Gold vs. Gold Stocks

30 Nov, 2012

Don Coxe is known to have made the link between gold and higher level theoretical physics by labelling it the “anti-matter” of modern finance.  One can presume Mr. Coxe is referring to the way investors rush into gold in times of fear and doubt (to clarify the analogy, antimatter is theorized to have an opposite charge and quantum spin than that of ordinary matter, similar to gold exhibiting negative correlation to equities during certain periods).  This stabilizer effect can be more intuitively described, in Mr. Coxe’s own words, as gold’s “newfound role as moral arbiter of governments’ fiscal and monetary policies.”

One might think that you can tap into the metal’s properties by investing in stocks of companies that deal with gold production. However, the relationship between the two asset classes  is not that simple. Since the start of 2007, bullion has returned 170% while the Market Vectors Gold Miners ETF (NYSEARCA:GDX) has only returned 36%. More recently, since January 2011, while bullion (Gold Spot) has been up 25%, GDX fell by 11%:

Hedging Production

Hedging practices have been known to cause poor relative performance in gold mining stocks. Many investors deploy capital towards gold stocks because they want leverage to the metal; a rally in gold prices can be amplified through the increase in miners’ profit margins if cash costs of production stay fixed. As leverage to the commodity is a main goal driving investors, they tend to punish companies that hedge a significant portion of their future production (Consider the poor performance of Barrick Gold (TSX:ABX) in the years around 2009).

To add onto the list of woes, this practice can be quite costly, as the futures contracts often used to effectuate the hedge can move against the firm before maturity (daily settlement), forcing a margin payout.

We see this dynamic at play by looking at two different gold miner indices: NYSE ARCA Gold Bugs Index (INDEXNYSEGIS:HUI) vs. NYSE ARCA Gold Miners Index (INDEXNYSEGIS:GDM).  The former only includes miners that do not hedge production while the latter is indifferent to hedging practices of component stocks.  Since gold’s decade long rally began in early 2001, HUI has returned close to 1100% while GDM has returned close to 600%.

While hedging practices have explained the relative lagging performance of certain gold stocks in the past, they fall short in explaining the recent disparity among the asset classes: both the GDM and HUI indices are down since January 2011 (-12% and -9% respectively) while gold is up 25% over the same period.

It is interesting to note that the difference between the two ETF’s has dissipated in recent years, hence their close performance since Jan 2011. This is mainly due to management within the gold mining industry realizing the many benefits of un-hedged production, resulting in hedges dwindling throughout the industry.  Observe the significant decrease of the practice over the past decade:

Source: ABN AMRO Gold Hedging Report – Q2 2011


An interesting area of analysis is the effect of geographic diversification of gold miner’s operations on their share prices. As with international manufacturers, the profitability of miners who operate in developing countries is partly contingent upon their ability to exploit low-cost third world labour. However, mining industry management has significantly lower bargaining power with their workers/labourers when compared to manufacturers, because they cannot simply relocate when wages get too expensive; they are tied to the geographic location of the resource.

This dynamic is underscored by the recent union disputes and large settlements across the industry: In December 2011, Freeport-McMoRan (NYSE:FCX) capitulated with a 37% wage hike offer to workers at its Grasburg mine in West Papua; Lonmin Plc (LON:LMI) agreed to increase wages by 22% for their Marikana mine workers, ending a bloody five week long strike that started over the summer and which saw the deaths of 45 people; Coal of Africa Ltd (JSE:CZA) agreed to increase wages by 26% to end strikes at the Mooiplaats site in South Africa which started in late September; AngloGold Ashanti Limited Plc (NYSE:AU) at one point had almost all of their 35 000 South African workers participating in wildcat strikes in September, and recently resolved many of the disputes by giving an undisclosed “improved wage offer.”

As these are significant increases in expenses, these strikes aggravate the increasing cost problem the global mining industry has been facing (see  “Costs and competing investments”), but disproportionately towards developing regions that suffer from labour unrest. Take a look at the chart of cash costs of production for the regions below:

To see if this has anything to do with the recent underperformance, one can use Bloomberg’s EQS function to produce a list of gold miners that generate over 99% of their operational income from North America (companies that are not just based in North America, but operate solely in the region).  One can then create a custom market capitalization-weighted basket to back test the performance of this group of stocks, and compare them to their geographically dispersed peers (GDXJ was used here, because the stocks generated from the screen were small to midcaps).

Over this two year time horizon the basket is still underperforming gold bullion significantly, thus suggesting that political risk isn’t fully accounting for the disparity.  It is still important to note the relative outperformance compared to their geographically dispersed peers, represented by GDXJ. One possible interpretation is that investors are reflecting concerns that the recent trend in wage disputes will spread across the industry, resulting in eroding margins and production capacity across developing regions. People are skeptical in mining companies’ ability to tap into cheap labour markets and control costs moving forward.

Costs and Competing Investments

Gold mining stocks face increasing competition for investor capital over the past few years. This is due to the rise in prevalence of ETFs and the industry-wide problem of rising cash costs of production.

Before the emergence of exchange traded bullion funds, there were limited options for investors to gain exposure to the gold space: they could either buy futures (where they would have to post margin and could easily be wiped out), buy bullion directly (which came with high transaction and storage costs for smaller investors, and which was a much less liquid option vs. stocks) or they could buy stock in gold mining companies. Stocks were the most convenient option for most investors, causing them to grudgingly accept the operational risks that come with mining companies.

The recent emergence of exchange traded bullion funds (SPDR Gold Shares—Nov 2004, iShares Gold Trust–Jan 2005, ETFS Physical Swiss Gold Shares—Sep 2009) on its own has diverted capital from gold mining companies, as investors now have an easy and liquid way to accurately tap into the metal’s performance. However, the inability to continue attracting investment capital was aggravated by the recent sector-wide problems in the gold mining industry. To build on the section above, though some regions are facing more labour problems than others, increasing cash costs of production have been a problem plaguing the global mining industry:

The above figures are quite conservative. Nick Holland, the CEO of Gold Fields Ltd., says cash costs are deceiving as they represent “only half the equation.” When focusing on total costs, which include capital expenditure, costs of replacing exploited reserves, and other overhead costs associated with production, Holland says you get a figure of around $1300/oz.

The only appealing reason to buy gold mining stocks is to obtain leverage to the commodity. But with gold itself doing so well this past decade, and mining companies facing increasing technical and geopolitical risks, the case for investing in gold mining stocks has been quite weak recently.

Don Coxe expressed concerns over this when he and his team suggested to the World Gold Council not to create the ETF, worrying that “the GLD would eventually compete with the stocks for investor favor.” He was spot on: according to Bloomberg data, holdings of gold through ETFs have more than tripled in the last 5 years, reaching 2,410.2 metric tons on March 13. This has coincided with decreasing gold mining stock premiums (gold stocks within the Standards and Poor’s/TSX Composite index traded at 16.7 times earnings in March, representing a 12 % premium over the rest of the index—the lowest level since 2003.)

With only a finite amount of investment capital available, more money flowing into gold and gold backed ETFs means less into gold mining stocks, leaving miners lagging behind.

Official Sector Demand

The official sector activity in the gold market has been booming in the past few years. According to the World Gold Council, emerging economies’ central banks have been large net buyers of gold since Q2 2009, with the motivation of diversifying their reserve asset holdings. This was fueled by a combination of factors, including concerns of overexposure to the dollar and the euro, and that sovereign bonds are now not as riskless as they once were viewed. These concerns make the low correlation that gold exhibits with other asset classes very appealing.

As shown below, official sector demand for gold has increased nearly 500% since 2010, while world gold demand increased 11% in 2010, and is flat over the same two year period (normalised as of 2010 annual data, as before that year central banks were net sellers since 1988).

When combined with the recent growth of bullion-linked ETF investments, the massive increase of official sector gold demand continues to add upwards price pressure only on the metal itself, further contributing to the disparity between the performance of the metal and gold mining stocks.

Looking Forward

When dealing with the financial markets, investors commonly question how long a deviating trend can persist before reverting back to the norm. In a recent Bloomberg interview, Joseph Wickwire, manager of the Fidelity Advisor Global Commodity Stock Fund, pointed out that we’ve seen bullion out-perform equities before during a 17 month period from 2004-2005, only to see a miners comeback in spectacular fashion to outperform the metal for the following 2.5 years. Low valuations across the sector in his opinion represent a great buying opportunity.

Experts across the sector such as Tanya Jakusconek, analyst at Scotia Capital, and David Christensen, CEO of ASA Ltd, a California based asset management firm which invests in precious metals, cite capital spending cutbacks and other forms of operational tightening as a way that firms will improve cash flow and as a catalyst for higher valuations.

Other catalysts include further appreciation of the price of gold, which, all else being equal, would positively impact margins and potentially cause management to start paying out decent dividends. Furthermore, a sustained rally in gold bullion can cause some lower grade resources which investors ignored in the past to become economically viable, increasing the valuation of mining companies.

If one decides that gold equities will outperform bullion moving forward, (they started to do so since July), I recommend focusing one’s exposure to mining companies that generate the majority of their income in politically stable regions. Since investors have expressed concern over the risks associated with the production process across the industry, I see a relative out-performance of North American and politically stable producers in the future, as the fear of spreading labour disputes will deter investors from deploying capital in developing areas.




About the Author
Magid Awad is a 3rd year finance major at McGill University. He is a member of the Financial Open trading simulation team, the McGill Debating Union, and is currently working with the U.S. Consulate conducting industry and company-specific research for their Commercial Service department.

About the author

Related Posts

Leave a reply