High Confidence In Gold Stocks Even If Consolidation Will Continue

This is an excerpt from In Gold We Trust 2015, by Incrementum Liechtenstein:

Last year, M&A transaction volume amounted to approx. USD 7bn, lower than in 2013.212 We expect that takeover activity will accelerate again in coming months. On the one hand, exploration was neglected due to cost cutting. On the other hand, numerous projects were written down or sold. As a result, the reserves of the largest producers have declined by 14% on average compared to last year.

We expect therefore that producers will pad their shrinking reserves by means of takeovers and mergers. The biggest beneficiaries of this trend are likely to be junior producers and especially fully funded developers. The majority of takeovers will take place in mining jurisdictions that exhibit low political risk. This was fundamentally different during of the bull market, i.e., until 2012. Due to excessive optimism and high-risk appetites, investments were made most of the time in countries with high political risk.

Production of top 10 gold producers 2013 vs. 2014 (in tons)

In principle, there are two different phases in which M&A activities tend to be undertaken. Firstly, close to historic price highs, when managers are extrapolating rising prices far into the future and are in the grip of megalomania. The second phase is close to the end of bear markets, when managers fear that prices might still fall further. In this period, the hunt is on for mine projects that promise to be economically viable in an environment of low prices. An increase in M&A activity is therefore often a reliable signal of an imminent trend change, similar to the 1998 to 2000 period, when numerous large-scale takeovers took place.

6 Reasons For Confidence

What is the reason for our optimism that better times are in store for gold mining companies?

• Production cost deflation: Some radical productivity increases, labor force reduction, new negotiations over existing contracts with suppliers, etc. are leading to lower operating and capital costs.
• Write-offs or sales of high-cost projects: Numerous exploration and development projects were sold or put on care and maintenance. Balance sheets were strengthened.
• Commitments to shareholder value: renewed focus on dividends, free cash flow and profitability.
• Increase in reserve grades: this implies that ounces mined in the future will no longer be of lower quality than previously mined ones. This will result in stronger cash flows.
• Attractive portfolio characteristics of gold mining stocks: The gold price is benefiting from a decline in economic confidence and recessions. As a result, the gold mining sector is one of the few sectors that exhibits a long-term negative correlation with the broader stock market.
• Relative valuation and sentiment

Conclusion

Market participants appear not yet to have realized that the margins of numerous gold mining companies have recently significantly improved, due to an increase in the real gold price. The real gold price (or the purchasing power of gold) is not directly measurable, but certain proxies such as the gold/CRB ratio or the gold/oil ratio can provide helpful pointers to its trend. It is after all not the nominal gold price that determines the profit margins of gold mining operations, but the difference between gold revenues and input costs.

We believe that the new commitment to cost transparency, greater financial discipline and shareholder value represent a crucial – if late in coming – insight into the sector’s managers. Whether this new focus turns out to be mere lip service or not will become evident in coming quarters. Since the sector’s massive write-downs and value adjustments were one-off events, they could result in greater upside leverage. We therefore believe that gold stocks continue to exhibit a strongly asymmetrical risk/reward profile at present.

from http://goldsilverworlds.com/stocks/high-confidence-in-gold-stocks-even-if-consolidation-will-continue/