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Searching for value amidst a wave of write-downs

There is little arguing that 2013, thus far, has been a rough year for investors in gold mining stocks. But just how bad it has been may come as a surprise to some. Not since the financial crisis of 2008 have investors seen so much of their...


There is little arguing that 2013, thus far, has been a rough year for investors in gold mining stocks. But just how bad it has been may come as a surprise to some. Not since the financial crisis of 2008 have investors seen so much of their wealth demolished in such a short period of time.

There may, however, be a golden lining for investors willing to look at the scenario with fresh eyes, as it may be presenting some interesting investment opportunities that otherwise wouldn’t be available.

Before delving into such opportunities let’s take stock of the series of bad news that has brought gold investors to this juncture.

It began early in the spring with the first whispers around the possible end to loose monetary policy. The problem was such talk wasn’t supposed to happen until a tsunami of inflation was unleashed due to the quantitative easing of the last four years. With still no signs of inflation on the horizon, and the chaotic European situation beginning to calm, the reasons for continuing to hold gold were no longer compelling.

For exploration and development companies that meant a drying up of financing, and their lower stock prices have been reflective of that fact.

For the producers the big consequence has been the massive write-downs they have had to take on their balance sheets as the forecasts and assumptions used to make valuations in the past have had to be re-calibrated with today’s lower gold price.

Particularly hard hit are miners that have made recent acquisitions. This has to do with recently adopted IFRS rules regarding the re-valuation of goodwill that is generated when an acquisition is made. Goodwill is the amount a company pays above the fair value of the assets it is acquiring. It is carried as an asset on the balance sheet but must be regularly tested to see if it accurately reflects real values. When gold prices fall, goodwill is the first asset to get hit as was seen with Kinross‘s (TSX:K; NYSE: KGC) acquisition of Red Back Mining and its Tasiast mine in Mauritania.

The other asset to get hit hard at a time of falling prices is development projects due to the overoptimistic estimates and forecasts used back when gold prices were higher. Barrick Gold‘s (TSX:ABX; NYSE: ABX) Pascua Lama project on the border of Chile and Argentina is a prime example of such a situation.

With assets that are worth less, the valuation of a company’s equity should fall, as well. Indeed, if markets were truly efficient, the value of the equity should fall in step with the decline in the asset value.

But as we will see, with some of the bigger companies this hasn’t always been the case, and therein may lie an opportunity for investors.

Barrick Gold (TSX: ABX; NYSE: TSX)

Write-down of $8.7 billion mainly connected to acquisition of Equinox Minerals and the Pascua-Lama development project.

Dividend cut by 75%.

Year-to-date its market cap is down roughly $8.52 billion.

Kinross Gold (TSX: K; NYSE: KGC)

Write-down of $5.5 billion mainly connected to acquisition of Red Back Mining and its Tasiast mine. Of that total, $4.5 billion has been written down over the first six months of this year.

Dividend has been eliminated.

Year-to-date its market cap has lost $2.58 billion.

Newcrest Mining (TSX: NM; ASX: NCM)

Write-down of $5.29 billion, connected to its acquisition of Lihir Gold and its interest in Evolution Mining.

Dividend has been eliminated.

Year-to-date its market cap is down $4.28 billion.

Goldcorp (TSX: G; NYSE: GG)

Write-down of $1.9 billion connected to its Penasquito mine in Mexico.

Dividend is actually higher this year. The company pays a monthly dividend and this year it has been 5¢ per share compared to last year’s 4.5¢ per share.

Year-to-date has lost $3.96 billion of its market cap.

Newmont Mining (TSX: NMC; NYSE: NEM)

Wrote down US$1.8 billion connected to stockpiles and two of its Australian mines. When including 2011 write-down of Hope Bay project in Nunavut, the number moves up to US$3.4 billion.

Dividend is directly linked to price of gold and fell 30% from the previous quarter.

Year-to-date has lost $5.23 billion of its market cap.

Using the loss of market cap relative to the size of the write-down as a guide to picking a value stock, Goldcorp would appear to be the best option as it has shed far more market cap than what its actual write-down would deem fair. Investors should also pay attention to the fact that the company has actually raised its dividend while the other companies have either cut dividends or eliminated them altogether.

By comparison Newcrest has only lost $4.28 billion in market cap compared to a $5.29 billion write-down and an eliminated dividend. This could indicate that a further reduction in its equity price is yet to come.

If an investor believes that market forces will eventually push the respective equity prices to a more intrinsic value, then a “pairs” trade can be established with a long position in the more attractive company, in this case Goldcorp, and a short position in the company expected to decline further, which using the above metrics would be Newcrest.

The pairs trade is established using equal dollar amounts in both positions. It also benefits from being relatively market neutral as both companies have a similar beta. A market neutral trade is established by going long and short stocks with similar betas. By nullifying the beta an investor’s position should be immune from overall market movements thus leaving the investor exposed only to the idiosyncratic risk and return profiles of the companies they are investing in.

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