Gold miner Centamin has appeal as volatility rises

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Gold miner Centamin has appeal as volatility rises

Owning Centamin (LON:CEY) as part of a diversified portfolio of shares looks like a sound move given the uncertain outlook for the global economy.

One of the big success stories of 2016 has been the rising price of gold. It started the year at $1,061 per ounce and now trades 18.3% higher at $1,255 per ounce. This beats the FTSE 100’s rise of 14%, although when dividends are added the total returns are within 1% of another.

However, gold offers better defensive characteristics than shares, which is why I believe that it has significant appeal.

Gold’s appeal as the ultimate insurance 

Gold has a history of being viewed as a relatively safe asset. In times of high inflation, recession and other economic crises, gold has been in high demand among investors. This trend could continue since the global economy faces a number of key threats to its growth outlook.

The most obvious of these threats as far as UK investors are concerned is Brexit. Already, the Bank of England has lowered its growth forecasts for 2017 and increased its unemployment forecast.

However, Brexit has the potential to not only hurt the performance of the UK economy in the short run. It could also cause an already weak Eurozone to tip into recession. In turn, the knock-on effects on global economic growth could be negative. In such a scenario, the popularity of gold may rise if investors adopt an increasingly risk-off attitude.

Similarly, the outlook for China is highly uncertain. On the one hand, government stimulus has boosted its performance. But on the other hand, the rate of GDP growth in China is on a path to a lower level. By 2020, the Chinese economy is expected to be growing by 4.8% per year versus the 6.7% growth rate achieved today.

While this is a concern for investors, the transition of the Chinese economy could have a bigger impact on the gold price. That’s because the Chinese economy’s transition from capital expenditure-led to consumer-led is unlikely to be frictionless.

This could cause waves of volatility, such as was seen in August 2015 and January 2016. In such a scenario, rapidly falling asset prices could cause the gold price to rise.

US interest rates – lower for longer

In the short term, the biggest impact on gold is likely to come from US interest rates. In 2016, gold has benefited from a lack of US interest rate rises. The market had priced in up to four interest rate rises in 2016, but now expects just one in the next year.

This is good news for the gold price, since it means that competition from interest-producing assets is likely to be relatively low in the short to medium term. It also means that the US dollar may not strengthen as quickly as expected, which would be positive news for the gold price.

Undoubtedly, US interest rates will one day be much higher than they are today. Therefore, gold will become less appealing relative to interest-producing assets. However, the pace of interest rate increases is forecast to be slow, with the market anticipating US interest rates of 2.25% in 2020.

Increasing production and a lowly valuation

Due to an upbeat outlook for the gold price, I believe that gold miner Centamin will rise in value. It is taking full advantage of the performance of gold by increasing production levels.

In its most recent production update, Centamin stated that its gold production had increased by 41% versus the same quarter of the previous year. It has also increased guidance for the full year. It now expects to produce up to 540,000 ounces of gold which is forecast to boost profit before tax by over three times in the 2016 financial year.

Even though Centamin offers defensive characteristics thanks to gold being viewed as a safe haven, it has a relatively low P/E ratio. Assuming it delivers on current year EPS guidance, Centamin has a forward P/E ratio of 9.2.

In my view, Centamin’s valuation has scope to rise even if the P/E ratios on other shares fall. That’s because the global economic growth outlook may deteriorate and gold miners could subsequently become increasingly in-demand among risk-off investors.

A few drawbacks to bear in mind

Where Centamin lacks appeal is with regard to its diversity. Its principal asset is the Sukari mine in Egypt. This leaves Centamin open to political risk as well as the potential for accidents at the mine which may slow or even halt production.

Further, the mine has a 20 year life span. This means that a generous portion of Centamin’s free cash flow will be required for exploration costs, as well as sustaining capex for its producing asset.

However, in my view Centamin’s valuation adequately accounts for these risks. Political risk in Egypt has lessened in recent months and Centamin’s lack of debt means it can afford to invest elsewhere to develop other assets.

Furthermore, its status as a pure play gold miner may not prove to be a disadvantage. In recent years, commodities such as copper, iron ore and oil have been positively correlated. Therefore, the benefit of diversification within the resources sector is sometimes overplayed.

Outlook

A US interest rate rise would be likely to cause the gold price and Centamin’s share price to fall. However, I feel this would only be a short-term effect since a slow medium-term US interest rate increase should maintain gold’s appeal versus interest-producing assets.

Additionally, the risks facing the global economy could lead to greater risk aversion among investors. This could increase demand for gold and send Centamin’s share price higher. On this topic, Centamin has much further to go in my view due to its low valuation and the potential for a continued ramp-up in production.

Although Centamin’s reliance on one site in one country increases its risk profile, I believe that its low valuation adequately compensates investors for this.

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