Gold Stocks Are in a 'Sweet Spot,' Says Goldman Sachs

Gold may have fallen to two-week lows in recent days but that has done nothing to damp enthusiasm for producers at Goldman Sachs, which on Friday claimed gold stocks were in a "sweet spot."

"We accept gold stocks have rallied significantly, (more than) 100% year to date. However we believe there is still a significant leg up for these equities," noted Goldman analyst including Eugene King and Abhinandan Agarwal.

The theory goes that gold producers have spent the past few years cutting capital expenditure and operating costs, and that with a 17% increase in gold's spot price this year are now reaping outsized free cash flow not yet factored into share prices.

Gold fell to $1,310.3 an ounce on Friday, down $7.70 or just over half a percentage point, but remains up almost 24% since the start of the year.

"Gold companies have endured the pain of repairing their balance sheets, selling/closing loss making mines and taking extra costs/capex out of the system," Goldman noted. "At spot gold prices, these companies should now generate greater than 6% average free cash flow yields to 2020."

Free cash flow yield is calculated by dividing the free cash flow per share by the share price. In general terms the higher the FCF yield the more an equity is potentially being undervalued by the market.

The evident explanation for gold's outsized FCF yield is fear that gold will pull back, likely when the Federal Reserve announces a much anticipated rise in interest rates possibly later this year. Goldman thinks the miners stocks are currently pricing-in an about 5% to 10% fall, or cushion if you prefer, in gold prices.

There is good reason to believe that the fear is unfounded.

Yes, if the Federal Reserve hikes interest rates there will inevitably be a gold price dip, but it is likely to be short lived.

A rate increase, if it happens, will be shallow and would almost certainly be associated with a downward revision of long-term U.S. growth - a negative for the prospect of future rate increases.

That is likely to reassure gold investors in the medium term and could encourage some who have been hanging on the sidelines to buy. Meanwhile uncertainty from the U.S. elections and the ongoing fall out from Brexit will provide spikes of uncertainty of the sort that gold investors adore.

The question then becomes what is going to trigger Goldman's "significant leg up" for gold stocks. The bank's answer is dividends.

Large gold companies currently pay an abysmal average yield of about 2%.

With cash flowing in, balance sheets already strengthened, and investment in new projects likely to be years away due to the drop off in spending on exploration in recent years, gold producers will come under pressure to increase distributions.

Goldman is currently predicting dividend yields will creep up to about 2.5% in 2017 and 2018, but notes that forecast free cash flow should enable companies to return an average 4% by 2017 and 5% by 2018.

Goldman's top picks are Randgold Resources (GOLD) , which has a 12-month price target of £120 ($157.3) per share, against a current share price of £73.20; Gold Fields  (GFI) , with a price target of 110 South African rand ($7.72) against a current price of R68.38; AngloGold Ashanti   (AU) , target price R400 against R217.6; and London-listed Centamin, which has a price target of 200 pence against a share price of 137.3 pence.

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