5 Reasons To Go For Gold (Miners)

Includes: ABX, GDX, NEM
by: Arsene Lupin

Gold miners aren't getting much love these days, even as gold itself is being recommended as a core part of portfolios to combat the inevitable onslaught of inflation. This divergence between the metal and its miners is clearly indicated (below) by the divergence between the Gold ETF (NYSEARCA:GLD) and the Gold Miners ETF (NYSEARCA:GDX) over the past two years. Where GLD has outperformed the S&P by 7-8% over the last two years, GDX has substantially underperformed virtually every broad stock index in the same time frame.

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There are a number of reasons a reasonable person would be pessimistic about gold miners. Two in particular are increases in mining cost (both exploration and labor) and resource nationalism. The chart below illustrates the former - while gold prices have risen about 125%, mining costs have also gone up about 80%. The concern is that the former will flatten while the latter will not. Resource nationalism (which goes beyond gold) is of particular significance to gold due to the paucity of new and "politically safe" mines going forward. So does the pessimism justify more downside, or is it a contrarian signal? In the rest of this article, I give you five reasons to go contrarian.

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  1. Leverage to Gold Price. Numerous pundits make sage arguments for gold price flattening over the next five years, I argue that is precisely the reason to go for miners over metal. Current estimates of gold mining costs for major miners is in the $575-700 range. Current prognostications on gold price upside is to $2000 and beyond, as the inflationary policies of U.S. and the EU take hold. Even if gold is "only" at $2000 in 3 years, that 15% rise on metal price translates to a 30% increase in miner profits due to the leveraged nature of their profits to metal price.
  2. Industry in positive reform. The above 30% upside in miner profits assumes no positive change in industry discipline. As this article points out, gold miners (ABX, GG, KGC) are "getting religion" and becoming much more disciplined in their business practices. While the upside of increased discipline is hard to quantify, other industries (e.g. Retail, IT) that cost cutting in 'fat' industries can add multiples to company earning power.
  3. Technicals. The GDX 2-year chart below indicates a favorable risk-reward ratio. It indicates about 10% downside (to the support at $40) versus 50% upside (to the resistance at $65).
  4. Company Insiders. Historically, the Gold mining sector isn't known for a lot of insider purchases. So the recent purchases by insiders on both Newmont (NYSE:NEM) and Barrick (NYSE:ABX) is noteworthy
  5. China. China needs to buy gold to reduce the economic impact of the dollar, and to potentially establish the Remnimbi as a (if not the) global currency. The figure below contrasting U.S. and Chinese Gold holdings indicates that the Chinese bank gold purchases could be significant both in absolute and relative terms.

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As always - use these comments as a guide and do your own research.

Disclosure: I am long ABX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.