With a circa 50% drop, 2013 may well have witnessed the largest ever decline of the gold mining equity sector, certainly of the last 30 years. 
Global markets did not appear to have any concern for risk. We saw the VIX and below investment grade (‘junk’) bond issuance at pre-crisis levels, equity markets at all-time highs and a benign inflationary environment. Gold, widely considered a hedge for financial and tail risks, and gold equities clearly fell out of favour with investors.
An additional factor placing downward price pressure on the gold price and exaggerating the under-performance of the gold mining sector are the large numbers of ‘short’ players in the market. Simply put, we will see no positive momentum in the gold price until gold bullion ETF redemptions cease.
Notwithstanding, we have seen a solid base emerge for the gold price at USD 1,200. First in June and then re-tested in December, we take this resilience as a very positive sign and it is not without support. We have seen repeated strength in demand, from China in particular, buying on the lows and providing a quasi floor to the price.
Additionally, although with a lag, we have seen the supply side respond with forecast mine production growth slowing through 2013. Indeed reserve calculations have declined and earnings season forward guidance generally confirms earlier than previously planned mine closures (i.e. a shorter reported mine lives) with some mines already in closure mode.
The case for an increase in the gold price
Despite clear signs of economic improvement – unemployment rates falling, GDP growth emerging, or normalising, and little fear for inflation - fiscal deficits and sovereign debts continue their steady increase and governments are still monetising this debt. Further, it is not clear that a withdrawal of QE operations will be without risk, that we will not see some form of market disruption. Amidst such uncertainty and through sporadic event risks, gold will again be rewarded as a safe-haven asset.
Further, despite the headline investment outflows, we see very strong consumer demand for Gold, particularly from the East where demand through 2013 had grown to around 5x that of consumer demand from the West. Indeed, according to HSBC estimates some 80% of outflows from Gold ETFs went to China in the last year, meaning that the nation is currently absorbing around 50% of the world’s gold production. At those volumes, and with the forecast plateau in production, the supply-demand dynamic will be very supportive of the gold price.
Gold stocks and gold equity investment remain very attractive
Although it is clear that the gold price must increase for the sector to soar, the gold miners themselves are in good shape.
From a valuation perspective, the miners are trading at very low levels and are exceptionally cheap on both a fundamental basis - with P/NAV at levels seen during the crisis – and relative basis – trading at deep discounts to both the physical (miners vs. bullion ratio ended January at 0.52x versus a 10 year average of 1.25x) and broader equity market (underperforming the MSCI World by a staggering 95% for the three years ending 2013).
In addition to compelling valuations, the gold mining industry itself is becoming more organisationally capable, responding to an environment of high costs and falling gold prices with a sustained focus on production efficiencies, cost reductions and increased flexibility in mine planning in response to gold price fluctuations.
How is the Fund currently positioned?
Given the above outlook for the gold price and our conviction in the opportunities within the sector, the fund is currently positioned to take advantage of the sensitivity of gold stocks to an increase in the gold price. We hold no physical (bullion) and are fully invested.
Regardless of how positive we are on the broad outlook for gold, we will always remain cautious in implementing our exposure. Currently, we remain invested in those companies that are better able to weather the storm of continued volatility - even declines - in gold pricing. That is, lower cost producers and those companies with strong balance sheets.
More specifically, the Fund is currently:
- underweight the large producers as they typically have weaker balance sheets
- overweight juniors with a bias toward producers versus developers
- overweight royalty and streaming companies as they have very low operating costs
- overweight silver miners as, with a greater exposure to industry, they have the potential to outperform gold miners in an environment of economic strength.
This positioning has so far served the Fund well over the rally of the first 8 weeks of the year returning around 28.6%, some 4.7% above benchmark and close to 19% above Gold (USD, PA share class performance to February 20th, 2014 versus FTSE Gold Miners and Gold commodity index).
