Gold Mining Stock Outlook - May 2017

Last year, driven by a combination of macroeconomic catalysts and pent up demand, gold found its way back into investors' good graces, globally. Notably, most of the year had been stellar for gold, with prices gaining 25% up until September. However, it relinquished some of its gains in the fourth quarter following Trump's electoral win and the FOMC's interest rate rise. Overall for the year, gold prices clocked 8% gain, an improvement from the trailing three years, which had dulled its shine.

Prices Gained, Demand Dipped in Q1

Gold prices have risen 9% in the first quarter of 2017 and witnessed a gain of 10% so far this year. Global gold demand was at 1,034.5 tons in the quarter, an 18% decline year over year. The quarter was pitted against a tough comparison considering that the prior-year quarter was the strongest-ever first quarter. Jewelry demand improved a meager 1% year over year but remained weak overall at 480.9 tons as higher trending prices quelled demand. Jewelry demand still remains 18% below the 587.7 tons five-year quarterly average.

India and China continue to be the major markets, hogging almost 56% of the demand. Jewelry demand in India benefited from pent-up demand and increased 16% year over year to 92.3 tons, as market conditions improved after a very tough 2016. However, demand in the country has remained below the 100-ton mark for the last three quarters.

Currently the industry remains wary, awaiting clarity on whether the forthcoming Goods & Service Tax (GST) will result in a higher tax burden for the end user. This will weigh on demand until the government's final decision, due for implementation in early July.

In China, demand for gold jewelry dipped 2% year over year. Demand was stronger at the beginning of the year due to Chinese New Year buying as well as wedding demand. However, demand soon dissipated due to the impact of higher gold prices. Demand in the first quarter was 176.5 tons, 5% below the five-year quarterly average of 186 tons.

Investment in gold bars and coins improved 9% year over year primarily owing to China, where retail investment was up 30%. Investment demand for coins and bars were above the 100 tons milestone -- the fourth time on record.

Central bank purchases declined in the quarter to a six-year low of 76.3 tons and a 27% drop year over year. China, which has been one of the largest purchasers in recent years, put a pause on its purchasing program as foreign exchange reserves remained under pressure.

ETF Inflows: A Promising Sign

Gold ETF Inflows were at 109.1 tons in the quarter and total AUM in these products was 2,251.8 tons with a total value of over $90 billion. Political uncertainty in Europe was the primary reason behind the inflows. The increase in inflows indicates a generally positive underlying attitude toward gold-backed ETFs.

Supply Growth in the Red: A Danger Signal

Supply contracted 12% year over year in the quarter to 1032 tons due to a 21% plunge in gold recycling. The plunge in recycling can be attributed to the high recycling activity observed in the first quarter of 2016 due to the sharply rising gold prices at that time.Mine production in the quarter edged down 0.5% to 764 tons. Production increased in mines that came on-stream recently in the U.S and Suriname.

Production in China dipped 2% due to extended New Year holidays and the imposition of strict environmental management restrictions. However, production took a hit from 8% drop in production at the Freeport-McMoRan Inc. (FCX)-operated Grasberg mine in Indonesia. Production was trimmed by around 60% to match domestic smelting capacity, after Indonesia introduced new restrictions on exports of unrefined metal.

Production has reached a plateau in recent years and is anticipated to take a downward slide soon. In recent years, additional production from new mines brought on-stream has waned and producers have cut down on expenditures and are instead focused on maximizing production from existing portfolio of assets.

Even though there are signs of renewed interest in brownfield development and extending the life of existing mines, it will not be adequate to offset the steep cuts in project development spending of recent years. This will eventually lead to a crunch in supply.

Sector Level Earnings Trend

As per the Zacks classification, the gold-mining industry comes under the broader Basic Materials sector (one of 16 Zacks sectors). Taking into account all the companies that have yet to report in the sector, the sector's earningsrose 15.9% in the first quarter, a marked improvement from the 3.5% growth witnessed in the fourth quarter of 2016.

Positive growth will continue in 2017 with second-quarter earnings expected to improve 3.0% followed by 7.6% and 18.4% in the third and fourth quarter, respectively. (For a detailed look at the earnings outlook for this sector and others, please read our Earnings Trends report.)

Industry Ranking - Negative

We rank all the 265 industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank . Currently, the gold mining industry is in the bottom 32% with a Zacks Industry Rank of #173, indicating a negative outlook.

Cheap Valuation

Going by the EV/EBITDA multiple (a preferred valuation metric for mining companies with high capital expenditures), the gold mining industry has a trailing 12-month EV/EBITDA multipleof 7.63, lower than the S&P 500 EV/EBITDA multiple of 10.57.

Improved Performance

Since the beginning of 2016, the Zacks-categorized Gold Mining industry has surged 66.6%, outperforming the S&P 500's corresponding gain of 26.2%. The industry has also performed better than the broader sector, with the Basic Materials sector gaining 32.5%.

Where Is the Industry Headed?

In the U.S., even though there are positive expectations about President Trump's economic proposals, there are also concerns. The US dollar has gained ground since Trump's victory but uncertainty is rife. This will help retain the safe haven demand for gold. An upward inflationary trend is likely to support gold demand as it is seen as an inflation hedge. Higher inflation will keep real interest rates low, which in turn makes gold more attractive. Further, inflation makes bonds and other fixed income assets less appealing to long-term investors.

Macroeconomic trends in Asia will support economic growth in the coming years. Given that gold demand is generally closely correlated to increasing wealth in the continent, gold demand will increase in tandem. In Asia, gold demand is mainly retail demand for the metal, due to festival and wedding-related buying activities in countries like India and China.

While demand will remain strong, supply of this precious metal has already attained peak levels as per reports. Lower gold prices in the past few years had restricted the ability of gold producers to invest in new projects. There are few new projects and expansions anticipated to commence production this year.

Further, those in the near-term pipeline are generally fairly modest in scale. Thus, global mine supply is in the danger of trickling down. The combination of lower mined gold supply and higher demand could eventually help prices navigate north.

How to Play the Industry

Despite a low ranking now, improved performance compared with the S&P 500, low valuation and earnings growth expectation for the industry makes a good investment case for the gold mining industry. Investors can consider the following gold stocks that are backed by a solid Zacks Rank and estimate revisions.

Golden Star Resources Ltd. (GSS), New Gold Inc. (NGD) and Seabridge Gold Inc. (SA) can be a solid addition to one's portfolio. These stocks currently carry a Zacks Rank #2 (Buy). You can see the complete list of today's Zacks #1 Rank (Strong Buy) stocks here .

Golden Star Resources has an expected earnings growth of 137.50% for fiscal 2017 and 105.26% for fiscal 2018. The company has delivered an average positive earnings surprise of 66.67% in the past four quarters.

New Gold has a projected earnings growth of 57.14% for 2017 and 32.36% for 2018.

Seabridge Gold has a projected earnings growth of 14.29% for 2017.

However, we suggest staying away from or getting rid of Zacks Rank #4 (Sell) stocks such as Alamos Gold Inc. (AGI), Eldorado Gold Corp. (EGO) and Pershing Gold Corp. (PGLC). These stocks have witnessed downward revision in their estimates and also have a negative record of earnings surprise history in recent quarters.

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Seabridge Gold, Inc. (SA): Free Stock Analysis Report

Pershing Gold Corporation (PGLC): Free Stock Analysis Report

New Gold Inc. (NGD): Free Stock Analysis Report

Golden Star Resources, Ltd (GSS): Free Stock Analysis Report

Freeport-McMoran, Inc. (FCX): Free Stock Analysis Report

Eldorado Gold Corporation (EGO): Free Stock Analysis Report

Alamos Gold Inc. (AGI): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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