The quiet boom in gold equities
By James Luke, Fund Manager, Metals at Schroders
Gold miners are generating record margins and have built fortress balance sheets, yet trade at unstretched valuations. The market is starting to pay attention.
In 2024 we set out our view that despite a secularly bullish outlook for gold, gold equity valuations were close to 40-year lows, adding that “the sector could rally 50% and still look inexpensive".1
Incoming interest has been picking up lately, and gold equities have been quietly booming. We say quietly because we don't see much in the way of hype from either investors or from the producers themselves. Recent interest can’t mask the fact that gold funds have seen net outflows of c.US$5 billion over the past 18 months (not what we were expecting).
Naturally, investors are asking whether they have missed the boat. Or is the move is now over and it is time to sell. Reviewing the data, we can’t help but think we were too cautious in our views last year. Despite rallying substantially more than 50% this year, gold equities do still look inexpensive from at least three main perspectives.
- Gold equity performance remains badly dislocated from record cashflow margins (which continue to expand)
Gold equities usually outperform gold in periods when cashflow margins are expanding and underperform when margins are contracting. This is very clear in the 2018 to mid-2023 period.
Since late 2023 producer cashflow margins have expanded to unprecedented levels as gold’s bull market has gathered pace. Current US$2,000/Oz average AISC3 margins are close to 100% higher than the previous peak seen in the COVID summer of 2020.
The reason for that margin explosion is disarmingly simple. Gold is increasingly being priced as a pure monetary asset, or “non-debt money” to quote Ray Dalio, for very good long-cycle secular reasons (see the end of this article). Meanwhile, gold producer cost inflation – mainly a combination of energy, consumable and labour inputs - has slowed substantially from the high inflation seen in the 2021-2023 period. - Unstretched valuations and fortress balance sheets
Margins are very elevated, but investors are rightly asking whether valuations are still reasonable given the move higher in absolute terms. In our view, very much so. We look at a range of valuation and returns metrics within our investment process. These stretch from long term discounted cashflow based metrics such as price to net asset value (P/NAV), to near term earnings and cashflow metrics (EV/Ebitda, free cash flow yields), returns metrics like return on invested capital as well development stage company-specific multiples such as EV/resource ounce. From our perspective valuations remain reasonable across all these metrics, even when running a gold price deck that remains meaningfully below spot prices (where consensus gold price forecasts remain). Overall, increasing share prices are being largely offset by increasing earnings expectations as analysts are forced to increase their gold price forecasts while strong cashflow generation itself works to compress the net debt component of enterprise value. - No sign of “mania” in the sector – in fact quite the opposite
Until very recently, the cumulative reaction from investors with positions in passive and active gold mining funds has been to “sell the rally”. Selling pressure has come in record volumes. Only very recently has interest begun to pick up.
The secular case for gold
Gold’s transition from “niche” investment talking point to real asset class in its own right remains relatively immature. In early 2024 we suggested cycle highs of US$5,000/Oz late this decade were perfectly plausible.
Gold prices are now at both nominal and real inflation adjusted all-time highs. The narrative of how they got here is very familiar: beefed up central bank gold demand after G7 freezing of Russian FX assets in 2022 escalated dollar weaponisation to new levels, the emergence of Chinese household demand as China’s onshore real estate malaise worsened, and recently the White House’s trade war and increasing attacks on Federal Reserve independence.
These are best summarised as fiscal fragility and a geopolitical new world order.
- Fiscal fragility: Unsustainable debt and deficit paths, largely driven by demographic trends and political paralysis in the face of them, are leading towards (some form) of fiscal dominance. That implies weakened central bank independence, higher inflation targets, further debt monetisation, and increasingly shaken confidence in the “safe” nature of long duration sovereign bonds or indeed the existence of a “risk free” asset at all.
- Geopolitical new world order: A continued move away from Pax Americana unipolarity and the post WWII international order towards a multi-polar reality crystallising around US-China competition. A new Cold War, as Niall Ferguson has termed it, that will also bring a monetary multi-polarity to replace the “dollar standard” of the post 1971 period.
Should we be surprised if these secular trends lead to a global economic re-ordering on a par with Bretton Woods? Will investor faith in 60/40 allocations really sustain in a world where long end bond yields ultimately need pinning down via central bank money printing (even if inflation stays above target)?
The point is that monetary demand for gold (a small US$400 billion market) from various gargantuan pools of capital is and will continue to be stimulated by the uncertainty created by these trends. Those pools of capital include emerging market central bank reserve assets, household deposits (particularly in China and the Middle East), institutional investment capital (endowments, pension funds, family offices) as well as increasingly the “cryptoverse”. Of those, only central bank demand has truly boomed, and even there the demand runway remains long.
Investment interest is only now beginning to really pick up. Current ETF holdings of gold are c.95Moz according to Bloomberg. The US$380 billion of investment (at spot) it would take to move those holdings to 200Moz sounds large until you compare the gold market to broader global financial aggregates. A simultaneous global bid will require both much higher prices and significant further jewellery demand destruction to absorb.
Further reading : The quiet boom in gold equities
