The benefits of investing in the mining sector

Historically, gold miners traded at a premium to most other equity sectors including the broader mining sector, but this is no longer the case. In addition, in the past two years, the performance of gold miners’ share prices has substantially diverged from the performance of gold.

While there should be a strong relationship between gold miners and the physical commodity, macroeconomic factors have been partially to blame for driving a wedge between company valuations and their main revenue source.

As the gold price has been driven by concerns about currency debasement and European sovereign risks, these same concerns adversely affected broader equity markets, in turn weighing on gold miners’ share prices.

The sluggish performance of gold mining stocks in recent years contrasts to the broader materials sector performance. Historically, gold miners have tended to outperform gold during periods of rising global business activity, as measured by the US Manufacturing ISM index.

Conversely, gold generally outperforms gold miners when growth is slowing and the global economy is in a downturn.

However, recently this relationship appears to have broken down. With growth in the US and China now starting to pick up again and most stockmarkets hitting multi-year highs, gold miners are trading at a 53 per cent discount to gold and 114 per cent below their 10-year average against gold, causing many investors to wonder whether their undervaluation may be explained by their underlying business fundamentals and management choices and how long this de-rating is going to persist.

The cost of producing an ounce of gold has soared at an annual compounded growth rate of 16 per cent in the past 10 years. The average cash cost of extracting an ounce of gold from the ground is estimated to have been roughly $671 in December 2012 compared with $151 in 2000.

As the amount of gold in a mine nears exhaustion, mining becomes more difficult and costlier. Higher prices for mining inputs such as energy, labour and equipment have put mining bottom lines under increasing pressure.

However, producers’ progressive de-hedging and the rising gold price have allowed gold miners’ margins to expand, outpacing the rise in cash costs in the past 10 years.

With the average realised price increasing at an annual compounded rate of more than 20 per cent, gold miners should have been able to secure substantial profits over the years. However, company valuations have continued to languish even as reported margin expansion has occurred.