Why Physical Gold Is Superior to Mining Stocks for Long-Term Investors 20 comments
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Many investors believe their portfolios have exposure to gold and precious metals because they hold stocks in mining companies. Bullion and mining stocks should be viewed as two different investments. But as a safe haven, no gold or silver or platinum mining stock (or even an ETF) compares with actual physical bullion. Let’s examine why physical bullion is the superior investment to mining stocks for long-term investors.
The risk/reward trade-off favours bullion
While mining stocks can provide attractive returns, they simply do not have the same risk-reward relationship or non-correlation to traditional financial assets as an investment in physical bullion. Physical bullion in allocated form is the lowest risk way to invest in precious metals. Unlike mining stocks, bullion is not subject to changes in production costs, management skills, availability of financing or exploration success. Allocated physical bullion provides the investor with unencumbered ownership because there is a huge difference between owning actual gold and owning a paper proxy such as an ETF or certificate.
Fully allocated physical bullion should form the foundation of the investment pyramid (Figure 1) because it provides the lowest risk of all the precious metals options available to investors. It is also the most liquid investment no matter what economic or financial conditions are prevalent. As confirmed by Ibbotson Associates, precious metals are the most negatively correlated asset class to traditional financial assets such as stocks and bonds. It is this key attribute that enables investors to reduce portfolio risk and obtain real diversification.
Mining stocks and bullion are entirely different asset classes. During a rising trend mining stocks are often correlated to the metals; however, in a downturn such as we experienced in 2008, they can become more correlated to the broad equity markets. Because bullion is a safe haven during financial crises, it tends to outperform mining stocks during turbulent times - often quite dramatically.
Of course, there are several categories of mining stocks, and each of these categories has a different risk/reward relationship and volatility profile. From a risk perspective, exploration juniors are at the top of the pyramid; further down are companies that have discovered reserves but are in feasibility analysis or in permitting; further down still are the producers.
But since most mining companies do not pay dividends and have a depleting asset base, they are more suitable for short-term speculation than long-term wealth preservation or portfolio insurance. Again, without a physical bullion component, portfolios are neither balanced nor diversified.
Bullion does not rely on anyone’s promise of performance
Mining stocks can be adversely affected by many internal and external factors beyond the underlying price of bullion. Variables include stock market volatility, geopolitics, environmental issues, management performance, business model, financial strength, mine life, productivity, efficiency, increases in operating and energy costs, and hedging policies.
Even when the price of bullion is rising, mining stocks can fall because ultimately mining stocks depend on the performance of the management team. Bullion, on the other hand, does not rely on anyone’s promise of performance and cannot decline to zero, as the shares of many mining companies have in the past.
Recently, spiralling production costs cut deeply into the margins of gold producers, in some cases making it unprofitable to mine at all. Because mining is such an energy intensive business, the volatile energy costs of the past year have made cash flow predictions difficult.
Bullion offers superior liquidity
When markets become volatile and stock prices decline, investors wishing to sell some of their positions may experience poor liquidity particularly in the junior companies. Allocated, segregated bullion, on the other hand, faces no such liquidity issues. The recent turnover of physical gold is over US$20 billion per day. The actual volume is estimated at 7-10 times that amount or about US$140 - $200 billion. This does not include gold futures trades on the commodities exchanges, or retail investment purchases, or jewellery.
Total aboveground gold is estimated at US$4 trillion. In comparison, the total market capitalization of all global mining stocks is only about US$150 billion. Barrick Gold Corporation (ABX), the largest gold-producing company in the world, has a market capitalization of about US$34 billion, and it trades about US$600 million of its shares per day. This represents a turnover of about 2% of its market cap. Even if this turnover rate is applied to all mining stocks it would equate to a volume of about US$3 billion, or only a quarter of the gold bullion traded in London alone. In addition to higher liquidity due to higher market size and higher trading volume, gold bullion is accepted as payment globally, whereas a mining stock certificate would have little if any value in many parts of the world.
Bullion is the ultimate safe haven
Bullion offers superior performance during monetary uncertainty because global investors turn to physical bullion as a safe haven, rather than to shares of mining companies. This phenomenon was confirmed during the 1970s bull market for gold. In Figure 2, you will notice that physical gold increased 15x (1,500%) during the 1970s. In contrast, the shares of Homestake Mining, the largest North American producer at that time, increased by only 8x (800%) during that same time period.
While it is true that many junior mining companies outperformed Homestake in the 1970s, producing impressive returns for their shareholders, many others faded into obscurity, resulting in painful losses. The risk factors associated with junior mining companies versus bullion are simply not comparable. However, if you have a high risk tolerance and a good advisor, then a small allocation to junior mining companies may be appropriate. But mining stocks in general need to achieve significantly higher returns than bullion in order to adequately compensate investors for increased risk and volatility.
During the 2008 crash, gold rose while mining stocks declined
While mining shares generally tend to track the price of bullion, they are still stocks. As such, they can become correlated to the broad equity markets. At the beginning of a bull market, it is well documented that mining shares typically rise, and often outperform bullion. However, when economic or market conditions deteriorate, global investors inevitably seek a safe haven for their wealth, as opposed to speculative investments. Thus, bullion eventually outperforms the shares.
As you can see from Figure 3, gold maintained its strength throughout the turmoil of 2008, even as financial markets and mining stocks (as represented by the XAU Index in purple) were plummeting in value in the second half of 2008.
As Figure 4 shows, gold increased by 31% in Canadian dollars during 2008, while the TSX declined by 35%, the Dow by 34% and the S&P 500 by 38%. When the broad-based equity markets decline, they tend to impact all sectors, including the mining sector, regardless of the fundamentals. Because the commodity sectors are small in terms of market capitalization, any sell-off often can result in much higher declines.
The Canadian mining stock mutual funds lost between 25% and 55% in 2008, whereas BMG BullionFund, a mutual fund that holds physical gold, silver and platinum bullion, lost only 4%.
Choosing to invest in bullion or mining stocks is not an either/or decision. Depending on your risk profile and time horizon, a combination of stocks and bullion can provide an intriguing risk/reward balance for certain investors.
Over the long term, bullion reduces risk and improves returns
In order to be fully diversified, investors need to include all the major asset classes in their portfolios: stocks, bonds, cash, real estate, commodities and precious metals. Of these asset classes, precious metals in bullion form are, over the long term, the most negatively correlated to traditional financial assets such as stocks and bonds.
Holding bullion reduces portfolio volatility and improves returns during normal market conditions, and will act as portfolio insurance during periods of economic stress, growing in value and effectively offsetting losses in the other asset classes.
During high inflation periods, bullion tends to outperform all other assets classes. During the 1970s, a memorable period of high inflation, precious metals outperformed all other assets classes for over 11 years. Many economists predict we will soon be heading into a period of inflation and possibly hyperinflation as a result of the ‘easy money’ policies implemented by deflation-phobic central banks.
When bullion prices are rising, mining stocks can form a significant part of the equity component of every portfolio. A study by Ibbotson Associates concluded that:
Investors can potentially improve the reward-to-risk ratio in conservative, moderate, and aggressive asset allocations by including precious metals with allocations of 7.1%, 12.5%, and 15.7%, respectively. These results suggest that including precious metals in an asset allocation may increase expected returns and reduce portfolio risk.
However, in order to fully protect portfolios from real inflation and market declines, a much higher allocation would be appropriate.
Bullion provides real wealth preservation
Gold and silver have been used as money for over 3,000 years, and platinum for centuries. Today, the world’s wealthiest families still hold bullion to protect their wealth. Precious metals have proven to be the best protection an investor can have against both inflation and monetary crises. As the financial storm clouds intensify in 2009 and beyond, any portfolio without a sizeable physical bullion component is needlessly at risk.
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Mining stocks on the other hand I do see as investments, with multiple reasons why holding them is a higher risk proposition than holding physical gold. However, with higher risk ought to come higher return. I believe mining stocks generally are stocks one ought to expect to realize higher than average returns on, or they should be avoided. It is essential to understand the speculative nature of, and risks inherent in, mining stocks – see ‘Valuation of Mining Companies’ in the E-Learning section of StockResearchPortal.com. To assist investors in their mining and oil & gas company research, StockResearchPortal.com recently introduced 16 new data components that topically segregate and filter all Press Releases fed to the website - for example, ‘Drilling Discovery News’ and ‘Resources and Reserves’ being 2 of the 16. We are unaware of any other website that does this, and think investors will find these data components very time-saving and extremely useful.
having TEN percent of the your liquid wealth in physical gold locked up in a safety deposit box or buried in a concrete bunker makes sense. this is an insurance policy for your entire wealth and your future family members inheritance.
in these times it would seem to be a no brainer. unfortunately, a common sense writer like this would be dismissed as a fanatical 'gold bug' by the popular TV commentators and people in the 'know'.
> I would like to see his analysis (with data rather
> than just speculation about what would happen during a crisis) on
> the difference between a gold ETF like GLD and owning physical bullion.
> It would be important to know if obtaining and holding physical metal
> is deemed to be worth the inconvenience.
Not just the inconvenience. Also the dramatically higher cost. The arguments for holding physical gold versus the ETFs always seem too alarmist. Hold physical gold if you've also bought a wood burning stove, a gun and a year's supply of canned goods...
On Apr 23 09:00 AM Ian R. Campbell wrote:
> I certainly agree that physical gold and mining stocks are different
> from one another, and that holding some amount of physical gold as
> a ‘safe-haven’ is eminently sensible. That said, I don’t think of
> physical gold so much as ‘an investment’ per se – but rather think
> of it as a ‘foundation’ on which to build an investment portfolio.
> As one of my friends who inherited significant wealth said to me
> one day: “I have always owned the amount of physical gold that would
> enable me to continue my lifestyle and give me a base from which
> to rebuild my wealth if I lost everything else I own”. Obviously
> not everyone is in my friend’s position with the ability to do such
> a thing, but I think his thinking is sensible.
>
> Mining stocks on the other hand I do see as investments, with multiple
> reasons why holding them is a higher risk proposition than holding
> physical gold. However, with higher risk ought to come higher return.
> I believe mining stocks generally are stocks one ought to expect
> to realize higher than average returns on, or they should be avoided.
> It is essential to understand the speculative nature of, and risks
> inherent in, mining stocks – see ‘Valuation of Mining Companies’
> in the E-Learning section of StockResearchPortal.com. To assist
> investors in their mining and oil & gas company research, StockResearchPortal.com
> recently introduced 16 new data components that topically segregate
> and filter all Press Releases fed to the website - for example, ‘Drilling
> Discovery News’ and ‘Resources and Reserves’ being 2 of the 16.
> We are unaware of any other website that does this, and think investors
> will find these data components very time-saving and extremely useful.
>
"Hold physical gold if you've also bought a wood burning stove, a gun and a year's supply of canned goods... "
I've got 3 out of the 4...but I'm working on the year of food!
Seriously, holding an amount of physical gold is not a bad idea. It is insurance in case of catastrophe. It has been a store of value for 5000+ years.
What the author doesn't state is that investing in companies that produce other commodities (i.e. food, energy) is also a decent play if one is concerned about the prospect of broad price increases in consumer goods. Diversifying among companies that produce different commodities allows one to buy companies that produce "stuff" without restricting oneself to a single sector.
Volitility in the mining stocks seems to me a good thing rather than a bad thing. As they go up and down in a trading range - it makes it MUCH easier to buy low and sell high within the range - growing holdings without much risk and increasing the dividends paid by them to the portfolio at the same time.
On Apr 23 12:31 PM Daniel Moser wrote:
> I know of 0 stores I have been to in the past 23 years of being alive
> in which they were willing to accept gold coins or bullion as a form
> of payment. Without a gold standard being brought back, there is
> limited hope for dramatic appreciation by holding physical gold.
> Furthermore the inflation case is really oriented around a dramatic
> recovery i.e. properly avoided deflation. In the case of recovery
> mining shares will dominate physical gold all day long because they
> have financial leverage as well as operational leverage.
For some people physical gold clearly makes a lot of sense. People who have large fortunes and can afford to allocate a percentage of that as insurance of continued wealth against the collapse of governments should do so. All their other material needs have been taken care of.
For the somewhat less wealthy you have to wonder. Can you allocate enough to get through a Black Swan event without impacting the growth of your wealth? For someone like this it is a much harder call.
And for those normal folks, what does buying gold get you? A 10% allocation in physical gold may not make much of a difference in your life in the event of a massive collapse. So what is the benefit?
P.S.
The first use of gold as money was about 700 BC. That's 2700 years ago, not 5000.
Theoretically bullion may trump stocks, but, practically, it sucks.
Thankfully I am now well and truly back in the saddle. I wanted to find a good gold stock and looked all around the world. The best value is invariably found in junior miners. I settled on Kingsgate Consolidated, an Australian company with a mine in Thailand which is a cheap producer and has great exploration upside. I now have a large investment in it so you shouldn't accept what I say but I would recommend that you visit the site and look at their latest reports. Forget physical gold, pick the right stock and you'll be laughing all the way to the bank.
On Apr 23 11:12 AM Steve Pluvia wrote:
> Exactly. Even a retarded dart throwing monkey can outperform gold.
> There's a time and place for every investment; holding gold bullion
> at this time is utterly stupid; only paranoid, market ignorant nut-jobs
> do this.
There are, of course, scenarios where gold is worthless. But in those scenarios, nothing else can be predicted to have value. I call this "The Water World Scenario". Only those long physical dirt had power on Water World.
Part of gold's value is that it can pass thru whatever strife exists until it can be exchanged. This is not true for stocks (companies can be obliterated), bonds (governments can fail), currency (currencies can fail), and energy (alternatives can come along).
A full strategy for the epic fail of the USA would include physical gold on hand to get out of the country and a gold account offshore to transfer into the currency of your destination. That doesn't mean travel (passports/visas) will be possible. So, glocks are nice, too.
Hey, I've been in the USA (and other countries) when there was massive power failure, road closures, no police, shortages of nearly everything. Guess what? I still conducted business with my fellow man. People do actually exist outside the existence of the state!