A look at Australia's gold sector

Let's talk gold with Australia's most well informed and optimistic gold analyst, Barry Dawes, the Executive Chairman of Martin Place Securities.

Barry has been a gold bull for a long time; it has its ups and down, and more recently it's having a bit of an up.

I asked Barry to reflect on what has been going on over the past few years in the sector and what we can expect from now on.

Here's Barry Dawes, the Executive Chairman of Martin Place Securities.

Listen to the podcast or read the full transcript below:

If we look at the Australian Gold Index, it peaked in July 2016 at around about 5,700 and we’re just about 5,700 so we’re just catching up to where we were in the middle of ’16.  The stars of the gold sector have been Northern Star, St Barbara, Evolution, Saracen, OceanaGold and Regis.  Those sort of five stocks have done wonderfully, wonderfully well and they’ve outperformed the index by probably 200 or 300 per cent.  They’ve done absolutely wonderfully well. 

The index has been held back by Newcrest, which has really followed the North American indices and Newcrest is still below the level it was in 2016.  When we look at those companies that have done wonderfully well – what’s happened there?  First of all, Australia’s geotechnical entrepreneurs have just done a fabulous job yet again.  In the case of Northern Star, they’ve acquired mines that other people had.  They understood them better, they improved the productivity, they’ve done more exploration.  And what’s happened over the last five or six years is as we’ve drilled deeper, we’ve found more gold, but we’ve also found higher grade gold as we’ve gone out of the oxide zones particularly in West Australian in the Yilgarn.

The industry’s done wonderfully, wonderfully well and Australian gold production is at record highs now for about over 320 tonnes annualised.  We got down to about 265 back in about 2008, but we’ve had over the past 10 years quite a strong growth in gold production and it’s a true reflection on the excellence really of the industry.  Exploration technologies have improved, drilling, blasting, just understanding how to mine.  Now, I think we’ve got about 65% of Australia’s gold production is now underground, whereas a decade ago it might have only been about 20%.  All that’s come from these companies having a better understanding of the gold deposits.

In a recent note to start the year, you talked about the current valuation of the gold stocks and said that they’re on a 23% earnings yield or a price earnings ratio (PER) of 4.3 times.  Can you take us through how you arrive at that?

As I say, there are six companies that make up 90% of the index.  If you look at their cost structures on average, it comes down to about $1,200 pre-tax costs.  In the industry, we have cash costs and we have all-in sustaining costs (AISC) that people like to quote.  But then you’ve got corporate costs on top of that and some companies might have paid some interest or whatever.  We’re looking at our average pre-tax cost of about $1,200, so if we’ve got $1,800 or thereabouts on the gold price that gives a $600 margin.  And as I say, 90% of the index is made up of those stocks, so that all makes a lot of sense.

When we turn that around, if you’re making a 33% operating margin on the basis of 600 divided by 1,800, and on an after-tax basis that’s 23% earnings yield after tax.  I’ve been saying for some time that these gold stocks will be paying better dividends than people who are seeking dividends in banks and whatever, and I think that’s come down very vastly, but these guys have got so much cash.  We’ve never had, in my understanding of the past 30-40 years in the markets, companies having this much cash that’s generated from operations.  If you go back to previous cycles, the MIMs and the CRAs and Western Mining and North and whatever – they had a lot of debt for new projects and they were always struggling.  These companies have paid off all their debt, they’ve got huge amounts of cash.  Northern Star had $400 million dollars’ cash plus other liquids and it was able to make that acquisition of Pogo in Alaska for cash. 

Right across the gold sector there’s a lot of cash, so that’s going to come out in dividends.  It also means that exploration is continuing, they’re developing more things.  The resources have been extended, mine lives have been extended and we’re starting to see a bit of the corporate mergers and acquisitions activity coming through.  Coming back to that point, these stocks are still very cheap, at about an $1,800 gold price they’re making a lot of money.  I think we’re going to get a higher gold price than that, so these things should move higher. 

Interestingly, that graph I put in there was basically showing the gold index relative to the AUD gold price.  We were trading at seven times the gold price at the peak in 2009, 10 and 11, and we’re three times now.  If we come back to that six stocks making up 90% of the index, it’s a pretty good proxy about where things are and I can’t see why we shouldn’t go to five times the gold price with the gold index on the same PE basis. 

Just on the yields, it’s an interesting point to make about them potentially becoming yield stocks, but they’re not there yet, that’s for sure.  Northern Star’s yielding 1%, Saracen not at all, St Barbara at 2.5% and so on…  I mean, they’re still quite low yields, you’re saying it – do you have any reason for saying that they are going to increase their dividends?

Absolutely.  Let’s go back two or three years when I was really saying that, the stocks have gone up enormously.  Northern Star was probably $3 dollars and now it’s $9.5, so its 12 or 13 cents was on $3 at 4.5% then.  Now, if we get a higher gold price we’re going to find more dividends.  But what’s been interesting is looking at the dividend policies, people have started off by saying, “Yes, we’ll give 2% of revenue, or maybe 4% of revenue, or 6%...” and suddenly it’s 25% of profits, or now it’s 40% of profits, and some will be 50% of profits, and others I think are already above 50%. 

But historically, these gold stocks used to pay out over 60% of their earnings as dividends.  As I see things at the moment, they won’t be able to spend the money faster than it’s coming in, so there will be some corporate activity.  I’m not quite sure which way it’s going to go.  We see some of the bigger companies are actually helping smaller companies develop, but the bigger companies have been fairly reluctant to look at acquisitions that might blemish their track record that they’ve achieved, so there’s that requirement.

But internationally, we’ve had something quite extraordinary happen with Barrick merging with Mark Bristow’s Randgold.  That’s now the world’s largest company, and Newmont Goldcorp have just announced they’re going to have a merger, so we might start to see some activity in the sector here in Australia in the next little while.  Some of the small stocks which have just been appalling performers unfortunately have just got outstanding assets and are very, very cheap in my view; very, very cheap. 

My view would be that a lot of these companies won’t be able to help themselves if they’ve got a lot of cash, they’ll look to expand their empires.  I suppose to some extent, the question of yields paying and whether something is an income stock or not is a matter of mindset of the board and the management.  Those banks and Telstra and all those companies, they see themselves as income providers and they pay out 80 or 90 per cent of their profit and that’s how they go about their business.  Whereas, mining companies and particularly gold companies don’t think like that, do they?  Are you saying that they are starting to change the way they think?

No, I think they’re just making so much money, they’re forced to think about it differently.  You’ve got to keep in mind that the resource sector has had a pretty miserable time really since about 2007, apart from the iron ore sector which has done wonderfully, wonderfully well.  It’s been a pretty tough time for a long time and so people have been very cautious and nervous.  You can see in the smaller end of the market it was just impossible to raise money late last year.  People just thought the end of the world was coming in terms of the US equity market and a lot of these small stocks have just found that there’s just a lack of buyers.  People are very, very cautious.  They’re still managing for caution, not yet for good times yet by a long, long shot.

Just on the gold price, I think it’s fair to say you’ve been saying the gold price is going to go up for a long time, but it really hasn’t.  Why do you think it is going to now?

The factors involved in gold are simple on one hand and complex on the outer.  Everyone looks at the US Dollar gold price but we’ve actually been in this sort of sideways movement for over five years and that’s very, very unusual.  I think we had a low at about $1,046 and the high has been about $1,370.  We’ve traded within that range for five years and each time I think we thought we were getting up through $1,300 and $1,350, we’ve thought, yeah, well if the fundamentals as I see it should be enough to drive it further but that hasn’t happened. 

But what’s really happened now is that we’ve seen the gold price in all sorts of currencies breaking that 2011 downtrend.  What was significant was that the AUD gold price finally broke, but the gold price in Swiss Francs broke its 2011 downtrend, the USD downtrend from 2011 has been broken, it’s important to understand that.  But it hasn’t been broken in the Yen and it’s just breaking out now in Euros.  We need to have the gold price rising in all those major currencies to show that we’re in a really important bull market.  But the minor currencies – and you go all around the world looking at the gold price in the various currencies – and it is moving higher and it is moving higher very, very constructively. 

It’s indicating to me that there will be a sharp move.  When that’s going to happen, I don’t quite know, but we need to break through $1,370 and when we do I think it’s going to be a very strong move.   We might need to test $1,370, come back and then go up again, but once we’ve broken free it’s going to be a very strong market for many years.  The way I see the gold market is that there’s about 3,400 tonnes of gold produced around the world each year, it’s growing slowly, but it’s growing.  China and Russia produce nearly 600 tonnes of that, so if you like, the west of that has only got 2,800 tonnes.  But the amount of gold which is going to India and China from the west is well in excess of that 2,800 tonnes, so the west is running down inventory. 

Shortages are developing in the west, nothing comes back from India or China and we’ve still got the Middle East as a net buyer.  I just see that when the west wants to buy gold, I see inflationary pressures building up from all the previous QE activities, notwithstanding the QT that we’ve got, I just sort of see those inflationary pressures suggesting that people want to buy gold in the west and consequently we’re going to get a really strong short cover.

I always get confused about whether gold goes up because of inflation or people worried about deflation.  The big run up from 2009 to 2011 seemed to be people worried about deflation, but which is it?

They were worried about the financial system.  Look, I just look at it in terms of supply and demand, and my understanding of it is as I described, that all the demand is coming from China and India and it’s just growing all the time, and other parties are coming in, the central banks are buying.  It’s got to come from somewhere and there’s only 180,000 tonnes in the world and about half of that is jewellery and half of that is in India.  When you start looking at the other 95,000 tonnes, you’ve got 36,000 tonnes owned by the central banks, you’ve got so much tied up in coinage and so on, and then you find that the private holders have got about 50,000 tonnes.  That’s growing and you can see it’s not going to come down, it’s just going to grow.  It just means that, hey, where’s the rest of the gold that people want?  They’re going to find it’s just not there.  It’ll be a very, very tight market.

The debasement of currencies is continuing all around the world as government debts and deficits continue, so you know that they’re going to print money one way or another and it’s just great to have gold in your portfolio.

It’s interesting because there was a time I think when everyone thought Bitcoin and cryptocurrencies would replace fiat money that was being printed, but that hasn’t turned out to be the case, has it?

No, it hasn’t, but it might.  There might be a Bitcoin 2.0.  Some of the people who are looking at that now after being bloodied in many of these things are thinking, well we might have another move.  But what did happen, which I feared would happen, is a lot of these fringe things came out were just fraud or just the usual thing that happens at the end of a boom, you get all sorts of fringe players coming in who aren’t managers of any sort.  Even if they had a good idea, they don’t manage them well and they just die, but who knows.  At the end of the day, gold is timeless and I can see as the sentiment changes, the demand for gold will be very robust and the availability will be very, very limited.

What do you think the best way for investors to get exposure to gold is?  Do you think it’s through Newcrest since it’s underperformed so much over the last couple of years?

I think so.  That’s a stock that I’ve been recommending to all my people over the last couple of months and it has broken its downtrend at last.  It does produce 2.5 million ounces of gold and it’s got more resources than any other gold company in the world.  For long-term low risk, it’s an excellent story.  But people need to be aware of Kirkland Lake and Fosterville.  It’s down there in Victoria and it’s just a day trip, not very far away from Bendigo.  But in their last quarter, they produced 124,000 ounces at 39 grams, and that sort of puts their cost down by…

What’s the name of the company?

Kirkland Lake, that’s been one of the best gold stocks.

What’s its code?

KLA.  It’s listed here.  I think there’s only a million shares available, but I guess that changes over time.  My people have had that from the mid-$20s.  I went and had a site visit, most impressed with that, but most impressed with the whole company.  They will have two mines producing half a million ounces each above 20 grams per tonne.  One is a thing called Macassa in Canada and Fosterville here in Victoria.  Fosterville should be producing half a million ounces next year, it should get to about 600,000 ounces with grades above 20 grams.  39 grams, I think, in the last quarter will probably be repeated in this current quarter.  I’m not sure if they’re going to be able to maintain that high grade, but they do have 1.2 million ounces at 60 grams, so it could be anything.  It’s just a wonderful, wonderful mine and I think they themselves were calling it the world’s greatest gold mine, which it probably is with those sorts of numbers.

Really?  Well, the stock’s gone from $28 to $38 dollars in not very long, a couple of months.  But as you say, there’s a million shares on issue, so it’s capitalised at $38 million. 

No, no, no…  It’s listed in Canada, but it’s [over talk]…

Oh, I see.

…here in Australia.

What’s the capitalisation, what’s it worth?

It’s about $8 or 9 billion.

Oh, I see.

It’s still very cheap.  I look at it in US Dollars and I think that the stock is 50% under-priced today based on those two mines and some other things that are happening in this company.  Kirkland Lake is the Northern Star of Canada, if you like.

You said before that the smaller gold mines, not the six kind of stars, but the other little ones have performed poorly – appallingly, I think you said – over recent times…

Yeah.

Is that about to turn around, and which of those smaller ones should people be looking at apart from Kirkland Lake?  Well, it’s not that small is it…

No, that’s not small, it’s a big company – it’s bigger than Northern Star.  With the little stock recommendation section that I gave late last year, I recommended Northern Star and Kirkland Lake and a company called Catalyst Metals which is also down in Victoria.  They look as if they might have another Bendigo and interestingly, the technical director there used to be the Global Exploration Director for Newmont Inc, so a very experienced player, came up through Western Mining.  But with Fosterville, Fosterville was a mine that everyone knew was sort of running 6 or 8 grams and it’s a refractory which needed biox treatment.  That was just running, it was okay, it wasn’t anything particularly fabulous. 

But when they found this Swan zone, it totally changed the way Victoria needs to be looked at.  This group, Catalyst Metals, they think that there’s a possibility that they might be able to pick up some of the Fosterville style mineralisation because that Fosterville-Swan zone is a much later intrusive event compared to the other gold in that mine.  So, other people are looking for those Fosterville style aged deposits which they’d never looked for before, that’s happening. 

I’ve been very keen on a company called Blackham, but it’s been a disaster operation.  Share market wise it’s gone from about $1.15 down to 4 cents, but it’s producing about 100,000 ounces.  With $1,800 it’s making good money, it’s got 6 million ounces of resource, it’s going along nicely.  A company called Pantoro, I think is very well-placed, but there’s probably about two-dozen other stocks in WA that have got resources that aren’t quite in production yet.  But what we’ve got this time around is a lot more infrastructure, there’s a lot of mills around this cycle with excess capacity, so people can actually setup a mine and deliver gold to someone else’s plant.

But we’ve also got Dacian with its new mine that’s just started.   Gascoyne had a few technical problems but its mine has just started, so they’re some start-ups.  We’ve got Gold Road, it’s operation should start this quarter, so there are other opportunities for people.  One of the things that I’ve noticed over the past year is that there’s a lot more deeper drilling underway, but more importantly we’re finding gold in rock types that people didn’t look at before.  If you like, the mineralising event sort of took place 2,600 million years ago and has sort of come up through the Yilgarn and it’s a matter of where the gold has found a reservoir, and they’ve found some really interesting new reservoirs, if you like, in different types of rocks. 

The history has been that the industry is really focused on one style of mineralisation – I mean, that’s a gross generalisation, but this oxide ore bodies up top and go down looking at a structure or contact between the various different rock types.  That’s been standard and at many of the mines in West Australia it’s sort of that standard.  But over the last year or two I’ve just noticed that the deposits are in very different rock types, and that’s very exciting because it really means that the Yilgarn that produces 75% of Western Australia’s gold and Western Australia produce about 65% of all our gold, so almost 50% of our gold comes from the Yilgarn and they’re finding new deposits and new ways of mineralisation and it just means that Western Australia’s got a huge future ahead of it. 

Just finally, Barry, are gold stocks a good way to play the Australian Dollar as well?

Well, look, I’m a bull on the AUD.  All my systems that I look at shows that the gold stocks and the AUD go up together.  Over a period of 1993 to 2013, there was an R².92 between the Philadelphia Gold Index, the US gold index, and the USD-AUD exchange rate.  That broke down when the gold stocks got really smashed in 2015 and 16, but it’s still quite high.  I expect that the AUD will rise with the gold price, because I see the gold price indicative of all commodities.  I don’t see the gold price operating by itself.  If the gold price is going to be strong, we’re going to see copper and metals strong, and so our export revenues will be picking up.

Those export revenues have been growing pretty strongly over the last couple of years and with iron ore at a good price, and with the LNG projects coming in, there should be quite strong exports underpinning the AUD.  And just very interestingly, the iron ore price at $74, if we get another couple of dollars on that, it too would have broken its 2011 downtrend and I think we could get quite a strong iron ore price.  I don’t think you want to be playing gold stocks for a weaker AUD, I think you’d want to be playing them for earnings growth and dividend yield and resource growth. 

The numbers that the industry has been able to achieve in terms of growth of production, resources and reserves have been really quite impressive.  I think we’ve had a 13% per annum compound growth rate in gold production from 21 companies ex Newcrest and I think we’ve seen about a 14% growth in reserves after that production.  And we’ve added about 40 million ounces to resources over the past 4 years, we’ve mined 20 of it, but we’re still 20 million ounces better off in resources and that’s been growing I think at about 7 or 8 per cent per annum compound.  The industry’s doing really well, so you’d be buying the gold stocks for growth, for income and the AUD gold price is just going to be much stronger so their earnings are going to be much stronger.

Good on you, Barry, it’s been great talking to you.  Thanks.

Thanks, Alan.

That was Barry Dawes, the Executive Chairman of Martin Place Securities.