Investment commentary: Searching for value amidst a wave of writedowns, pt. 1

There is little arguing that it has been a rough year for investors in gold mining stocks. But just how bad it has been may come as a surprise: not since the financial crisis of 2008 have investors seen so much of their wealth demolished in such a short period of time.

There may, however, be a golden lining for investors willing to look at the scenario with fresh eyes, as it could present some interesting investment opportunities that otherwise wouldn’t be available.

Before delving into such opportunities, let’s take stock of the series of bad news that has brought gold investors to this point.  

It began early in the year with the first whispers around the possible end to loose monetary policy. The problem was that such talk wasn’t supposed to happen until inflation followed the quantitative easing of the last four years. With no signs of inflation and the chaotic European situation reaching a state of calm, the reasons for holding gold were no longer compelling.

For gold exploration and development companies, dried-up financing and lower stock prices show this fact.

Gold producers have consequently taken massive writedowns on their balance sheets, recalibrating the forecasts and assumptions used to make valuations in the past to match today’s lower gold price.

Particularly hard hit are miners that have made recent acquisitions. This has to do with new international financial reporting standards (IFRS) regarding the revaluation of goodwill that is generated when an acquisition is made. Goodwill is the amount a company pays above the fair value of the assets it acquires. It is carried as an asset on the balance sheet but must be regularly tested to ensure it reflects real values. When gold prices fall, goodwill is the first asset to get hit, as was seen with Kinross Gold’s (TSX: K; NYSE: KGC) acquisition of Red Back Mining and its Tasiast gold mine in Mauritania.

Development projects also took a hit from falling prices, due to the overly optimistic estimates and forecasts that were made when gold prices were higher. Barrick Gold’s (TSX: ABX; NYSE: ABX) Pascua-Lama gold-silver project on the border of Chile and Argentina is a good example.

With assets that are worth less, the valuation of a company’s equity should fall as well. Indeed, if markets were efficient, the value of the equity should have fallen with the decline in the asset value.

But with some of the larger companies this hasn’t always been the case, and this could be an opportunity for investors.

Barrick Gold

Writedown: US$8.7 billion, mainly from acquiring Equinox Minerals and developing Pascua-Lama.

Dividend: Cut by 75%.

Market cap: Down C$8.5 billion year-to-date.

Kinross Gold

Writedown: US$5.5 billion, mainly from acquiring Red Back Mining and its Tasiast gold mine. Of that total, there has been a US$4.5-billion writedown over the first six months of 2013.

Dividend: Eliminated.

Market cap: C$2.6 billion lost year-to-date.

Newcrest Mining

Writedown: US$5.3 billion, connected to its acquisition of Lihir Gold and its interest in Evolution Mining.

Dividend: Eliminated.

Market cap: Down C$4.3 billion year-to-date.

Goldcorp

Writedown: US$1.9 billion, owing to its Penasquito mine in Mexico.

Dividend: Higher this year — the company pays a monthly dividend and this year it has been 5¢ per share, compared to last year’s 4.5¢ per share.

Market cap: Lost C$4 billion year-to-date.

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Newmont Mining

Writedown: US$1.8 billion connected to stockpiles and its two Australian mines. When including the 2011 writedown of its Hope Bay project in Nunavut, the number moves up to US$3.4 billion.

Dividend: Linked to gold price. Fell 30% from the previous quarter.

Market cap: Lost C$5.2 billion year-to-date.

Using the loss of market cap relative to the size of the writedown as a guide to picking a value stock, Goldcorp would appear to be the best option, as it has shed far more market cap than what its writedown shows is fair. And the company has raised its dividend while the other companies have either cut dividends or eliminated them altogether.

By comparison, Newcrest Mining (TSX: NM; ASX: NCM; US-OTC: NCMGY) has lost C$4.3 billion in market cap compared to a US$5.3-billion writedown and an eliminated dividend. This could indicate that a reduced equity price is on its way.

If an investor believes that market forces will push the respective equity prices to a more intrinsic value, then a “pairs” trade can be established with a long position in the more attractive company — in this case Goldcorp (TSX: G; NYSE: GG) — and a short position in the company expected to decline further. Using the above metrics, this would be Newcrest.

The pairs trade is established using equal dollar amounts in both positions. It also benefits from being relatively market neutral, as both companies have a similar beta. A market neutral trade is established by going long and short stocks with similar betas. By nullifying the beta an investor’s position should be immune to market movements, which exposes the investor to little more than the idiosyncratic risk and return profiles of the companies they are investing in.

Next week: Part 2.