Gold and Precious Metals: Relationship on the rocks

Precious metals equities have re-rated to historical peaks or above. Morgan Stanley lifts its bull cases to reflect this, but still the risk reward is unappealing bar continued commodity price rises. MS downgrades Randgold to UW, with Centamin most and Fresnillo least preferred.

Equity valuation disconnects… The recent rally in precious metals equities propelled valuations to levels that are at or far above historical peaks. While earnings expectations have lifted on higher gold and silver prices, we argue that >2/3 of equity performance was driven by multiple re-rating. Our analysis suggests that the market is paying a 29% premium to what it has historically paid for reserves and resource. Without diminishing the risks of more upside if risk aversion continues, we highlight that equities are discounting gold and silver prices that are, on average, 35% above spot through perpetuity if we use an average WACC of ~10% across our coverage.

…downgrading Randgold to UW, Centamin most preferred, Fresnillo least preferred. We move Randgold to Underweight on stretched valuation, with the shares trading above historical peak multiples (EV/R&R value, EV/EBITDA) and discounting a gold price of US$2,350/oz (10% WACC) or a WACC of 0.1%. We still like the company’s solid balance sheet, its prudent capital allocation, and excellent operating track record. We increase all of our bull cases to reflect a scenario in which the shares trade in line with historical peaks in the gold price. While our price targets imply on average ~12% downside, our relative preference remains Centamin, with levers left to pull to increase output/reduce costs. Fresnillo is our least preferred, as we think the shares are pricing in perfect project execution, leaving little room for error.

Operationally and financially in good shape. Unlike their base metals peers, gold and silver producers retain robust balance sheets, with 3 out of 6 companies keeping a net cash position. This gives optionality to better manage sector cyclicality without exposing shareholders to disproportionate risks and to seize reinvestment opportunities as they arise. Companies have shown prudence and discipline so far, in our view. Additionally, cost improvements and overall price deflation over the last 12-18 months reduced all-in cash costs (AISC) whereby gold and silver prices would need to fall by ~36%-51% before those companies burn cash on just sustaining capital.

This rally is (somewhat) different from historical precedents. We identify 6 rallies in gold equities with >60% performance over the last 40+ years including the current one, but excluding the super cycle. The current rally stands out. It has occurred over a relatively short time frame, with gold equities up 111% in just 8 months, compared to 20 months in one previous instance with a comparable level of performance, and 18-24 months for 2 rallies with over 200% absolute performance.

Morgan Stanley Research