Pop goes the value

AngloGold, the biggest of the South African mining houses, has at last taken another run at consolidation with its bid on Ashanti Goldfields. Having lost out to Newmont Mining in the bidding war for Normandy Mining, AngloGold is ready to conclude a friendly merger with a willing partner this time.

A successful takeover would make AngloGold the world’s largest gold producer, with 7.6 million ounces annually, vaulting past rival Newmont’s 7.3 million ounces.

This time, there’s less risk of failure — narrowly defined here as “not closing the deal you set out to make.” That much should reassure those AngloGold shareholders who are on board simply to be part of one of the world’s largest gold producers. Shareholders with the admittedly unconventional goal of making money from gold mining may not be so easily calmed.

There has been an assumption, especially among the larger investment houses, that the gold industry must consolidate to make itself attractive to investors. Size matters, to those charged with managing money, because they must track the market indices that closely follow the performance of the world’s largest companies. Only large companies will be on their radar screen.

That’s a satisfactory strategy for money managers who need to cling to a stock index for the validation of their skills. It may not, however, be a good way to make money if large-capitalization companies become bad investments. There is an old axiom that nobody will criticize you for losing money in IBM; that may hold, but you’ve still lost the money.

Nor is catering to that investment philosophy a surefire way for gold producers or their shareholders to make a decent return. For it is at the top of the consolidation food chain — with the Barricks, Newmonts and Placer Domes — that the least money has been made in the two years or so that the gold price has been rebounding.

Over the past two years, the gold price has risen about 27 per cent. Over the same period, share prices for two of the industry’s Big Five — Barrick and Placer — have actually fallen, and interestingly enough, they were two of the “winners” in bidding wars. Meanwhile share prices for mid-tier and small gold producers have rocketed; some small producers, like Hecla and Eldorado, are up 400 per cent in the same stretch.

It’s not altogether a coincidence. Acquisition has been costly, and while it may improve cash flow, reserves and production, it consumes capital. This has been reflected in the share price of some of the acquisitors.

There can be little doubt the gold industry suffers from being fragmented: with the number of small producers, and the relatively small market share commanded by its biggest fish, it would seem to be an industry that needs to be consolidated. But if the alternative is the kind of consolidation that destroys value, then perhaps it is time to look at the gold business through a new prism.

Gold deposits are finite in size, and there are a great many more small ones than there are large ones. Moreover, smaller deposits will, in some cases, be more economic to mine than large ones. The restriction — wisely identified as the “scale trap” by Alan Carter of BHP Billiton — is that large companies see no impact on their value if they find or acquire a small-to-medium-sized gold deposit. They therefore buy either other companies with a number of producing mines, or junior companies that have found large resources.

In either case, they often ignite costly takeover battles, which drive up the cost of the acquisitions. In the second case, they pay an acquisition premium for deposits whose principal virtue is size, rather than profitability.

In the end, the question is: how much is a shareholder prepared to pay in order to hold shares in the largest gold producer in the world?

There is definitely a point at which he will be paying too much.