(Reuters) - Gold mining shares are set to exceed gains from last year, fueled by a bullish outlook for gold prices and a pick-up in merger and acquisition activity, potentially giving the sector an edge over other miners. Gold miners .XAU jumped almost 36 percent last year, outperforming a near 25-percent rise in gold prices in the same period as investors piled into safe-haven assets. The sector underperformed gains in the precious metal in 2008. Analysts expect the sector to advance more sharply than gold in 2010. Year-to-date, the gold mining index is up 1.3 percent, against a 4.1-percent gain in the precious metal. Gold's advance in 2010 has been helped by investors once again seeking refuge as worries over the fiscal health of Greece and other euro zone economies intensified. Demand has also been fueled by anticipation of a pick-up in inflation following ultra loose monetary policy globally. "We do think that gold equities will outperform gold itself," said Bradley George, head of commodities and resources at Investec Asset Management. "We see a 10 to 15 percent upside in the gold price but we see more like 20 to 30 percent upside in the equity names because they're going to have an improving operating margin and we don't think the market has fully priced that in yet." Gold prices could climb as high as $1,300 an ounce in 2010, driven by higher investment demand, according to metals consultancy GFMS Ltd. The metal was trading at $1,138.55 on Friday. Analysts said gold miners could outpace base metal miners if investors turn pessimistic over the global economy and pare back on riskier assets in favor of gold. "Copper, zinc and aluminum prices have moved up quite quickly already and if we see some sort of slowdown in the recovery then those base metal prices could turn downwards and the gold miners could outperform those mining companies," said Investec's George. Analysts' favorites among the miners are companies such as Semafo (SMF.TO), Petropavlovsk (POG.L), Red Back Mining (RBI.TO) and Avocet Mining (AVM.L) and Afican Barrick Gold (ABGL.L) "People are looking for EPS momentum and that's with the likes of Randgold (Resources) RRL.L but its not with the likes of Barrick Gold (ABX.TO) which is just too big," said Joe Lunn, analyst at FinnCap. "Gold miners... can get too big and the EPS momentum dries up and you're struggling to get value," he said. Valuations look compelling for Toronto-listed Semafo and Red Back Mining, which trade on one-year forward price-to-earnings (P/E) of 30.85 and 48.17 times, against the sector average of 82.38. London-listed Avocet and Petropavlovsk look cheap, with estimated forward P/E of 12.27 and 11.55 times, compared to an estimated average of 15.38 for the sector. M&A DRIVE Analysts also see gold mining shares buoyed by M&A as a preferred means of increasing reserves to exploration and identification of new projects -- often a slow and expensive business. "M&A will probably drive the gold sector this year the same way that the gold price rises did in 2009," said Brock Salier, analyst at Ambrian Capital, citing healthy margins as one of the main drivers for consolidation in the sector. For example, the ongoing potential deal between Australia's Newcrest Mining (NCM.AX) and local rival Lihir Gold (LGL.AX) could create the world's fourth-largest gold producer. "We see places like West Africa especially being an incredibly hot area. There are lots of junior companies... with good new deposits and there is a good feeding ground which enables the mid caps to grow by acquisition," Salier said. He cited Centamin Egypt (CEY.L) and Avocet as being well positioned to pick up smaller rivals. Another factor which could turn to the gold miners' advantage is that they carry relatively low amounts of debt. "With the exception of the South African miners, which don't themselves have very much leverage, I would say the industry is very underleveraged," said Ian Henderson, fund manager of the $6.5 billion JPMorgan Natural Resources Fund. "I'm not saying there is no capital required by the industry as a whole. But I would say that the balance sheet for the industry today is as good as it has been in the past 20 years." Gold miners' shares are seen benefiting from rising inflation, which could pick up toward the end of the year as a result of loose monetary policy around the world aimed at reviving the global economy following the financial crisis. Analysts see gold miners as a more appealing hedge against inflation compared to their precious metal counterpart, given their ability to generate greater returns. "From a valuation point of view it makes more sense to hold the miners rather than gold," Investec's George said.

Source