies worse off than if they had accepted the spot price instead – angering shareholders.

A slowing growth of production and increasing production costs at the same time meant many equity investors turned instead to EFTs typically backed by bullion – they now hold about $140bn – while central banks bought up bullion.

The de-rating of shares in this environment and since the global financial crisis, in Gregson’s view, excessive.

“We accept that gold shares are unlikely to regain the valuation premiums enjoyed in the past, simply because the industry is currently in a very different cycle, we do believe that the devaluation relative to gold spot prices has largely run its course.

“Today, many gold mining companies are trading at 0.7 to 0.8 times their underlying NAV, and market estimates suggest that their valuations have discounted an equivalent of $1,200 per ounce of the gold price versus the current spot price of around $1,500 to $1,600 per ounce.

“In our view, gold equities are trading at depressed levels, the industry is recognising the importance of better capital discipline, cost control and paying increasing dividends to compete with gold ETFs. As such we believe investors should not give up on gold stocks.”


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