Big miners losing out to gold funds

Major gold firms grappling with declining output and surging costs are being cold-shouldered by investors opting for exposure to bullion through exchange traded funds (ETFs) or high-growth junior firms. A wave of money flowing into gold ETFs, which issue shares backed by physical stocks of bullion, touched a record last week as investors sought a safe haven from other markets.

Traditionally, investors have bought gold mining shares for the extra leverage to benefit not only from a rising gold price but also higher profit margins.

The equation has flipped in recent years despite a surge in the gold price to new highs this year. The Philadelphia gold index, which includes world's top gold miners such as Barrick Gold Corp and Newmont Mining Corp, has lagged the gold price by 11 per cent over the last 12 months instead of outperforming it.

Performance of firms varies, with shares in the biggest by output, Barrick, having the edge over gold by seven per cent while number two Newmont underperformed by 15 per cent.

"I know from our roadshows done overseas and particularly in America that many investors have become quite disillusioned with some of these big gold names," said analyst Steve Shepherd at JP Morgan in Johannesburg.

"A lot of investors have been saying that management of most major gold mining companies has left much to be desired these last few years, leading to a view that investment risk had significantly increased. Many have preferred exposure to gold through ETFs instead."

ETFs track spot gold prices, which powered to an all-time high of $1,030 per ounce on March 17 and was trading at $973 per ounce yesterday morning.

Many investors are reluctant to buy gold bullion because of the inconvenience and expense of storing and insuring it.

FLAT OUTPUT, SOARING COSTS

The surge of interest in ETFs has coincided with a global rally in commodities that has sparked a sharp rise in mining costs due to shortages of skilled workers and equipment. At the same time, miners have been battling to find new deposits. Global gold production has failed to grow for the past five years, edging down by 111 tonnes to 2,476 tonnes over the period, while total cash costs soared by 25 per cent in 2007 alone, according to metals consultancy GFMS.

"One thing that has deterred people from buying equities is their miserable operating and financial performance. The revenue line is going up but the cost line is going up as well," said metals analyst John Reade at UBS Investment Bank in London. "Certainly ETFs are a cleaner exposure to the gold price because you don't have to worry about sovereign risk, you don't have to worry about currency movements, mining cost inflation, royalties, all manner of things."

In South Africa, home to three of the world's top five gold companies, firms are also grappling with power shortages and a government crackdown on fatalities at some of the world's deepest mines.

AngloGold Ashanti, the world's third-ranking gold producer, has seen output fall nine per cent over the three years to 2007 while unit cash costs have climbed 33 per cent. "The major gold producers are typically strapped for reserves, so when the gold price started moving up there has been a tendency to mine lower grades, which diminishes margin expansion in a rising gold price environment," Shepherd said.

Firms grappling with falling output have also tended to make acquisitions at high prices, which can also erode shareholder value, analysts said.

HIGH-GROWTH MINNOWS

Some fund managers are avoiding many of the big-name gold producers and are going for smaller rivals that are increasing production. Daniel Sacks, head of resources at Anglo-South African Investec Asset Management, said certain gold equities still have leverage since they are ramping up production. Some have the added sparkle of huge gains if they become takeover targets. "I think selected gold equities are preferable to a gold ETF. Anything growing gold production with control over their costs should give you a better performance and also often there's a potential for M&A activity."

One of his favourites is Toronto-listed Great Basin Gold, which is developing gold mines in South Africa and Nevada in the United States. The firm, which is ramping up production, aims to more than double annual output by next year to about 275,000 ounces from 80-100,000 ounces in 2008.

Great Basin, whose shares have outperformed the gold price by 50 per cent over the past two years, is a potential target for one of the major producers, Sacks added.

Analyst Brad Humphrey at Raymond James last month pegged his top pick as Eldorado Gold Corp, with a price target of $11.50. The US-listed shares have gained 66 per cent over the past 12 months to $8.33. "In the most recent bull market there has been significant disparity in the performance of gold and silver stocks versus bullion prices, highlighting that investors must select precious metal equities cautiously," he said in a research note. (Reuters)