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Since the fall of 2008 and spring of 2009 when the economy, commodity prices, and stock market reached its bottom, commodity prices across the board have seen significant price appreciation. Everything from copper to oil to steel to gold have increased dramatically. As expected, the companies associated with these commodities have also increased dramatically.

However, the performance of companies has varied across sectors, with some companies seeing dramatic price appreciation and other companies seeing lower returns. This article reviews the performance of gold companies in an attempt to identify which companies have the highest cost structures and hence benefit the most from price increases, but subsequently suffer the most from price declines. These are the marginal players on the global supply curve for gold.

Globally traded commodities are generally subject to supply and demand economics that set their prices. Companies that participate in the extraction and supply of these commodities all have varying levels of operating costs that determine their cost structure and ultimately their profitability. Some companies have operations that consistently have low costs in turn have lower exposures to commodity price changes. Other companies are much more marginal and carry much greater exposure to commodity prices. In a way, these equities can work like options on the underlying commodity. The table below illustrates two hypothetical companies.

This example is overly simplified since all costs are assumed to be variable; however, it illustrates the basic point. So if commodity prices appreciate more than expected, the companies with the greatest benefit are the ones with the highest cost structures. In the boom and bust cycles of refining capacity, it is possible to purchase very marginal assets in the hopes that the future price increases will push the asset into profitability. This can create a substantial return to the investors.

Potential evidence of this effect in gold companies would be companies with strong equity performance but lower margins. The key challenge is understanding what the market expectations are for the price of gold for the different companies. If market participants expect gold prices to increase, they should be willing to bid up companies with higher cost structures more than companies with lower cost structures since those companies would make disproportionately larger profits and cash flows than the lower cost structure firms.

Companies Reviewed

I reviewed the following eight companies to see if this occurred and then to suggest which companies would be hurt most by an unexpected decline in gold prices. Price information is as of close on January 21, 2011. 12-month returns are from Yahoo Finance pulled on January 23, 2011.

In comparison, the SPDR Gold Trust ( GLD ) has appreciated 22.3% in the past year and 48% in the past two years. So purchasing GLD would have outperformed all but 3 of the above companies. Additional analysis also shows that the Enterprise Value of these companies is closely linked to the equity value showing that the returns are not driven by financial leverage. Equity Value/Enterprise Value ranged from a low of 92% to a high of 105%. A ratio above 100% implies that the company has more cash than debt on its books.

Analysis

The focus of the analysis is to compare cost structure to performance and identify the companies with the highest cost structure and companies with lower cost structures. Companies with lower cost structures are clearly more stable and viable in the long term however, high cost structure companies are more volatile with changing markets and potentially offer significant alpha opportunities.

Note that Gold Fields, Kinross, and Royal Gold have year end financials in June so the 2008 figures were from year end June 2009 and 2007 were from year end June 2008. I adjusted the companies' operating income by adding back nonrecurring expenses.

The 24-month return shows that the companies with the highest returns had lower average margins in 2007 and 2008. While the companies with the lowest returns had high margins. In particular, Royal Gold, with the highest margin in 2007 and 2008 showed the lowest return, despite maintaining a high operating margin.

While valuation metrics were distributed, the top performers showed a slightly higher ratio, suggesting that some of the performance was due to multiple expansion. This multiple expansion might be driven by the lower margin under the belief that gold prices will continue to rise, giving them disproportionate increases in value captured.

Key Issues

This analysis does have some limitations and requires further detailed analysis of the companies to eliminate other possible explanations of valuation, margin and performance. Key factors include hedging decisions, overall exposure to gold, and management strategy.

1. Hedging - Because gold is a commodity with a futures market it is possible that certain companies have hedged a portion of their production and not captured the full appreciation of the gold prices over the past couple years. Furthermore, these companies may have hedges going forward that will limit their earnings if gold prices continue to increase. These factors would be reflected

2. Exposure to Gold - While the companies reviewed are primarily in the business of exploration and production of gold, they are engaged in other activities for other metals, often including silver and copper as well as lead, zinc, uranium and sometimes oil and gas. For example, KGC has gold reserves worth about 80% of its total reserves, while for GG this ratio is just 49%.

3. Management strategy - Valuations and performance will change based on stated management goals and decisions. Determinations to make significant investments or distribute cash flow to shareholders can impact future performance and valuation. The eight companies reviewed all had similar divided yields of around 1% with a low of .4% and a high of 1.1%.

Conclusions

Based on this analysis, it seems that companies with higher cost structures (lower margins) showed better equity returns recently suggesting that they would also fare worse in a downturn. The other interesting note was that valuation multiples showed significant variation across market participants ranging from a low of 5.5 to a high of 18.6.

1. If you believe that gold will make a significant move, both AngloAshanti and Gold Fields would be good candidates. For a upward moves, going long either would be best, while for gold price declines going short would work. AngloAshanti would be better as a short candidate given its high multiple while Gold Fields would be the better long candidate given its low multiple.
2. Newmont Mining also represents an interesting long option given its low valuation to its peers.
3. A potential valuation pairs trade could be long Newmont Mining and short Barrick. The rationale is that the valuations should come together, while the similar profit margins suggest similar cost structures so that changes in gold prices should have similar impact on both.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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