Mines’ Eyes Have Not Seen The Glory
Gold prices are on a relentless march toward $1,000/ounce. Gold bullion closed on February 29 at $974 an ounce on the New York Mercantile Exchange, and some precious metals analysts are predicting gold will eventually reach $1,700 an ounce or more.
The reasons for the strong move are many. Gold historically has had a strong positive correlation to the price of oil and an inverse relationship to the dollar. With oil on an upward trajectory and the dollar weakening, gold has been following the script. Meanwhile, rising demand for gold in emerging markets, a growing fear of inflation, the unknown depth of the credit crisis and prospects of a U.S. recession are also factoring into the gold rally.
But the interesting thing is, while gold price have gone up and up, gold equities, i.e., the stocks of gold mining companies, haven’t kept pace. The chart below compares the performance of gold bullion (represented by the streetTRACKS Gold Fund [GLD]) and gold mining companies (represented by the Philadelphia Stock Exchange’s Gold and Silver Sector Index [XAU]), which tracks the performance of 16 gold and silver mining companies.
The chart reveals a fundamental truth about gold investing: Owning gold mining stocks is not the same as owning gold. Why the difference?
One old truism is that, in times of economic uncertainty, gold bullion tends to outperform mining stocks, as investors turn to the safe haven of physical bullion. Year-to-date, gold bullion is up by 11%, while XAU is up just 5% and the unhedged Gold Bug’s index (HUI) is up 3%.
There are many reasons for the disparity between the share prices of gold mining companies and the price of the metal. First, gold stocks are typically valued using the rearview mirror. When Wall Street analysts come up with their price targets for the shares of gold mining companies, they’re looking in the rearview mirror. They typically don’t incorporate the full value for a commodity price that is pushing to new highs, because they assume that the metal will soon come down. So analysts, at least until recently, aren’t using $1,000/ounce gold in their forecasts. Their consensus forecast for gold this year is in the $850/ounce range. At $1,000 an ounce, it’s a different story, and gold stocks could get a boost of support if those price levels hold up.
Secondly, while gold is a stalwart in times of economic recession, gold stocks don’t have a strong history during economic slowdowns. In fact, gold stocks have fallen an average of 12% during recessions. That being said, gold stocks are relative outperformers compared with the broader market, which typically falls 20%-25% during recessions.
During equity bear markets, however, mining stocks suffer along with the rest of the stock market. For example, in the 1987 stock market crash, the Dow declined by 35% and the XAU mining stock index declined by 42%, even as the actual price of gold rose.
There’s also the actual business of mining to consider. Mining for gold is an expensive activity, and it’s gotten more expensive in recent years, as energy and labor costs have outpaced gold’s rise. So as miners pull more expensive gold out of the ground, they are paying more to do so. Furthermore, even as the price of bullion is rising, gold mines and mining companies are still affected by a host of factors such as geopolitics, environmental issues, management capability, financial strength, mine life, productivity, energy supplies and hedging policies. Ultimately, mining stocks are only as good as the company and its management team’s ability to navigate these obstacles. Bullion, on the other hand, does not rely on a management team to retain its value.
Moreover, production has actually declined even as prices have gone up, crimping the miners’ ability to capitalize on higher prices. That reflects in part on a long period of underinvestment when prices were low, and the long lead time for new mines to be created.
Of course, gold mining companies can provide great upside if they execute well. If your heart is set on buying shares of gold mining companies, the safe bet is to invest in companies with proven resources already in the ground, as opposed to pure exploration plays. This second group of companies sometimes relies on nothing more than geologist findings to justify their valuations. Companies that have the goods already in the ground can be analyzed and researched and offer more correlation to the price of gold.
One example of a company with the golden touch is El Dorado Gold (AMEX: EGO). It mines for gold in places where other companies don’t go, regions such as Turkey and China. El Dorado’s cost of production is only $186 per ounce. Other mining companies with active production include Anglo American (NASDAQ: AAUK), with operations in Chile, South Africa and Brazil; AngloGold Ashanti Ltd. (AU); Barrick Gold Corp. (ABX); and Compania de Minas Buenaventura SA (BVN). On the opposite end of the risk spectrum, Seabridge Gold (AMEX: SA) has a classic red flag - a $1 billion valuation with no revenue. The company claims to have lots of promising data from its various properties, but until that data translates into actual gold, Seabridge may be a high-risk proposition for any investor.
Investing in gold mutual funds can be cost efficient and help diversify the concentrated and geographic risk of investing directly in stocks. Many of these mutual funds also include companies that specialize in other or different precious metals. The hope is that the manager can separate the bad gold companies from the good.
Whether the economy ends up falling into recession or not, there’s no question that gold is benefiting from current uncertainty. The tradition is for gold to rise during times of inflation, easy money and a weak dollar, and all of that is happening right now. If you are considering an investment in gold, you should keep in mind that historically, global investors will inevitably seek a safe haven for their wealth, and that will often be gold, not gold companies. That should be a cautionary note if the "gold bug" bites.
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