The force that have pushed gold prices to record highs in recent years are likely to end, according to Charlotte Thorne, co-chief investment officer and co-founding partner of Capital Generation Partners, the firm that is based in London’s Berkeley Square.

The force that have
pushed gold prices to record highs in recent years are likely to end, according
to Charlotte Thorne, co-chief investment officer and co-founding partner of
Capital Generation Partners, the firm that is based in London’s Berkeley
Square. (Her firm was developed out of a private investment office serving a
single family.) Her views are her own, but this publication is pleased to share
her views on this important topic that goes to the heart of a major issue –
wealth preservation. Late in June, the price of gold fell below $1,200 per ounce, although it is recovered slightly since.

Over the past ten years the price of gold has risen
tremendously, buoyed by new methods of access, regional shifts in supply and
demand and new regulation. In recent months, however, the yellow metal has seen
more volatility than it has in the previous 30 years, this quarter the gold
price is set for its biggest drop since 1920. Many investors have viewed the
sudden price crash as an opportunity to buy, while others see it as a natural
correction as a bubble bursts and real interest rates increase.

For those that wish to seek exposure to gold there is a lot
of choice about how to do so – be it physical (bars, coins etc.), exchange
traded funds, gold derivatives such as options or gold mining equities. This
choice is made more complicated by the fact that the price of gold mining
equities has been dislocated from the wider price of gold.

When the price of gold hit its height of over $1,900 per
troy ounce in 2011, the valuations of miners remained subdued. This has been a
long-term trend - from 1984-2012 the Philadelphia Gold and Silver Miners Index
rose by 46 per cent yet the gold price rose by 343 per cent over the same
period. So why is there such a large divergence?

One of the chief reasons for the dislocation is the
fundamental difference in risk/rewards for equity and commodity markets. For
example, miners are subject to operational risk, with the chance of accidents,
cost overruns, political intervention and general mismanagement priced into the
equity value. For gold mining companies in particular, cost risk is also a
fundamental issue, with declining resources and rising prices encouraging the
mining of ore that is more costly to extract. Furthermore, building new mines
is a time consuming and risky process, requiring careful management of
governmental relationships, local communities and possible environmental
issues. These risks are not an issue when using other methods of gaining exposure
to gold, such as ETFs or buying physical gold.

When mining companies are not building new mines, they have
undertaken high-risk M&A transactions. Historically, gold miners have used
times of plenty to increase their capital expenditure instead of paying larger
dividends, in order to offset declining production. The creep of CAPEX is
viewed by investors as a substantial risk, with the market reacting negatively
due to a series of high profile failed and costly deals.

The dislocation is also a reflection of the fact that the
different methods of accessing gold exposure have very different investor bases
that have reacted differently as the market has changed. Since 2000 there has
been a large shift to investment as a source of demand for gold and
correspondingly a great deal of innovation in how institutional and private
investors gain exposure. In the past, a gold investor had few choices – taking
physical delivery of bars or coins, or investing in gold mining stocks. With
the advent of the first gold ETF, investors were given a new method of gaining
exposure that negates many of the risks and costs associated with mining
stocks.

While some of the investment demand for gold mining stocks
has now been removed and relocated to ETFs, the use of these vehicles has
changed pricing in different ways. ETF investors are often speculating on the
spot gold price, whereas investors in gold miners are typically more interested
in dividends and company cash flows, using the long-term gold price. As a
result, the valuations of gold miners will typically move more in line with the
longer end of the gold forward curve, which is less volatile than the spot price.

So, will this dislocation ever end? There is a persuasive
argument to suggest that there will soon be a reversion to mean due to changes
in the gold mining industry.

Over recent years the gold mining industry has done much to
improve its operating efficiency. In the past gold miners may have been plagued
by disastrous expenditures that have had little positive result; however, there
are signs that the industry has learned from this.

Shareholder pressure

Responding to shareholder pressure, many miners are now
making larger dividends and have switched from semi-annual to quarterly and
monthly pay-outs, while others have linked their dividend payments to the price
of gold. This may result in a re-rating that will also be encouraged by the
fact that miners are now ending their historical hedging strategies, which
served to decrease their exposure to the gold price and participation in any
short-term price rises.

The recent large drop in the gold price has brought the gold
price close to the marginal cost of production, and is likely to lead to
further writedowns by miners who spent on costly acquisitions over the last 10
years, such as Newcrest Mining's recent decision to write down $5.5 billion.
This could lead to consolidation in the industry and some miners share prices have
fallen far enough to be potential acquisition targets. A return to rising
equity markets and a stable or rising gold price would help provide a catalyst
for the miners to close the performance gap with the gold price.

The price of gold is still volatile; however, the market has
shown that it is able to react and survive periods of upheaval. While the price
dislocation has been caused by fundamental shifts in supply/demand dynamics and
the launch of gold ETFs, the divergence may soon come to an end.