Gold producers worth a look

GOLD is something that has piqued our interest in recent weeks but it's beginning to feel like the market may have overreacted.

GOLD is something that has piqued our interest in recent weeks. Since late last year we have seen some precipitous falls in the share prices of gold producers, largely driven by a declining gold price. In fact, looking at a sample of ASX-listed gold companies, the average share price fall since October is close to 60 per cent. It's beginning to feel like the market may have overreacted.

When we say "gold", we should add our focus for the moment is on producers, rather than the metal itself. Investing directly in the metal requires a confident view on where its price is going, and to have that confidence requires a self-delusion that for the moment is lacking. More on that later.

We need to acknowledge that further large changes to the gold price will affect the fortunes of gold producers, and so we can't put our head in the sand in respect of them, but if we can see good value in gold producers based on the gold price remaining broadly where it is, that can stack the odds in our favour, possibly enough to justify the risk.

Before you ask, we should also add that Newcrest Mining is not among the companies we are looking at. Newcrest has consistently dismal economics and we have never understood why our peers have been willing to pay the prices it has previously traded. Today, with the price having fallen by almost 60 per cent since its peak in September last year, Newcrest still looks expensive in our estimation and our interest in it remains firmly "un-piqued". What I find more interesting are some of the lower-profile gold producers. In particular, companies that may have healthy production growth profiles that the market has lost interest in.

Before we consider their merits, we should return to the gold price. Since October, when it traded at about $US1800 an ounce, the gold price has fallen by about 25 per cent to now be in the mid-$US1300s. During that decline, the Montgomery (Private) Fund has not held the shares of gold companies. In Australian dollar terms, however, the decline has been softened by the falling currency, which is about 17 per cent. This is still a meaningful change, but arguably small compared with the near 60 per cent share price decline for the typical ASX-listed gold company in the same period.

We can't exclude the possibility that the gold price will continue to fall. While it is considered a financial asset, gold earns no income, and we know of no reliable way of assessing its "value". All we can say with confidence is that the current price reflects the market's best judgment of what gold is worth (for now). There is a school of thought that says the gold price shouldn't fall much further, because many of the world's goldmines will start losing money at lower prices.

The logic says that a gold price below the cost of production would curtail supply, and the forces of supply and demand would drive the price back to a "profitable" level for gold producers.

We're sceptical about that argument for commodities generally, as we have seen many commodities trade below the cost of production throughout history. We are especially sceptical in the case of gold. Most of the gold that has ever been mined now sits in investors' vaults, and there is nothing preventing those investors from selling it.

If they decide for whatever reason to sell, then it can become part of the supply equation, and the marginal cost to remove it from the vaults is close to zero. In fact, it may well be that the cause and effect relationship runs the opposite way for gold prices. It seems very plausible that a high price would prompt marginal goldmines to start operating and thereby raise average production costs, rather than the gold price being set by the level at which the world's gold producers can operate profitably.

So we are left with the current market price as our most reliable indication of what gold is worth, and the question we are interested in is: based on that gold price, are there gold companies whose share prices now look cheap based on our best estimate of the potential future profits, and having regard to the risk?

That debate still has some way to run at Montgomery, but we do have a good idea of where we are most likely to find a positive answer. Some of the companies that we will be running our analysis over include: Silver Lake Resources (SLR), Medusa Mining (MML) and Resolute (RSG).

Roger Montgomery is the founder of Montgomery Investment Management and author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com.