1 Golden Mean Reversion Opportunity
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Gold continues to be a hot topic of investing even if it has been slumping of late. It doesn’t hurt when you have Charlie Munger, Warren Buffet’s right hand man, recently quoted as saying,
“I think gold is a great thing to sew into your garments if you're a Jewish family in Vienna in 1939, but I think civilized people don't buy gold. They invest in productive businesses.”
Nevermind that Berkshire Hathaway has never paid a dividend either, instead it was just bought by investors hoping to sell it at a higher price. Gold often gets the glamor, but gold miner stocks have been cast away during the last two and half years. For those investors that strongly adhere to mean reversion, then gold stocks offer a shining opportunity.
Investing in gold can be accomplished in three common ways.
- Buy and own the actual metal
- Buy a gold ETF
- Buy gold mining stocks
If you believe Armageddon is around the corner, which I firmly do NOT believe, then options 2 and 3 will provide no protection from collapse as all asset correlation go to 1.0. To own the actual metal takes a lot of storage and transaction costs. It is the best method if an investor wants a permanent portion of their portfolio in gold. Gold ETFs are a viable option for tactically gaining exposure to the metal. The best method is via SPDR Gold Trust ETF (NYSE:GLD), the largest physically backed gold ETF in the world.
Gold stocks are the topic of this conversation and they are extremely cheap on a historical price-to-NAV (net asset value) basis. Gold mining stocks have historically been a sort of leveraged play on the underlying price of gold, i.e. rising or falling substantially faster than the price of gold itself. Since GLD peaked last August, the price has fallen 16% to its current reading of $154. Gold miners, as measured by the Market Vectors Gold Miners ETF (NYSE:GDX) has fallen more than 35%. This ETF holds a diversified basket of large-cap gold miners and is the best way for investors to gain diversified exposure to individual gold mining companies. And from the market bottom in October 2008 to the peak last August, GDX outperformed to the tune of +300% versus +160% for GLD. However, this is partly distorted by the massive sell-off that gold stocks endured during the Global Financial Crisis. Note the point above detailing how asset correlations go to 1.0 during market panics.
Since the end of 2009; however, GLD has climbed 41% while GDX has FALLEN 10%! This isn’t a small sample size either at nearly two and half years. The chart below details just how cheap gold mining stocks have gotten relative to the price of gold. Is this a golden mean reversion opportunity for investors? History would say yes, but there are some clear hurdles that may have seriously altered the historical relationship.
It’s all about GLD
The first factor inhibiting the performance of gold stocks is that investors are clamoring into GLD and other gold ETFs that track the price of the metal and NOT into gold stocks. The chart below details the total gold ounces held by ETFs. From 0 in 2003, it has ballooned to more than 76 million! And GLD, with more than 40 million ounces of gold, is clearly the market behemoth. Even though GLD is a stock, it appears that investors view it as an alternative asset class, but they seem to still view gold miners as more of the traditional stock investments. As financial advisors and investors seek to provide some diversification into gold, they are looking into GLD and other gold ETFs and completely ignoring gold mining stocks. Whether this makes sense or not, there doesn’t appear to be any evidence of change.
Escalating cash costs
The fundamental change affecting gold mining companies is escalating costs getting the metal out of the ground. This hurts margins and leaves them very vulnerable to any notable pullback in the price of gold. According to Bloomberg data, the average net cash cost for senior gold miners was $542/oz in 2011, a 50% increase in just four years. This number varies significantly from company to company and is a vital determinant to earnings growth and ultimately stock price appreciation. Still, the price of gold more than doubled in that same time interval and earnings growth was notable. This will need to continue to happen for gold mining stocks to show mean reversion relative to the underlying price of the metal. If gold were to be stagnant for a year or two and cash costs continue to escalate, investors should anticipate notable underperformance in gold shares. Thus, gold stocks now seem poised to win if gold continues to rise, but look vulnerable and less likely to rebound in two other situations- flat or declining gold prices.
Still in a bull market
The spot price of gold is down 1% year-to-date, but has recorded eleven consecutive yearly gains. As far as I know, it is the only asset class that can make that claim. The metal remains in a clear secular bull and it almost always makes sense to be long asset classes in secular bulls.
The continued bull case rests on two key pillars, cycles and interest rates. Commodity cycles historically last 16-18 years on average. Of course that doesn’t mean it will happen exactly like that, but at 11 years, there seems plenty of time left if history is a guide. The second and most important is based on the current interest rates. According to Ned Davis Research, gold gains more than 17% per year when real long-term interest rates are negative. This is currently the case today with 10-year Treasuries yielding 1.8% against 2.3% inflation.
Investors that want a diversified basket of miners will be well suited to consider GDX. Those that want to seek a little, well maybe a lot, more risk and reward may want to consider Market Vectors Junior Gold Miners ETF (NYSE:GDXJ). This fund owns a diversified basket of small gold miners, many with one or two mines. This diversification will eliminate bets on a single mine, which can often times be disastrous, but still allows one to be exposed to stocks that are more highly leveraged to rising gold prices.
Anything can happen in the mining business. Take Agnico-Eagle Mines (NYSE: AEM) a mid-tier Canadian-based gold mining company. They were one of the fastest growing gold companies prior to the Global Financial Crisis, having gone from a one mine company to four solidly profitable mines with more on the way. The company was forced to shut one of its most profitable mines, Goldex, due to structural issues. And one of their other mines has incurred costs far exceeding expectations. In less than 18 months the stock has gone from $85 per share to under $35.
The single stock name to own is Barrick Gold (NYSE: ABX), the largest gold mining company with more than 7 million ounces in annual production. The stock comprises the largest share, at more than 18%, of the Gold Miners ETF. The company is expected to close on the $7.5 billion Equinox transaction this quarter. This will bring copper reserves to 20% of total reserves. They are like the inverse to Freeport –McMoRan which is 80% copper and 20% gold.
Unlike Berkshire Hathaway, Barrick Gold pays an annual dividend that amounts to a 2.2% yield. The five-year annual dividend growth rate of 19% is also appealing. Barrick’s largest mine is in Nevada and they derive more than 40% of production from North America. The company has more than 20 mines and projects, operates in politically stable countries, has a below average cash cost curve, and is poised to see free cash flow (future dividends) expand notably amid rising operating cash flow and flattish capital expenditures.
Gold stocks have been pushed to the side and have decoupled from their historical relationship with the underlying commodity. If history is a guide, now is a great time for patient investors to add to this forgotten industry. There are some concerns, but it is exactly these fears that allow for the dislocation to happen in the first place. Absent a bearish view on gold, investors look better served to buy the gold stocks themselves rather than GLD. Gold historically hits its yearly high in December and is weaker in the summer months. August and September are usually the best tandem months for the yellow metal. While the summer is usually weak for gold prices, it might make sense to get into the gold stocks ahead of the seasonally strong months for equity prices during Presidential election years. And have you heard anything about QE3 lately? Not as much as in prior months, but Europe is a disaster, China is super weak, and U.S. headline CPI inflation is falling fast. We may not be far off from some dovish talk and more easing from Uncle Ben, which should help support gold prices in the short term.
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