INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaMcLeod Senior Portfolio Manager, with responsibility for advising the Anchor July 15 th, 2013 Outlook for Gold and Gold Stocks Stock market outlook Our July 1 Anchor Note highlighting our Stock Market Outlook, expressed some optimism for a summer rally but we underlined that, in view of the longevity of this cyclical bull market, we needed to re-evaluate come the fall. However, we also expressed the opinion that the severe backup in 10-year Canadian and U.S. government bond yields of the last two and a half months should run out of steam shortly, which should help the gold sector. We will be highlighting that in this Strategy Note. Outlook for gold and gold stocks Introduction A couple of months ago, we featured an outlook for gold and gold stocks in our Anchor Note. Our conclusion was that there was a decent prospect for the bullion price to stabilize between $1,300 and $1,400 per ounce and, if that were the case, the valuations of some of the major miners could be regarded as very cheap. One of the indicators we said we would be following closely was the pace of ETF liquidation: if the weekly liquidation pace continues to drop over the next few weeks, our confidence in the price of bullion having found a bottom at or above its intraday low of $1,321 an ounce on April 16 would increase commensurately. The period since May, however, has seen further downside in both the metal and the stocks. Bullion registered a short term bottom at $1,179 on June 28 with about a $100 an ounce recovery subsequently. The XAU (Philadelphia Gold/Silver Index) hit a low of $82.29 on June 28 and has recovered close to 9% since. We have recently spoken to senior management of most of the gold companies in our universe and thought it timely to provide an update on the sector. a) Pace of ETF liquidation The May Gold Council Quarterly report, reviewing the first three months supply/demand picture, highlighted the strong demand for physical gold in the form of jewellery, from gold bar and coin demand and the contrasting liquidation of gold ETFs. All of the Q1 improvements in demand for physical gold were dwarfed by the decline in ETF demand. In Q4, there was net increase of 88 tonnes while, in Q1, there was liquidation of 177 tonnes. The bulk of the drawdown appeared to have come from institutional investors as hedge funds and other investment funds turned negative on bullion.
The pace of ETF liquidation accelerated in April by 174 tonnes, which was almost the equivalent to the decline in all of the first quarter and was the major factor behind the $130 an ounce drop in the bullion price in the month of April. The selling of gold from ETF s was at its most intense in the middle two weeks of April, which saw weekly declines of over 60 tonnes for those two weeks. The pace of liquidation slowed in the last week of April and the first three weeks of May according to Bloomberg s daily tracking of total gold holdings in all ETF s as the weekly liquidation averaged 29 tonnes a week over that period. For the last week of May, the liquidation was only 16 tonnes and the bullion price moved back above $1,400 an ounce. The liquidation kept at that pace until Bernanke had his press conference explaining the potential time frame for tapering. Investors interpreted this as a sign that there would be less liquidity flowing into markets, which initially further hurt bonds, gold and to a lesser extent stocks. ETF sales were 53 tonnes in the week ending June 28 and 36 tonnes in the following week. In the latest reported week, the liquidation had dropped back to 22 tonnes. In sum, the ETF peak at the end of 2012 was 2,628 tonnes. The current level is 1,987 tonnes for a decline year-to-date of 24%. To feel confident that the bear market in bullion is over, we would like to see the ETF liquidation slow further and preferably disappear. b) Managed Money positioning in gold As mentioned above, hedge funds generally have been liquidating their long positions in gold ETF s. In addition, a number of traders have jumped on the momentum band wagon and shorted gold. Traders categorized by the CFTC (Commodity Futures Trading Commission) as Managed Money had record short positions as at July 2 of 81,627 contracts of 100 troy ounces (data available back to the beginning of 2008). This compares with 30,254 such contracts in the first week of January. Long contracts were 103,011 as at July 2 down from 117,603 contracts at the beginning of January. After the $100 an ounce rise since the end of June, those investors that are short might be feeling a high degree of discomfort currently. c) Seasonality In terms of seasonality, we also mentioned in our May note that May/June tends to be a seasonal low point for gold and gold stocks. Performance of both is often robust between July and September/October. We have done further work on seasonality and narrowed the best period of the year for bullion to be more likely the end of June to the end of September and for the stocks to be the last week of July to the last week of September. If seasonality works this year, in our opinion, now would be the best time in the year to be increasing exposure in the sector. This of course does not speak to the long term. d) Situation of the various companies in light of the recent decline in the gold price Our recent interviews with the companies underlined the changed emphasis on the part of managements of the major gold miners to stress profitability rather than production growth as a result of investor pressure to improve returns. This is, of course, harder to accomplish at $1,200 to $1,300 an ounce gold than it would be at $1,400 an ounce gold. Evidence of this can be found in the trend of these companies now providing guidance around all-in costs per ounce not just operating cash costs but also G & A (general and administrative cost), debt service, exploration and sustaining capex costs. On this basis, for example, Barrick s all-in cash costs are estimated at $1000 an ounce, Goldcorp at $1,050 an ounce, Agnico Eagle at $1,100 an ounce while Yamana is targeting $900 an ounce by the end of the year. Kinross s Q1 all-in costs were $1,038 per ounce.
Investors have been clearly worried about asset write downs after Barrick s announcement that it would likely be taking a $4.5 to $5.5 billion impairment charge on its Pascua Lama project with publication of its Q2 results on August 1 plus potentially other write-downs. As in 2008, when the bullion price was weakening sharply, that set analysts looking at debt covenants for each of the gold companies as it related to minimum book values. This could be a problem for Barrick if the impairment charges turn out to be large. However, in such cases, it is likely that the covenant could be renegotiated at some incremental cost to Barrick. All the other companies we spoke to suggested that it was unlikely that there would be any major other impairment charges recorded outside of Barrick and possibly Kinross until the fourth quarter as managements would wait to see where gold prices settled out over the next number of months. In the case of Agnico Eagle, its biggest susceptibility to impairment would be Meadowbank in a lower gold price environment as its cash costs at this operation are about $1,000 an ounce (Goldex would also be around $1,000 an ounce but it is a very small operation comparatively). However, AEM took a major write-down at the end of 2011 on Meadowbank and this operation s book value is only $679 million currently or less than $4 per AEM share. Goldcorp has limited write off risk.yamana s highest cost operations are Alumbrera and Jacobina. However, the book value of each is $230 million and $800 million respectively for a combined total of only $1.40 per share. Balance sheets for the various companies vary considerably. Obviously, with in excess of $12 billion of debt, Barrick Gold s balance sheet is of the greatest concern to investors although there are no short or medium term repayments to speak of. In our opinion, Goldcorp is in excellent shape financially as it has debt of $2.3 billion but cash of $2.1 billion and available credit of $2.0 billion. Agnico Eagle had long term debt of $800 million at March 31 2013 but cash of $264 million and lines of credit of $800 million. Kinross has debt of $2.2 billion but cash of $1.4 billion and lines of credit of $1.5 billion (as at March 31 2013). Yamana has $870 million of debt but cash and available credit of $1.0 billion. $780 million of the debt is due in 2018 or after. Franco Nevada has no debt and cash of $900 million (figures are current as of July 12, 2013). e) Valuations of the various companies We have always preferred to evaluate gold companies on the basis of cash flow. Obviously, cash flow estimates going out this year and the next couple of years are highly dependent on the gold price assumption one uses. Analysts are busy revising their estimates downwards to reflect lower prices for bullion. However, based on current consensus estimates, which, in our view, are likely to be high variously by 10% to 20%, Barrick Gold and Kinross have the weakest growth in cash flow per share between 2013 and 2015 at +6% and -4% respectively. The strongest growth in cash flow per share over this period would be Goldcorp (+62%) followed by Agnico Eagle (+37%) and Yamana (+31%). In terms of cash flow multiples, Barrick Gold is the cheapest in both relative and absolute terms as it trades at just 3.8 times blended 2013/2014 CFPS. However, in light of the impairment and balance sheet concerns, we now believe that it will suffer for the while from extremely low valuations. Yamana, on the other hand, sells at 7.7 times blended CFPS a 34% discount from its average P/CF multiple of the last two years while Agnico Eagle trades at 9.3 times blended CFPS a 27% discount to its average P/CF multiple of the last two years. Kinross trades at 4.9 times blended CFPS 34% below its 2-year average P/CF multiple but justified, in our view, by the uncertainty as to the progression of the Tasiast expansion and impairment risk. Goldcorp trades at a 37% discount to its 2-year average P/CF multiple, which akin to Agnico Eagle
represents reasonable value in view of its growth profile and strong balance sheet. Finally, Franco Nevada sells at a 14% discount to its 2-year average P/CF multiple but the multiple is likely to stay somewhat depressed in the very short term until the Company announces its next acquisition, which will likely be forthcoming in the next three months and very possibly in the oil and gas field. In sum, we think the chances, from both a seasonal and contrarian point of view, are reasonable that gold and gold stocks could stage a decent rally in the short term. Longer term will depend on the resolution of some of the supply/demand fundamentals such as the ETF liquidation falling into place. As described in the section below, we now have modest exposure to the sector in the relevant portfolios. price for AEM has so far given us a partially offsetting gain. We also added to Yamana in the Anchor Dividend Growth fund. These trades were funded in the Anchor Dividend Growth fund by reducing our position in Manitoba Tel (MBT). As a result of the Allstream deal and the net rise in the stock, MBT had become the biggest holding in this fund. Finally, in the Anchor High Income fund, our 5% current position in Agnico Eagle was funded by the sale of Barrick and small reductions in our BCE and Telus holdings. Portfolio changes Our recent interview with Barrick and resulting concerns over the construction delays and impairment risk for Pascua Lama led us to switch out of Barrick into Agnico Eagle in the Anchor Dividend Growth and High Income funds albeit at a loss. Fortunately, our purchase Nick Majendie, CA Director, Wealth Management Senior Portfolio Manager
Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of Scotia Capital Inc., is the manager of the Anchor. ScotiaMcLeod, a division of Scotia Capital Inc. is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaMcLeod, provides portfolio advice to the Funds. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaMcLeod or on www.sedar.com Anchor hold securities of the following issuers referred to in this note: Agnico Eagle, Manitoba Tel and Yamana. Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: Agnico Eagle, Manitoba Tel and Yamana. This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaMcLeod, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice.