Three Ways to View the Gold Rally from an Equity Viewpoint

by Steve Land, Vice President, Research Analyst Portfolio Manager, Franklin Equity Group, Franklin Templeton Investments

Gold prices rose above US$2,000 per ounce for the first time in August, as investors responded to a weaker US dollar, record-low US real yields and intensifying US-China geopolitical tensions. The unprecedented amounts of stimulus and other relief funding used globally to prop up economies hobbled by the COVID-19 pandemic, including rock-bottom interest rates, have also continued to be a boon for the price of gold.

Although gold prices reached historic highs this summer, we still see some potential drivers that could move prices even higher. In our view, gold may benefit from bouts of elevated market volatility and mounting concerns over the coronavirus’s economic impact as investors seek perceived safe-haven assets. A classic feature of gold is its very low correlation with other asset classes, supporting increased interest in owning it as a portfolio diversification tool in uncertain markets.

Opportunities for Gold Producers

We continue to like the long-term prospects for select gold- and precious-metals-focused equities, especially if gold prices can hold near current price levels or move even higher in the months ahead. In our view, peak gold prices present gold producers with opportunities to redefine themselves as a vital part of a diversified investment portfolio.¹

Opportunity #1: Capitalise on Higher Gold Prices to Grow Profitability

Gold-mining stocks haven’t rallied in lockstep with gold prices over the past few years. Many gold-focused companies struggled to generate free cash flow with gold at US$1,250 per ounce—close to the six-year average that persisted from mid-2013 through mid-2019—as total costs for many producers are close to that level, according to our analysis.

Mining costs tend to be relatively fixed, so higher gold prices can flow straight to the bottom line. In our view, the recent rally in gold prices should provide a significant lift in cash flow across the industry. With gold moving even higher and input cost pressures subsiding on the back of lower fuel prices and low labour inflation in many parts of the world, the margin expansion makes gold equities look even more compelling to us now.

Even with the price of gold moving to all-time highs, most mining companies have maintained a focus on improving the cost structure of their operations, debt repayment and asset rationalisation, which we believe should result in better businesses and improved stock performance potential going forward. In our view, management teams look increasingly focused on turning higher gold prices into free cash flow that can be returned to shareholders via dividends or reinvested in high-return projects.

Opportunity #2: Leverage Increased Scale to Improve the Business

Given several years of underinvestment by the gold industry, we expect to see further merger-and-acquisition activity in the months ahead. Although the pace of acquisitions has been slowed in the near term due to travel restrictions and other short-term business impairments associated with the COVID-19 pandemic, in the longer term, we believe companies that operate multiple mines should be able to make better capital allocation decisions. In our view, these companies will likely deploy capital toward only their best projects and achieve higher market multiples as a result.

Labour availability is another driver for consolidation—there is a shortage of skilled, experienced workers interested and qualified to work in the mining industry. Larger, well-run companies should be more successful in the competition to hire and retain top talent.

Companies with multiple mining assets also help to diversify portfolio risk for generalist investors. These investors may not be interested in holding several gold companies in a portfolio or taking on the increased risk associated with owning a single-asset or development-stage miner. Additionally, in a world dominated by index funds, we believe there are tangible advantages to having a larger market capitalisation and better trading liquidity.

Opportunity #3: Create New Ways for Consumers to Engage with Gold

With the help of considerable education and support from the World Gold Council (WGC), central banks around the world now recognise the role of gold as a store of value and a crucial part of their government reserves base. As a result, many central banks have moved from a major source of supply in the late 1990s to significant buyers over the past several years. In fact, central bank purchases of gold in 2018 and 2019 were at the highest level in the last 50 years.²

The development and broader adoption of physical gold-backed exchange-traded funds (ETFs)—also partly due to the WGC’s efforts—have helped to expand market participation and create new sources of investor demand for gold. The introduction of gold ETFs in the early 2000s was a significant step forward for the industry. These ETFs have attracted large new pools of capital that previously wouldn’t have invested in gold and helped to create greater efficiency in the gold price-discovery mechanism. ETF purchases have been one of the main sources of physical gold demand over the past six months.

However, much of the world’s gold, and most of the gold produced each year, is still held as jewelry or small-investor coins and bars. 3D printing and advances in material science have created new ways for consumers to interact with many materials, but little of this knowledge seems to have been applied to the gold industry outside of sophisticated electronics that require highly reliable connections, switches and relay contacts (e.g., computers, TVs, media players, cell phones and game consoles all contain small amounts of gold).

Most of the gold items sold today are almost identical to those made 100 years ago. We believe more should be done to support the physical ownership of gold; new product introductions could represent a solid source of demand growth looking forward.

Looking Ahead

Before the recent upswing in gold prices, the gold industry went through a harsh downturn that has reset the playing field for gold producers. The industry now has an opportunity to use rising gold prices as a stepping stone towards building stronger and more sustainable businesses.

As we look out over the next several years, we see an opportunity for gold producers to shine as they create stronger businesses and continue to modernise the sale and marketing of one of the most ancient, best-recognised universal stores of wealth—gold.

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. The precious metals sector involves fluctuations in the price of gold and other precious metals and increased susceptibility to adverse economic and regulatory developments affecting the sector. Risks of currency fluctuation and political uncertainty are associated with foreign investing. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. Investing in smaller companies, which can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies. A non-diversified portfolio involves the risk of greater price fluctuation than a more diversified one.

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1. Diversification does not guarantee profit or protect against risk of loss.
2 Source: World Gold Council, “Gold Demand Trends Q1 2020,” 30 April 2020.

This post was first published at the official blog of Franklin Templeton Investments.