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This article first appeared in Corporate, The Edge Malaysia Weekly, on August 1 - 7, 2016.

 

FOLLOWING the fallout from Brexit, gold prices shot up 8.7% to a one-year high of US$1,366 per ounce on July 8 but saw some consolidation amid profit-taking in the following two weeks. The 

precious metal, however, reversed its recent downtrend last week and rebounded to US$1,342 per ounce after the Federal Reserve decided to keep a US rate hike on hold at its recent meeting on June 27.

To put things in perspective, gold has gained 26% year to date on strong investment demand, a weaker dollar and safe-haven buying, as the outlook for Europe became gloomy amid weaker global growth and political uncertainty. Gold prices also received a boost from a slower Fed tightening cycle and the unconventional monetary policies undertaken by the world’s major central banks.

Both institutional and retail investors have moved into gold. Hedge funds, including billionaire George Soros’ Soros Fund Management, have built up positions on rising prices while money managers and retail investors have piled into gold assets, mainly through gold exchange-traded funds (ETFs) and gold-linked equities.

This has led to the outperformance of gold ETFs and gold stocks vis-à-vis the underlying physical assets. Compared to gold spot prices, gold ETFs posted a stronger 30% return in the past year and their performance has led spot prices since May (see Chart 1).

 

How to play gold … stocks

Nonetheless, both asset classes pale in comparison with gold mining stocks (Chart 2). Senior gold mining stocks, which include the largest and the most established gold producers globally, generated an outsized 122% return in the past year while mid-tier firms produced a more impressive return of 156% — five times and seven times that, respectively, of gold ETFs and gold spot prices.

Even the junior gold mining companies, which are often exploration companies or operate just one gold mine and thus carry higher risk, saw their aggregate market capitalisation surge 77% from a year ago. There are a few reasons why gold mining equities outperform gold bullion by a substantial margin when gold price is rising.

First, gold stocks offer a leveraged way to have exposure to rising gold prices. For example, a 10% increase in athe gold price would translate into more than a 10% gain in the operating earnings of the mining companies, thanks to the positive operating and financial leverage. As such, mining companies with improved profitability would appreciate more than gold bullion would, particularly in a gold bull market when valuation multiples typically expand.

Second, some gold-mining companies pay dividends vis-à-vis gold, which yields no coupon or dividends and has few industrial uses. Miners with low production costs are less likely to be affected by fluctuations in gold prices and are able to sustain dividend payments. Further, higher gold prices could translate into better profitability, free cash flow and dividends.

Conversely, the counter-argument for gold miners include higher volatility due to the higher beta for gold equities versus gold price, particularly for the junior gold companies. Additionally, investors need to take on more risks such as country risk, equity risk and company-specific risks to earn potentially higher returns. As such, investors who wish to have exposure to gold equities should look for miners with operating leverage and strong fundamentals, that is, high quality assets, robust balance sheets, attractive margins and near-term free cash flow.

 

Low domestic capital market participation

While Malaysia is not a major gold-producing country, opportunities in gold mining in the gold belts running through Kelantan, Terengganu, Pahang, Johor and Sabah — have attracted a number of foreign investors in recent years. Most of these gold-mining companies with domestic operations are listed abroad in financial hubs like Singapore and London or major gold-producing countries like Canada, Australia or the US (see Table 1).

Canadian producer Monument Mining Ltd, which is listed on the TSX Venture Exchange and Frankfurt Stock Exchange, operates the Selinsing Gold Mine in Pahang and is the largest by production volume. This is followed by Singapore-listed CNMC Goldmine Holdings Ltd, founded by Chinese national Lin Xiang Xiong, who is the chief adviser on Kelantan-China international trade.

Other gold-mining companies with domestic operations are much smaller in terms of production volume or saw their operations halted in recent years. Borneo Oil Bhd and US-listed Verde Resources Ltd have mine operations in Merapoh, Pahang. Singapore-listed Anchor Resources Ltd, which just raised S$7.2 million from a initial public offering, operates the Lubuk Mandi mine and Bukit Panji property in Terengganu.

Shares of Malaysian-owned Peninsular Gold Ltd were delisted from London’s Alternative Investment Market (AIM) in 2015 after its mining operations in Raub, Pahang, were halted, pending environmental approval from the Malaysian authorities. Australia-listed Global Gold Holdings Ltd, which derived all of its revenue from gold trading in Malaysia in 2014, has ceased operations and is looking to inject new businesses into the company.

 

All that glitters is not gold

All in all, it would appear that all these mining companies operate only one to two gold mines or are still exploring gold mining opportunities in Malaysia. As shown in Table 2, most of these junior mining stocks have generated returns of 21% to 40% in just one month since Britain voted to exit the European Union on June 23. CNMC, in particular, has been the best performer year to date, yielding a handsome return of 175% for investors who bought the shares at the start of the year.

Although most possess healthy balance sheets by virtue of their net cash positions, CNMC is the only company that fits the criteria of a gold mining stock with operating leverage and strong fundamentals. Commanding the highest return on equity of 41% among its peers, the stock also offers decent free cash flow yield of 10% and dividend yield of 1.1%.

Based on Bloomberg data, CNMC is currently tracked by KGI Securities and NRA Capital. Both rated the stock a “buy” on average return and low risk. Calling it an undervalued low-cost gold producer, KGI Securities’ Renfred Tay points out that CNMC is still trading at a forward PER of 7.9 times, way below the junior gold miners’ average of 24 times.

In a July 26 note to clients, NRA Capital is positive on its 2Q2016 results outlook, as it produced a record 9,807.4 ounces of fine gold during 2Q2016 or 24.5% higher than in 2Q2015. The research house also highlighted that the company has been transparent in disclosing the circumstances about the stop-work order.

To recap, CNMC on July 19 received a letter from the Kelantan government, requesting it to temporarily stop all works and operations at the Sokor gold field project. CNMC has since clarified that the stop-work order was in connection with its application for large-scale operation status, which will allow the mining of unlimited amounts of ore.

Backed by net cash of US$26.1 million, CNMC is now looking to acquire a 51% stake in Pulai Mining Sdn Bhd — which owns a brownfield project next to its Sokor mine — for RM13.8 million, or about US$3.4 million. While the second concession could be a rerating catalyst, the current consensus target price of S$0.47 has yet to fully factor in the potential income from the new mine.

Closer to home, Borneo Oil, which is perceived by certain quarters to be a strong proxy for gold, has seen its share price jump 24.5% since Brexit. On July 11, the counter was slapped with an unusual market activity query (UMA) from Bursa Malaysia following a sharp rise in trading volume.

For 1QFY2017 ended April 30, the company posted record net profit of RM10.7 million on the back of RM1.5 billion in revenue. By comparison, it reported a net profit of RM11.5 million and revenue of RM256.1 million for the full FY2016.

Borneo Oil attributed the substantial increase in its bottom line to its mining, energy and related divisions but did not say whether it was one-off in nature or sustainable in the future. In its reply to the UMA query, Borneo Oil explained that it made RM1.48 billion in revenue and RM7.6 million in pretax profit from gold investment, mainly from the sale of gold investments.

It added that it was investing in gold for the past year in the belief that the low prices were temporary as it was trading below the industry’s mining and production costs. Notably, revenue derived from gold-mining activities in 1QFY2017 amounted to a mere RM969,000 but the company is exploring gold-mining opportunities in the Bukit Ibam mine in Pahang.

The company clarified that there is no revenue during the exploration stage until the discovery of an economical ore reserves. For FY2016, fast food operations was the largest earnings contributor, accounting for roughly half of its operating profit. Free cash flows for the past four quarters totalled a negative RM71 million, translating into a negative free cash flow yield of 13.9%.

 

Next catalyst: Slower-than-expected rate hike

The near-term share price driver for gold stocks is likely to be gold prices and the outlook for the metal remains dominated by the timing and pace of the Fed’s rate increases and the impact on the dollar, according to JP Morgan.

In its quarterly commodity markets outlook report dated July 26, the World Bank expects silver and gold prices to rise 8%, but are likely to decline going forward on expectations of US monetary policy tightening and a strengthening US dollar.

That said, some investors remain optimistic and believe that precious metal prices will be supportive for equities through 2016 and into 2017, citing the Fed and wider dovish macro themes as well as geopolitical risks such as the upcoming US election.

With spot gold reaching analysts’ base case forecasts of US$1,300 to US$1,310 in 1H2016, gold will only break above US$1,400 an ounce in 2H2016 in a bullish case — that is, no Fed rate hikes for 2016 weakening the dollar, central banks around the world moving deeper into negative rates and economic worries on emerging markets spread. 

 

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