The Mystery of the Underperforming Gold Stocks 18 comments
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Further to my last post Bullish signs for the inflation trade, I would also like to point out that Warren Buffett, in the latest Berkshire Hathaway letter to shareholders, also indicated that inflation is likely the effect of the macro policy response to the financial crisis [emphasis mine]:
This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.
Why are gold stocks underperforming?
The most obvious way to hedge against inflation and rising inflationary expectations is with gold and gold equities. However, gold stocks are not performing up to their potential in light of the relatively buoyant market for bullion.
The chart below (click to enlarge) shows the monthly ratio of the PHLX Gold & Silver Index (XAU) to the London PM gold fix. I also linked the Amex Gold Bugs Index (HUI) to the XAU price series to show the difference between HUI and XAU. While HUI has outperformed XAU, both gold stock indices have been lagging the price of bullion in the past few years. More importantly, gold stocks have not shown the same upside potential as they have in the past relative to gold.
Analysts have advanced several interpretations of the relationship as shown by gold stock to gold ratio. The simplest explanation is that gold equities are cheap relative to bullion and that they should be bought now.
Loss of leverage and speculative appeal?
Another possible explanation is that as gold prices advanced, gold stocks have lost much of their speculative appeal as levered vehicles to play the rise of the yellow metal.
When gold prices were $300 an ounce about a decade ago and production costs of the senior miners were in the $200-250 range, gold stocks were in effect call options on gold with a strike price in the $200-250 area. As gold prices rose, gold equities became deep in the money options and their leverage to gold declined. Speculators who wanted to play the rise in the gold price lost interest, especially with the introduction of very liquid gold ETFs around the world.
Synthetic gold stock is still undervalued
While the loss of leverage thesis does hold some water, the numbers don’t make sense. About a year ago I wrote a posting on a synthetic gold mining stock model that I built in 2006 using a series of gold call options. When I revisit that synthetic gold mining stock valuation today, the synthetic still looks very cheap.
To briefly summarize the model: Conceptually a mine can be thought of as a series of call options on the underlying commodity, with the exercise price as the cost of production. If the commodity price falls below the cost of production, the mine operator has the option to either close or mothball the mine until prices improve. I created a synthetic gold stock by building a model based on these principles. Key features of the model are:
- A series of eight deep-in-the-money call options on the price of gold, with terms of 1, 2, 3 … 8 years, which models a mine with an eight year life, a common estimate of long-lived gold mines;
- An exercise price equal to cash production cost of $250, rising each year by the current inflation rate. ($250 appeared to be a common estimate of cash costs for existing gold stocks in 2006);
- Equal amount of gold mined each year; and
- The position is rolled forward once a year at a cost of 1.5%.
The chart below (click to enlarge) shows the value of the synthetic compared to the gold equity index. The valuations started to diverge in early 2007 and the gap has been steadily widening since.
The chart below, (click to enlarge) which shows the difference in valuation between the synthetic and actual gold stocks, indicates that the discount of gold equities to the synthetic is near all-time lows:
Why the discount?
The prolonged valuation gap is a mystery to me. To be sure, there are differences between the model behind the synthetic and actual gold stocks, but I believe the difference are relatively minor in magnitude:
- Gold mining companies have exploration upside, operational risk (strikes, fires, etc.) and political risk, which the synthetic gold stock does not;
- Gold mining companies may hedge the gold price with forward sales and other derivatives (but most don’t these days other than for the purposes to lock in a price to develop a new property);
- Actual gold mines can somewhat manage the cost of production by high-grading when gold prices are low and mining a lower grade of ore when prices are high. The synthetic gold stock’s assumed cost is inflexible.
- Many ore bodies do not yield only gold, but other byproduct base metals (e.g. silver, copper, etc.) The synthetic assumes that the mine only produces gold.
- The synthetic model only describes the asset side of the balance sheet for gold companies. If the company is financed with debt then the behavior of the equities would be different from the one forecast by the synthetic (but most gold miners don't have a lot of debt).
Some questions to ponder:
- Are gold stocks just cheap relative to bullion? If so, why the prolonged mis-pricing?
- Is there a conceptual error behind the synthetic gold model? Does the market just not think about gold stocks this way?
- Could a PE fund buy out a gold producer or mine and use the synthetic model to arbitrage the difference in value?
- Are production costs spiraling out of control at gold miners that investors are discounting the prices of their equities?
- Have gold mining companies, as a group, not re-invested their cash flows in a way that has enhanced shareholder value and therefore investors are marking down their share prices?
- Has the stock market been so beaten up that gold stocks are underperforming their potential? (This explanation doesn't make sense as the discount began in early 2007, well before the market break.)
I would be especially interested to hear any response from mining analysts. You can either respond directly in the comment section or email me at cam at hbhinvestments dot com.
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"As a rule, persons having gold or silver mines to develop always go to the Money Kings or their agents for the capital to develop them. And the Money Kings never put any money into a mine without having a majority of the stock given them, so as to secure to them its absolute control. They must have the lion's share in any enterprise before they will invest in it. They usually put in one of the original stockholders as their agent and manager; and generally the mine is so managed as to freeze out the other stockholders."
greatreddragon.com/cha...
Hello: Re lagging miners [2nd note is a copy of a question I sent to seeking Alpha in general]
I bought CDE at 2.98, and suffered the downturn in it. All the while, watching gold go up [and silver].. I have made, in three months, 859% annualized with a 4 - 1 leverage situation on silver, and have exited it, and just purchased a large block [for me] of CDE. The news is glaringly good for it, but the price continues to lag. From where I just bought it, if it goes just back to where it was I will be in silver clover. If not, I will not be hurt. I have a lot of physical in the "floor".
The reason I feel the mines are not showing an upsurge with the metal, is quite simple. (which is why most folks miss the move, it is too simple) They have information overload. With all the sources we have now streaming in, it is like trying to drink the Amazon waters before they can hit the Atlantic Ocean. You drown in data. It actually creates investor block. With all the pros and cons for doing or not doing something everyone freezes and says, "I have no idea." So, the results are like the end of last weeks trading, just simply froze in place. Shorting the market is a perfect example, it is too foreign to most investors. Look at the volume in most issues. It is low and getting lower. No one knows if this is the bottom or top. (except you and I, and we aren't telling, right?)
I feel if we go back to basics, and ask a few basic questions the answers on 'what to do' will become readily obvious. Do I need to elaborate? Let me simplify more. Is our government creating an inflationary atmosphere for the near future? Yes. Is it going to be a long term effect also? Yes. [not probably] Are we on the right track on most things economic? No. Is it short term, long term mistakes, or both? Both.
Okay, are we getting the idea? Sort of? Okay, How's this for more grist? How can a bad business survive? [by the way, a bad business is one that is not making a profit.] How hard was that? Should we put more money in a company that cannot turn a profit, and call the gift profit? No. Will we? Yes. Should we? No. Should we let GE, GM, Ford, etc go belly up? Yes and why not? The phoenix's that will rise out of the ashes will have cleaned up their act, gotten the fat out, and return to profitability or go down too.
So where is the blame / onus / responsibility to land. Squarely on those who took the risk, didn't manage correctly either with their ballots for company officers or keeping bad stocks. The stock holders should take the blame. ALL of it. I have lost a lot of money in the stock market, now I am supposed to lose more by bailing out failed stocks that I did not choose to risk money in. Who is going to bail me out for my losses. This is total nonsense, and not likely to stop any time soon. So.. bottom line, the folks are afraid to buy ANY stocks at ANY price, and I blame them little. So, I stick my nose out in the cold, buy some cheap metal miners, the Biggies will go up first,then the juniors, so that is where my money is, on a good junior stock.
I own CDE, AUY options, (which are not looking too good), some UDN, and NLY, NOTHING else. I am heavy in Silver physical, and a little gold. Wish I could buy more gold.
So... Junior mines will probably fly with the big boys just take a few minutes more. I suspect Gold to $1300 by April, 2009, and silver to $17 - 22 by midsummer. Then you will see the miner stocks popping and you will not catch them at these levels ever again, and it will be like trying to grab the popcorn coming out of an untopped pan...
Happy investing...
Enjoy your stuff and advertisers. Question please: Why do we not see any comment on copper prices, inventories, or usage. nor iron price moves. Copper and Iron prices usually presage an economic downturn from highs or upturn from lows depending on where we are.
We have total price breakdown in Copper and other industrial metals and when orders start coming in, it is a sign of the recovery beginning, and maybe time to do a valuation look for stocks of good companies driven down in the dirt by the recession.
In one of your not too recent articles, you said to watch the power [electrical] use in China. Now how the heck are we supposed to do that? Not saying it is a bad idea, but I can't go read meters or papers in Chengdu...
I notice copper prices and inventories are beginning to change, spot copper rose above 1.70, down from over 4.00, and inventories were spilling out the top of warehouse roofs. Now I see a slight drawdown in LME and other exchange warehouses.
Kitco - Spot Copper Historical Charts and Graphs - Copper charts - Industrial metals
I see no other signs of the "decession" [ my own word describing the transition from recession to depression] softening, in fact I feel it is deepening.
Well,anyway, your comments please.
Capt Brian Bobbitt
PS. I have not owned a stock for over 18 months. I sold all long ago, (except for those listed above and day trading)
dragonslayir@aol.com
If the gold price pops over $1,000 and-or the market in general stabilizes gold bugs will come back into the speculative gold stocks.
Look behind the barrage of spin fed to us every day. The world's biggest banks are bankrupt. Everything else will surely follow.
Governments are effectively bankrupt too, they are just not telling you.
The US gov't borrowed 3% of GDP in 2007, in 2009 they need to borrow 14% of GDP to pay for the biggest pork program ever created. China is broke and can't lend us that much money. The US dollar will crash this year....
A lot of the recent divergence can probably be explained by the '08 anomaly of both gold and gold stocks moving in synch with the stock market for awhile (only gold bullion less so). This opened up a huge gap just because the miners are stocks and, if it was a stock, it was trashed last year. But both gold and the gold stocks have returned to their more typical behavior of moving inversely to the stock market since about December. So the stage may be set for a swift catch up move by the gold stocks.
Three possibilities:
a) Speculative investors are fleeing shares (all shares) for gold.
b) Price manipulation of gold.
c) There are big buyers of physical gold for their government vaults.
You suggest that the creation of ETFs for trading gold/silver has taken alot of the money that may have gone to mining shares. I rank this as a good portion of mining stocks underperformance.
The recent beating mining share owners received is making them think twice about committing again. Along side this is the melt in the general equities keeping people on the sideline.
There is also the issue of naked short selling which has contributed to the junior explorers hugh downfall.
Gold/silver price has been very volitile and until inflation shows signs of emerging again investor have doubt of current price level.
Until we see higer highs in gold/silver confirming the trend and some good numbers profitwise from miners shares will continue to lag.
Yes the first graph is a little confusing. The history for XAU dates from 1983, but the history for HUI dates from about 1997. I created a "gold equity index" by linking XAU from 1983 and then HUI from 1997.
The solid line from 1983 to 1997 and dotted line from 1997 to present is XAU/gold. The solid line from 1997 to present is HUI/gold.
I hope that makes thing clearer.
Gold Corp sounds ideal, having low production costs, all it's mines in "NAFTA" countries, increasing production, and have no need for additional dilutive equity financing.
However, I believe gold stocks are just that, stocks. And often suffer with the general market. Additionally, if investors believe gold prices are near a peak, the stocks will not respond.
We saw a similar occurrence in the summer of 2008 as oil zoomed from $100 to $140 and the oil stocks went sideways, that is, they did not go up.
Another factor is that mining is a capital intensive operation requiring periodic equity and bond financing. This is not a good environment for such companies.
On the other hand, take a look at this snippet from Gold Corps last quarterly report:
"Fourth Quarter 2008 Highlights:
* Revenues were $609 million on gold sales of 680,200 ounces.
*Operating cash flows before working capital changes2 totaled $230.5 million, or $0.32 per share.
*Total cash costs3 amounted to $323 per gold ounce.
*Dividends of $32.7 million were paid during the quarter.
*Cash and equivalents were $262.3 million with no Goldcorp debt at December 31, 2008.
Full-Year 2008 Highlights:
*Produced 2.32 million ounces of gold at total cash costs of $305 per ounce."
According to Yahoo Finance, the market cap of Gold Corp is about 22 Billion US Dollars. Why not just buy out the company, take it private, and keep a couple million ounces of gold (and silver) in private hands. Where else could you get your hands on a couple million ounces of gold per year, if one was so inclined?
You mean Goldcorp (Ticker GG). The presentation is at www.goldcorp.com/_reso...
See pages 12 and 13. In 2006 cash costs were around $250/oz and now they are closer to $450/oz.
The reason why gold stocks have underperformed is because cash costs have risen so dramatically and therefore leverage is being lost.
Of interest, there were about two dozen other precious metal and natural resource companies represented at this conference, and each presentation is available on iTunes for free. I found it fascinating.
On pages 12 and 13 of the presentation you linked to, the cash costs on the bar chart for GG per ounce of gold was $365 not $450. Barrick was $460.
I wonder if the 75% decline in the price of oil and natural gas is helpful for their margins? However, I like your idea about a loss of incremental margin improvement as the price of gold increases.
However, does the gold company then become an undervalued asset play, valuing ounces in the ground at a small fraction of their market worth. Of course, the same was said about oil and gas companies before energy prices collapsed.
I suppose there has to be some confidence in the durability and sustainability of the elevated prices for gold and other precious metals.
You will note that the cash costs shown on pages 12 and 13 of the Goldcorp presentation are based on guidance for 2009. The cash costs that you quote for Goldcorp is shown on page 8 of the presentation.
Goldcorp presentation is here: www.goldcorp.com/_reso...
The gold mining sector is small, and is not well-known to the majority of financial advisors. Most advisors can recommend a fund that holds gold miner stock, but they don't know much about the stocks except to say "Barrick". It takes lot of research to become fluent on the subject of different individual miners, and when you suddenly study miners when all you've been used to is American and Canadian corporations the miners seem very risky by comparison.
Also, it is difficult for miners to show production growth and profit growth, since the global gold mining sector is in a sort of "peak gold" condition, and many of the regions where gold is mined have perplexing or intimidating political/cultural situations. This scares investors who are used to comparing the corporate environment in Orlando to the corporate environment in Toledo their whole lives, where things are tame by comparison.
Gold miner stocks tend to have very brief periods when share prices suddenly shoot up and profits can be taken, in between which the stocks display volatility and are hard to predict. This upsets people used to investing in other commodity corporations, say Exon Mobil or Peabody Coal, where they've come to expect big smooth curves on the charts and comfortingly predictable patterns.
Gold miners have been regarded with suspicion and scorn by many people who look at environmental concerns, and have gotten negative reporting similar to the way coal companies have been mis-treated by the press. You'd think gold miners were trying to sell "blood diamonds" or something.
Finally, for the majority of buy-and-hold investors, it used to be axiomatic that people who invested in gold miners were out on the fringes, regarded as eccentric. Now, people who invest in gold miner stocks are ahead of the curve, and not all of them are willing to share what they know.
I have been following the market as an outsider for 2 years, and what I found to be the issues in my mind so far are:
-People think of gold in nominal terms, not it's buying power. Gold has excellent buying power as currencies across the globe deflate. The dollar nominal value aside, you can buy more euros,equities,commodi... and so on with gold. The "Real"price of gold is skyrocketing. Once people divorce themselves from a dollar to ounce ratio, they will realize that gold is easily a reserve currency-not the Euro,Franc or Yen.
-With the above in mind, people are viewing gold nominally in dollars and choose to stay in dollars or treasuries at the moment. We know what will happen to bonds later...
-GOLD MINERS, because of the massive deleveraging in October, have given some investors 3rd degree burns that are hard to forget
-MINERS are very much removed from the commodity via exposure to costs and other metal prices
-MINERS are equities, and investors are in the process of capitulating on equities
-Investors don't understand that gold does well in a deflationary environment just as well as inflationary
-I saw an earnings chart of Barrick versus some orthodox equities on the S&P500.
Barrick was making a lot of MONEY.More money than all these loser companies combined! Miners are going to become the premier equity investment. Unlike the others, Miners are in growth mode,have dividends and make a profit(the seniors and midcaps.)
-Gold price is manipulated by all sorts of large entities-including the Central Banks. It's just something one has to deal with since they OWN the gold anyway. They can jerk the market around all they want-it's their loss in the end.
-The Miners are too associated with gold price, which is part of a "risk" investment. Once the investing crowd gets a lookey-loo at the earnings of the companies, gold price will not matter unless there's a huge fallback to 600 an ounce or so.
-The last run up of miners was associated with gold price-but that run up was in the biggest commodity run up ever in the 2007-2008 timespan. BUT, their margins and profits were not outstanding because labor was expensive, fuel was at an all time high,land was pricey and so on.
-Banks have lost tons of liquidity due to the loss of credit-as-money. They have to recapitalize by stealing taxpayer money via Treasury injection PLUS they need to store cash assets(which was taken back by the Fed and swapped with Treasury Credit) with something. That something will partially be gold as it's highly liquid and universally accepted. The miners are gearing up for a huge request by banks to make money for them that has no claims on it.
People are just really, really confused about the benefits of owning a mining company because of the GOLD PRICE, which I have said already is sort of moot until a massive correction hits. The margin gap is growing and growing. If gold corrects, load up on miners and play them for 2-3 years.