Gold small caps where global predators are prowling

Smaller gold miners look set to follow their bigger rivals as takeover targets, with many remaining undervalued despite a strong run up in the precious metal price.

If retail investor demand were to increase further from its lows as recessionary fears grow or if sharemarkets become more volatile, that could further support the gold price.

More Australian gold miners could receive takeover bids in coming months, with many remaining undervalued despite a strong run up in the gold price and the global appeal of local miners highlighted by Newmont’s takeover of Newcrest.

Significant announcements could be made in the lead up to Australia’s Diggers and Dealers mining conference that starts in Kalgoorlie on August 7.

Many companies have used the conference as a platform to announce merger activity.

There are several reasons why the recent merger and acquisition activity in the Australian gold sector is likely to continue.

First and foremost is the outlook for the gold price. While recent positive economic data and hawkish global central bank commentary has tempered gold’s appeal, the outlook for the precious metal remains fundamentally strong for the second half of 2023 and beyond.

Support for the gold price is underpinned by unsustainably high debt levels, sticky inflation and rising geopolitical risk.

The combination of these factors and the risk of a recession is likely to provide a solid floor to the gold price.

Growth through acquisition increases the miners’ leverage to the gold price that is trading near all-time highs in Australian dollar terms.

To date, investors have rewarded the larger more mature gold miners over smaller developers and explorers.

The disconnect in valuation makes the current situation for large producers ideal to make sensible acquisitions of additional resources to incorporate into their existing mine plans. Australian gold explorers are trading at an enterprise value to gold resource metric of approximately $45 an ounce versus the long-term average of $75/oz.

In general, the balance sheets of gold miners are strong with most in a net cash position. Unlike previous gold bull cycles, the sector has remained disciplined and not overstretched balance sheets, allowing acquisitions simply to add gold ounces to production even if they are unprofitable.

Goldminers now appear willing to grow but only if it adds value to the acquirer.

Access to capital has become significantly more difficult for explorers and developers. The ability to fund capital-intensive exploration and development programs has been significantly constrained.

In addition, the inflationary cost environment has made it difficult to justify new developments. This provides a window of opportunity for cashed up producers to swoop in.

There are relatively few large gold miners in Australia producing more than 500,000 ounces of gold annually, and one even fewer when Newcrest merges with Newmont this year.

The Australian gold industry remains very fragmented with a larger number of producers producing 100,00 to 300,000 ounces a year.

The opportunity is to consolidate at this next level and be re-rated by the market as a large producer.

Cameron Judd

Offshore interest in the Australian gold sector is also very real. In addition to a favourable exchange rate, Australian miners offer a favourable jurisdiction with relatively low political and legal risk.

While exploration drill rigs continue to turn, the rate of new gold discoveries has reduced

substantially.

As producers continue to mine, their gold inventory is depleted. It is an ongoing battle to replace mined gold with new gold. Given the low valuation of explorers, it is now cheaper

for producers to acquire an explorer with inventory than to discover and build new projects.

In the last three recessions since 2000, the gold price has outperformed US equities (as measured by the S&P 500) on average by 23 per cent, justifying gold’s position as a hedge against financial turmoil.

Further, in periods of high inflation, gold has a history of preserving its purchasing power.

We believe investors should allocate 5 to 10 per cent of their portfolios to gold to reap superior risk-adjusted returns over time.

If the risk of recession increases this year, and the US Federal Reserve reduces interest rates, gold prices could rise.

An economic contraction could be driven by a significant increase in corporate defaults or slowdown in consumer spending given the high interest rate environment.

Historically, recessionary periods have resulted in higher volatility, significant stockmarket pullbacks, and an overall appetite for high quality, liquid assets such as gold.

Another potential support for the gold price could be retail investor demand.

To date, retail investors have been relatively slow to buy gold-backed exchange-traded-funds – gold ETF demand remains near three-year lows despite the strength in the gold price.

If retail investor demand were to increase further from its lows as recessionary fears grow or if sharemarkets become more volatile, that could further support the gold price.

---

Cameron Judd is portfolio manager for gold strategy in the Global Multi-Strategy Fund at the Victor Smorgon Group.