Three small gold stocks ready to shine

Gold miners have rallied to a one-month high and they might just be the best performing group over the next year.

This thought will appeal to the contrarian in all of us, given that gold equities have been the worst performing class of stocks on the market over the last 12 months.

Tim Treadgold’s piece at the start of the week on why investors should buy gold (Sleep easier on gold’s currency cushion) has coincided with the 1.2% jump in the S&P/ASX All Ordinaries Gold Index of 40 gold stocks to 4,525 yesterday.

The increase marks the index’s third consecutive day of gains as the precious metal regained it glitter on fresh worries about the European crisis, with the bailout for Cyprus thrown in doubt overnight.

Despite the recent bounce in gold stocks, they remain close to their more than four-year low following the close to 30% slump in the gold stock index over the past year. This is twice the loss of the broader S&P/ASX 300 Metals & Mining Index.

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It’s early days yet, but there are reasons to believe that gold equities are at a value inflection point as the factors tarnishing sentiment towards the sector are easing, if not reversing.

Foster Stockbroking analyst Haris Khaliqi believes that gold stocks have suffered more than other miners in the past several months because of the pickup in global growth.

“If economic activity is picking up then the appeal of gold as a hedge [against a global recession] is removed,” he said.

“And if things really start motoring on both domestically and internationally, there is a risk that the gold price could fall [considering] it has risen circa 80% to 100% over the past five years.”

But the latest developments in Cyprus, while fairly small in the grand scheme of things, is a reminder of the danger in being too complacent to the threat the European sovereign debt crisis poses.

The reawakened appreciation of how winding the road to the global recovery is will likely prompt a reversal in fund flows to gold stocks, according to Hartleys analyst, Mike Millikan.

“Some of the larger funds took a view to exit the space for a little while, but I suspect some of these guys will come back in again,” said Millikan.

However, investors shouldn’t only blame the sector’s underperformance on the macro environment.  Gold mining executives need to shoulder some of the blame as they have issued a series of production downgrades over the past 18 months.

Further, gold miners have done a poor job at creating value in spite of the historically high gold price. The sector’s poor track record in returning cash to shareholders, combined with weak capital and cost discipline shown by many miners, has put off many investors.

The growing frustration with gold management teams is the reason why even miners with negligible disappointing news have been harshly sold off by the market, according to Macquarie.

This sense of frustration has prompted investors to abandon gold stocks for gold exchange-traded funds (ETFs), in the bank’s opinion.  Gold ETFs give investors an easy way to gain direct exposure to the physical commodity.

But there is light at the end of the tunnel.  Gold miner managements are aware of the frustration and they know their jobs are on the line.  Macquarie has noticed that most gold miners under its coverage have provided guidance that is more realistic than it has seen in many years.

Management is also starting to be more proactive in seeking ways to unlock value.  Ramelius Resources said this week that it is undertaking a “strategic review of its assets with the aim of realising greater shareholder value”.

ETFs are also arguably less enticing than gold stocks at this juncture, as gold equities are trading well below their fundamental value.

A lot of bad news is priced into stocks, which gives them a greater margin of safety than the commodity.  This is particularly obvious since gold stocks gave up their historical premium over the yellow metal 18 months ago.

Gold stocks used to be valued in excess of their gold reserves and would generate better returns than the physical metal, but the stocks are now trading at their largest discount to the Australian-dollar spot gold price since the dark days of the global financial crisis at the end of 2008.

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While it may be easy to find well-priced gold stocks in this environment, three of them appear to be better placed to ride any upswing in the sector.

Northern Star Resources (NST)

The Western Australian gold miner is a key pick of both Foster Stockbroking and Hartleys as it checks all the boxes for a quality stock.

Northern Star has a growing production profile, a portfolio of quality assets, low-cost operations, a capable management team and a strong balance sheet.

A large gold reserve upgrade announced last week only bolsters Northern Star’s investment appeal. 

The miner said its resources at its flagship Paulsens project have increased by 38% to 555,000 ounces of gold and that grades have improved by 14% to 5.7 grams a tonne, which makes Paulsens a high grade project by global standards.

What also makes the $440 million market cap miner a standout among its peers is the fact that it pays a dividend (Hartleys is forecasting a 2012-13 yield of 3.3%) and has managed to produce a 42% return on equity when the average for the gold sector is a dismal minus 37.5%.

Management is expecting to produce 100,000 to 115,000 ounces of gold from Paulsens this calendar year at a total cost of between $850 and $950 an ounce.  This will generate $85 million in surplus cash for the miner.

Millikan believes Northern Star has the potential to double annual gold production if its Ashburton project lives up to expectations, and has a price target of $1.45 on the stock. This implies a close to 40% upside to Tuesday’s closing price.

ABM Resources (ABU)

Those looking for a bigger payoff and who are willing to move up the risk curve might like to have a look at ABM Resources.

The Northern Territory gold explorer has a busy year ahead as trial mining at its Old Pirate high-grade gold project is about to start in June.

The miner said Old Pirate could be “the best high-grade never before mined gold deposit in Australia” as early drilling showed gold grades of up to 11.96 grams a tonne.

Lime Street Capital bought into the stock for the potential scale and quality of the Old Pirate and Buccaneer projects, which are believed to hold around 3 million ounces of gold in resource.

“If management can prove up the economics of the projects, I would think the company is worth four to five times its current market cap,” said Lime Street’s director, Grant Craighead.

The near-term catalyst for the stock will be results from the trial mining that is expected in the June half.  The program will be funded from ABM’s cash reserves and could potentially be cost neutral from the sale of gold.

Ramelius Resources (RMS)

The fledging gold producer is worth watching not only because of its strategic review, but also because it is one of the cheaper producers in the gold sector.

It is unclear what the strategic review might entail as no one at the company was available for comment, but it could involve a merger of some sort or a capital return to shareholders as both will support the share price.

Ramelius is trading on an enterprise value to gold reserves of $66 an ounce, when the sector average is $394 an ounce.

The miner has no corporate debt, is able to fund current projects from existing resources and has $43 million in cash, which is a very sizeable balance relative to its market capitalisation of around $120 million.

Ramelius expects to lift annual production to 100,000 ounces of gold by September this year and it predicts cash costs to fall from $1,019 an ounce as production increases.

The stock is part of the Uncapped 100 Index, which comprises the 100 stocks that small cap investors should know about.

Subscribers to Uncapped will get timely updates and analysis on breaking news affecting these stocks when the site is launched.

Brendon Lau is the editor of Uncapped and may have interests in some of the stocks mentioned in the article.

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