The golden ratio

PORTFOLIO POINT: Newcrest’s reserves put it in striking distance of the world’s biggest gold miner.

Gold is not a popular investment among DIY funds, who are often consumed with finding investments that offer both stability and yield. Of course gold has a long history of big price fluctuations and as we all know, there’s no yield in holding gold.

It’s something of a pity because at times gold can be a fantastic defensive investment. And so we find that the share register of leading gold miner Newcrest is dominated by Australian institutions that hold about 30% of the stock, and foreign institutions that hold most of the remainder.

When it comes to resource stocks, Australian private investors much prefer to invest in giants such as BHP Billiton because their stock is available at a price/earnings multiple that is about half those of the gold miners, which makes them look cheaper on paper.

This week the price of gold soared in value and hit fresh highs of $US1447.40 overnight. It has risen 7% since the start of February; in the same time the ASX 200 has fallen 1%.

This is yet to be reflected in Newcrest’s share price, which has deviated significantly from the gold price over the past two months, according to a recent note from Goldman Sachs.

But as we all know, gold can go through long periods of being out of favour, such as in the late 1990s and early 2000s when it traded for less than $US300 an ounce.

But aside from those fluctuations, in simple terms, gold is a hedge against one of the biggest risks facing the world: that the global reserve currency, the US dollar, suffers a severe decline. Australian investors are lucky because in Newcrest we have access to one of the best value gold investments in the world.

I was directed towards Newcrest by a Eureka Report reader who pointed out that my previous article showing that China planned to elevate the yuan to a currency with global status (see Rise of the 'redback’) meant that the US dollar would fall and accordingly gold would be a great investment over two to five years.

If we remember that the elevation of the yuan is a long-term play, not a short-term game, the logic behind this strategy is hard to fault. So investors wishing to protect themselves against a structurally weaker US dollar will be attracted to gold. It must also be said that Newcrest shares will react like all gold investments if the value of gold slumps.

Newcrest is a remarkable Australian company. Since it acquired Lihir Gold in 2010, the market value of its reserves has risen beyond $US220 billion – ahead of Newmont, with $US180 billion, and in striking distance of the world’s biggest gold miner, Barrick, with $US300 billion. This is a great achievement.

What should be just as interesting to investors is that world markets ascribe a higher value to both Barrick and Newmont than Newcrest, but that gap is likely to close in the next few years. Newcrest is a gold play with a value kicker.

The global market tends to value gold companies around 25–30 times earnings, or more than twice the level of major miners such as BHP Billiton. The extra premium comes from the currency risk hedge that gold shares offer.

When it comes to production, Barrick is clearly the world leader, producing about 7.8 million ounces a year compared with Newcrest’s 2.74 million ounces. However, all that is about to change.

Over the next three years, to June 30, 2014, Newcrest will progressively increase its output by 8% a year thanks to the commissioning of three new mines including Hidden Valley and Cadia East, to reach a total of 3.75 million ounces.

Newcrest is likely to increase its output even further in the years that follow, which means that gold production at the company is set to rise almost 50% over the next four years. Earnings will follow a similar trend assuming the gold price remains constant. If gold shares continue to be valued on the same basis as they have been for the past decade or so then Newcrest shares will rise in tandem with the higher production and profits.

But there is a second aspect to consider when valuing gold shares because the market likes to see reserves of at least 15 times current production.

Barrick, with reserves of about 140 million ounces and production of 7.8 million ounces, meets that test with reserves that are almost 18 times its annual output. Newmont has gold reserves of 93.5 million ounces or 17.3 times its production of 5.4 million ounces. Newcrest has reserves that are 29 times its current output.

Unfortunately, once reserves reach around 25 times production the market is not interested of putting a value of them and so a significant portion of Newcrest’s asset base is given no value by the market.

When Newcrest production reaches four million ounces, the current 80 million ounces reserve would represent only 20 times production and still be well ahead of the 15 times trigger point. Importantly, Newcrest has unproved gold resources of 140 million ounces, so there is clear scope for it to lift reserves at some point in the not too distant future.

According last month’s Newcrest presentation, the market value of the gold, copper and other reserves of Barrick and Newmont is five or six times their enterprise value (enterprise value being market capitalisation plus debt). By contrast, the market value of Newcrest reserves are seven to eight times the current enterprise value!

The reason for the difference is simply that Barrick and Newmont produce more gold. Their higher production and therefore higher profits are the main driving force setting their share price. However, Barrick has found it difficult to find new gold reserves to replace its high levels of production, which was set as a result of a series of acquisitions.

As Newcrest increases its production it will encounter a similar reserve problem but that difficulty is probably a decade away. Newcrest is comfortable that it will be able to produce more than four million ounces a year for some time. Recent drill results from an exploration target in Papua New Guinea called Wafi-Golpu have been described as “world class”.

Rampant gold bulls often build portfolios where gold is their main cornerstone. That is a very high-risk strategy and not one I would recommend to most self-managed fund investors, particularly as the Australian dollar provides a partial hedge against gains in the gold price. The successful chief executive of Newcrest, Ian Smith, is also due to depart and there are some questions about the company’s exposure to Lihir’s controversial PNG assets.

But for those prepared to ride the inevitable fluctuations in gold a proportion of any equity portfolio should include an exposure to gold to prepare for the fact that the Chinese wish for the yuan to at least partially replace the US currency.

And we are fortunate that one of the best world gold investments is housed in Australia. In years gone by Newcrest was a prime takeover target for either Barrick or Newmont, particularly when the former board of Newcrest gambled on currency swap securities and lost heavily plunging Newcrest shares.

But the majors hesitated and Newcrest recovered and it now has reserves that are larger than Newmont and are beginning to challenge Barrick. Newcrest is too big for the majors unless Newcrest is prepared to recommend a bid, which is highly unlikely.

-The big league
Company	ASX	Market cap	52-wk low	52-wk high	Close 24/3	Consensus target	% diff	2011 P/E
Newcrest	NCM	$29 billion	$35.15	$43.71	$38.05	$47.70	25.36%	22.64
BHP Billiton	BHP	$248 billion	$35.58	$47.63	$44.71	$54.25	21.38%	11.04
Rio Tinto	RIO	$160 billion	$58.86	$89.04	$81.60	$106.27	30.23%	8.17

Our Eureka Report reader suggested that BHP might acquire Newcrest, but that is also unlikely because if the Newcrest assets were housed in BHP they would not reflect the much higher premium given to gold shares.

Indeed, Newcrest started off as BHP Gold, which the Big Australian hived off so its shareholders could take advantage of the higher premium given to gold assets. Accordingly, most merger activity in the gold industry is conducted by other gold companies, not the big miners.

Newcrest is not for everyone but it represents one of the best gold plays in the world and the beauty of it is that it is based right here in Australia.