By Sumit Roy
Research analyst at ETF issuer Global X explains the difference between the two mining segments.
Alex Ashby is a research analyst at Global X funds, a New York-based provider of exchange-traded funds. One of the company's products is the Gold Explorers ETF (GLDX), which is tied to the gold exploration industry and has $42 million in AUM. Ashby provides research and analysis for the suite of Global X ETFs through investment cases and other materials. He is also active in new product development for the firm. HAI's Sumit Roy recently spoke with Ashby about investing in gold explorers, which he described as the venture capital of gold.
HardAssetsInvestor: Why have gold miners consistently been underperforming gold in recent years?
Alex Ashby: It's an interesting divergence that we've seen there. If you look at the performance of the physical commodity relative to the miners- whether it be the larger-cap miners or the juniors or the explorers- it's definitely outperformed significantly in the past few years. Looking at the longer-term trend, however, the miners are at a lower valuation and the divergence is more significant than we've seen historically.
There have been difficulties that have been facing the mining industry, and you don't have that same exposure with the physical commodity. The miners have had to deal with escalating costs and capital expenditures and that sort of thing. This is partly why some investors have moved toward the physical commodity and out of the miners and explorers. Moreover, the new ETFs and products out there have made it much easier to invest in physical gold. Some people who used to get their gold exposure through the miners are now getting their exposure through these physical ETFs.
But it's a trend we think will eventually revert back to the historical mean or the average. And right now, a lot of people are seeing opportunities in the mining companies as a result of that recent underperformance. It's also important to note that the tax treatment of a physical gold investment is different, as these investments are treated as collectibles and subject to higher tax rates than equities. Physical gold investments also do not provide income in the form of dividends, which is something that investors may receive with an allocation to the miners and may be appealing in this low-interest-rate environment.
HAI: Speaking of those costs, what's the most difficult cost for gold miners to manage?
Ashby: Costs related to personnel have been difficult to manage. There's a lot of difficulty in the industry at the moment in terms of finding the qualified personnel at levels that are cost-efficient for the companies. Capital costs have also increased, and significant capital is required to develop a mine and maintain high levels of production.
The other issue where there's a lot of uncertainty is taxes and regulation. We've seen in a lot of different countries in recent years, higher tax rates and changes in policy, where there's pressure on some of these governments governments-especially emerging markets or developing countries-to extract a little bit more in taxes from these international companies that are operating mines within their borders. There's definitely uncertainty with regard to the tax situation in some of these countries. And maybe that's part of the reason for some of the underperformance recently as well.
HAI: What gold price is necessary for miners to be profitable? And is that price steadily rising?
Ashby: The current price is still well above the level where miners are going to be profitable. But, if costs rise, that price point becomes higher and higher.
It's a bit of a moving target. Moreover, each company is different depending on where it operates, what its cost structure is like, what the quality of its mines are, and what stage of development it's in. As a mine continues to age, the ore quality deteriorates and the cost of actually extracting the commodity is going to rise.
And that's actually a reason why we think the gold explorers are an interesting segment. Generally, new mine discoveries have been trending downward. And a lot of the larger mining companies have later-stage mines in development. We see the explorers as a key area to provide some additional supply. But the explorers have underperformed the junior and more senior miners. They're trading much lower than historically we would expect them to do.
HAI: How does the Global X Gold Explorers ETF differentiate itself from other gold miner ETFs?
Ashby: The main difference is the exposure you're going to get. This is further down the market-cap chain compared to other ETFs, which focus on the larger-cap companies that are out there or even the junior gold miners, which comprise that middle tier that generally has some production properties and is actually producing gold, but also may have some exploration properties.
And then you have the explorers, which are a pretty different segment in terms of the life cycle of mining. The majority of those companies have properties, but they aren't necessarily developed and producing gold. They're really in the exploration stages of determining what the assets are in the ground, determining whether there's a viable mine that could be developed in the future.
It's a different business model and it's a different cost structure. They don't have all the capital costs and expenditures that the companies that are actually producing and mining do. What they do is explore for these properties and determine where a new gold mine might be a possibility. Then typically, they will either partner with or, in some cases, be acquired by larger mining companies who are looking to expand their supply.
We think GLDX is pretty distinct. We've seen an increase in investor interest and people are starting to realize there are some significant differences between these different types of companies that are involved in the gold-mining life cycle.
HAI: You spoke about the reversion to the mean, how the miners would eventually begin outperforming gold. What do you see as the catalyst for that to happen?
Ashby: It's partly related to the risk-off environment that we've been in. There's so much uncertainty in the markets. People are generally nervous about equities given various macroeconomic concerns. We could see a reversal in 2013 if the macro situation improves. In terms of the catalyst, people are going to be looking at the performance of the companies themselves, including earnings and whether these firms are able to control those costs we discussed.
Typically we've seen gold miners as a leveraged play on gold itself. As the gold prices rise, typically the profits of the gold miners will rise disproportionately more so. And the reverse is true on the downside-when prices go down, typically the miners will move down a little bit more quickly.
But like we've said, we've seen a divergence recently. Gold has been relatively steady and even increasing in price, whereas the miners have moved in the opposite direction. The real catalyst is going to be sustained or higher gold prices. Then when people start seeing that actually filter through to the earnings of the mining companies, we may start to see the miners outperform.
HAI: What do you see as the biggest risk to an investment in GLDX or gold miners in general?
Ashby: GLDX is a little bit different. It's higher on the risk/reward profile. When you're investing in individual exploration companies, the main risk is that they aren't successful in discovering a viable mine that actually has significant assets, in terms of gold in the ground.
The valuation of an explorer can increase or decrease rapidly and significantly depending on if they release positive or negative exploration results. We often refer to it as the venture capital of gold. There will be companies that are very, very successful, and will increase significantly. And then there are others that may not successfully find a mine that they can actually end up developing or partnering with another company.
We see the benefit of the ETF as a way to get access to that part of the market, while reducing some of your single-company or company-specific risk. Rather than choosing individual exploration companies, the ETF gives you a basket of these types of companies, where you can benefit from the success of a few and not be too damaged if some of the other companies underperform or are not able to discover any significant properties.
The risks are a little bit unique for the explorers, relative to the rest of the miners. When you're discussing the junior mining companies or the larger-cap gold miners, a lot of the risks are related to what we were discussing earlier, in terms of escalating costs in certain areas, as well as the political and regulatory uncertainty in some of the markets where these companies either operate or have mining operations.