Prime Time for the Midas Metal Miners

10/23/2012 9:30 am EST

Focus: COMMODITIES

Gavin Graham

Chief Strategy Officer, INTEGRIS Pension Management Ltd

Gold miners have underperformed the metal significantly for some time now, but this just may be the time where they pull back into sensible parity with bullion, notes Gavin Graham of The Canada Report.

The price of bullion has been rising, but gold mining stocks have been lagging the price of the metal badly. Major gold miners such as Barrick (ABX), Newmont (NEM), and my recommendation Goldcorp (GG) are all down for the year.

However, the situation is changing for the better. The exchange traded fund for gold mining companies, the iShares Global Gold Index Fund (Toronto: XGD), rose 5% against an increase of only 2% for the SPDR Gold ETF (GLD). The latter fund tracks physical gold, with each share representing ownership of one-tenth of an ounce of bullion.

However, since the beginning of 2012, and over the 12-month period to mid-October, the situation is very different. Year-to-date, physical gold is up 12.3%. Over one year, it has risen 4.6%, and that period included a major slide in the price of the precious metal last fall.

By comparison, XGD is down 5.9% year-to-date and 12.9% over one year. That means the miners have underperformed bullion by 19.2 percentage points in 2012 and 17.5 points over one year.

This is not a short-term phenomenon. Over the last three years, physical gold has risen by 55%, but amazingly, gold stocks have fallen by 2%. Over five years, bullion has doubled while gold stocks are only up 10%.

The same is true for silver, where the numbers are very similar. Silver has gained 22.1% this year and 75% over three years. The one-year and five-year gains are about the same as the gold figures.

By any reasonable measure, gold stocks are selling at the biggest discount to the underlying metal for a number of years, if not decades. In August, the Philadelphia Stock Exchange Gold and Silver Index, which tracks mining companies, reached its lowest level relative to the price of gold in 28 years, according to Bloomberg data.

Several arguments have been advanced for this disparity in performance. The first, and one of the most believable, is that until the launch of GLD eight years ago, the only practicable way that investors could own gold without physically buying gold coins was to own mining stocks.

Once GLD arrived, investors who wanted exposure to gold could buy with the click of a mouse, paying very low brokerage fees rather than a premium for coins, and in some cases sales tax as well. They could then have their interest in gold bullion held in a secure vault for less than a 1% annual custodian fee.

This eliminated the costs associated with owning physical gold such as insurance and safe deposit charges. Investors were duly impressed; GLD now has more than $50 billion in assets.

Furthermore, individual gold stocks are subject to the normal costs and risks of running a mining or resource company. Expenses for labor, fuel, machinery, insurance, environmental problems, and liabilities continue to rise. Political risks include expropriation and increased taxes.

Then there is managerial risk: the possibility that senior management will make an acquisition to offset declining reserves that dilutes existing shareholders by issuing too many shares for properties that prove to have fewer reserves and resources than originally estimated. A couple of CEOs of major companies have had their heads handed to them in the past year for exactly this reason.

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Plus, there is the inescapable fact that mines are a wasting asset—eventually you extract all of the commercially valuable metal and there's nothing left.

All that said, the failure of gold and precious metals stocks to match the performance of the underlying metals seems excessive. Mining stocks are, after all, leveraged plays on the underlying commodity.

If the mines are working successfully, investors will benefit from steady or increasing output of the metal combined with a rising commodity price. If the company makes a successful discovery of more resources, its value will increase. If the company uses its shares to acquire additional resources, and the reserve estimates are accurate or even conservative, then they will be accretive and add value.

That is why mining stocks tend to shoot up in the final stages of a resource bull market, such as occurred for gold and silver in 1979-1980. As the price of the commodity accelerates, the value of the mining company’s reserves (and its share price) rises even faster, because reserves which were previously uneconomic to develop now become mineable.

Resource bull markets almost always end with a blowout final phase, where share prices ascend much faster than the underlying commodity. Long-term investors tend to make more than half their total returns from owning resource stocks in such situations. This happens when new investors who have been skeptical of the bull market finally succumb to peer pressure and the fact that not owning such stocks is hurting their returns and drive prices up well beyond any rational level.

There will also be a burst of initial public offerings as investment bankers rush to get their client companies funded before common sense returns. They know that the capital markets are either open or closed for junior resource companies; if you are not being inundated with cash, you will not be able to raise any money at all.

While it is premature to identify the final stages of the bull market in precious metals, the circumstances for such a scenario are certainly present. Central banks have publicly declared their intention of creating unlimited amounts of liquidity for as long as is necessary to overcome the deflationary effects of the Great Recession of 2008-09. Chairman Ben Bernanke of the US Federal Reserve has confirmed that short-term interest rates will not rise until 2015, if then.

No developed country has any interest in a strong currency; indeed some European nations such as Germany, Switzerland, Denmark, and the Netherlands have negative interest rates on short-term debt, in an effort to stem the flow of foreign capital.

Gold has risen every year for the last 12 years, and seems likely to do so again this year. GLD and an ETF holding real-return (i.e. inflation protected) bonds have been the two asset classes with the best risk-adjusted performance over the last five years—through the worst equity bear market in 35 years and a 100% rebound in stock markets.

These two seemingly unrelated assets have in common a concern over the erosion of an investor’s capital in real terms, as both gold and real-return bonds effectively maintain their purchasing power in a period of inflation.

The fact that inflation is relatively subdued at present does not mean it will not return. In fact, governments seem determined that it will, if only to enable them to reduce the real cost of the enormous amounts of debt they have incurred over the last few years.

Against that background, I am adding Franco Nevada (FNV) gold stock to our Recommended List this month—one which is very different from traditional mining companies in terms of its business model.

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