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Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.

The growling of bears has been very loud in the precious metals space recently, almost boisterous, which often coincides with them losing their grip. The chart is also offering some early signs that we might be seeing some upside again in the not too distant future. The back end of Sell-in-May and the upcoming summer doldrums might provide interested investors with a buying opportunity to take advantage of an upswing in the precious metals in the second half of the year. At least, this is your humble scribe's thesis of the moment and therefore we are putting in the ground work in terms of research so we are ready to strike should our thesis hold water.

Probably the most convenient and direct way to trade gold is via the SPDR Gold Trust ETF (NYSEARCA:GLD). Please note that we have used the word 'trade' here rather than 'own' which reflects our conviction that ownership is best and only achieved through physical possession. As a matter of personal preference, we prefer leveraged instruments for our trading purposes and have been looking at the Market Vectors Gold Miners ETF (NYSEARCA:GDX) to this end. In this article we would like to share our findings.

GDX is designed to replicate NYSE Arca Gold Miners Index ( ^GDM) and has achieved this goal to high precision throughout the past 5 years. GDM and by extension also GDX are often used as a proxies for the gold mining sector as a whole. GDX has been managed by Van Eck Global since 2006 and has $5.3B in assets. Its 194.6M shares trade on the NYSE. The expense ratio is 0.52%.

The chart below shows the price development of GDX in comparison with GLD over the past 10 months including the rally starting in August 2012 and the drop in gold price that has been taking place since last October. Also shown are the fund's top performer during this time frame Nevsun Resources (NYSEMKT:NSU), and the worst performer Allied Nevada (NYSEMKT:ANV). While GLD has shed 13.8% during this period of time GDX has lost 34.9%. GDX obviously follows GLD with leverage as visualized by this chart.

GLD Chart

GLD data by YCharts

The diagram below illustrates the performance of all stocks included in the GDX throughout the same period as shown above. New Gold (NYSEMKT:NGD) provides the median for the group posting a loss of 33.8% since August 1 2012.

(click to enlarge)

We have grouped the fund's holdings of 31 stocks into six categories:

  1. The first category includes the obvious "big three" Goldcorp (NYSE:GG), Barrick Gold (NYSE:ABX) and Newmont Mining (NYSE:NEM) for an aggregate total of just over 30% of GDX's holdings. Notably absent in this group is Newcrest Mining (OTCPK:NCMGY).
  2. The second category of stocks held by GDX totaling another 37.9% of holdings is made up by selected gold miners with market capitalization in excess of $4B including Randgold Resources (NASDAQ:GOLD), Yamana Gold (NYSE:AUY), AngloGold Ashanti (NYSE:AU), Gold Fields (NYSE:GFI), Minas Buenaventura (NYSE:BVN), Agnico Eagle (NYSE:AEM), Eldorado Gold (NYSE:EGO) and Kinross Gold (NYSE:KGC).
  3. The third category of holdings is comprised of a number of mid-cap gold miners with market capitalization between $500M and $3B. This group includes New Gold , IAMGOLD (NYSE:IAG), Harmony Gold (NYSE:HMY), AuRico Gold (NYSE:AUQ), Allied Nevada Gold and Nevsun Resources .
  4. Two royalty companies, namely Silver Wheaton (NYSE:SLW) and Royal Gold (NASDAQ:RGLD), make up 9.1% of holdings, whereby remarkably Silver Wheaton has a distinct focus on revenue streams from silver production.
  5. The inclusion of silver-specific investments is emphasized in the fifth category of holdings that is comprised of primary silver mining stocks with very little gold production. Strictly speaking, this group contradicts Van Eck's statement that "Index constituents must be primarily involved in the mining for gold." The companies in this group include Pan American Silver (NASDAQ:PAAS), First Majestic Silver (NYSE:AG), Coeur Mining (NYSE:CDE) and Hecla Mining (NYSE:HL). We are also including Aurizon Mines (AZK) in this group of holdings since this companies is about to be taken over by Hecla by an approved plan of arrangement in the near future. Holdings of this group of miners with a silver focus adds up to 8.2% of GDX holdings.
  6. And finally, a small sixth category totaling just 1.38% of holdings can be identified including exploration stage companies. The fund managers have chosen Seabridge Gold (NYSE:SA), Tanzanian Royalty Exploration (NYSEMKT:TRX), Golden Star Resources (NYSEMKT:GSS), Vista Gold (NYSEMKT:VGZ) and Great Basin Gold (OTCPK:GBGLF); the last of which is practically bankrupt and has been de-listed.

The diagram below illustrates the weighting of the described six categories of GDX holdings.

(click to enlarge)

For further analysis we assumed an investment of $1000 in GDX and calculated the number of attributable shares this investment would buy us from each company of the fund's holdings. We also compiled production and reserve data of each company included in the fund and computed the amount of gold production and reserve ounces this $1000 investment would buy.

In total a $1000 investment in GDX provides participation in 0.28 ounces of gold production and 7.2 ounces of gold reserves.

We then computed attributable production and reserve ounces in the ground for a $1000 investment in each of the mining companies held by GDX. Attributable production for a direct investment into one of the companies ranged from 7.42 ounces (Barrick Gold) to 0.14 ounces (Aurizon Mines) with the median being 0.66 ounces (Eldorado Gold). Attributable reserves ranged from 161.3 (Barrick Gold) to 1.46 ounces (Nevsun Gold) with the median of 16.35 ounces provided by Randgold.

For all these calculations we used a silver-to-gold ratio of 50 and mostly ignored base metal production of the referenced companies. The table below lists the details of this scenario.

Note: Royal Gold was not included in these considerations. This stock represents 4.25% of GDX holdings. Results were adjusted for this omission.

(click to enlarge)

Van Eck provides a pie chart illustrating what is called the "domicile weighting" on their web site as shown below. This pie chart gives the impression that three quarters of the ETF's geographical exposure are associated with Canada and the USA. We assume that this chart uses the exchange listings of the stocks.

(click to enlarge)

(taken from Van Eck company website)

We have dug a bit further and analyzed the locations and amounts of actual gold production and reserves of the mining stocks included in the GDX and have weighted this information with the individual holdings. The results of this rather painstaking work are shown in the charts below.

The first 75% of gold production of the companies held by GDX takes place in the following countries: USA (16.3%), Peru (10.3%), South Africa (10.2%), Australia (9.9%), Mexico (9.5%), Ghana (7.4%), Canada (6.0%), Argentina (4.4%) and Brazil (3.3%).

The first 75% of gold reserves are distributed among the following countries: South Africa (15.0%), Canada (13.9%), USA (13.8%), Mexico (9.2%), Chile (6.9%), Ghana (5.7%), Australia (4.7%), Argentina, (4.1%).

We would suggest that these distributions put an undue emphasis on South Africa, while under-representing gold mining jurisdictions such as Canada and Australia.

Some Observations

GDX provides leveraged exposure to the gold spot price. The selection of companies included in the fund ensures participation in the gold mining industry as a whole. However, the company selection also provides noticeable exposure to the silver mining sector. This sector often moves in tandem with gold exaggerating gold's moves, but is also characterized by high volatility not always shared by gold. Overall, the fund's holdings are heavily skewed towards the larger-cap stocks in the gold mining sector.

The performance spread of the companies included in the fund is considerable, which in our opinion reflects the state of this particular industry nicely. Some companies are battling with severe problems which are presently emphasized by the declining gold price. Consider, for example, Barrick Gold offering a multiple of exposure to gold production and gold reserves when compared to other miners but showing a below than average share price performance of late due to a multitude of problems plaguing this company. Or consider Allied Nevada who are punished by the market for building a large capex mine in times of funding insecurities.

When analyzing the geographic distribution of production and reserves we noted a larger than expected exposure to South Africa. We would consider this finding a disadvantage considering the problems faced by the mining industry in this country. Moreover we would suggest that this emphasis does not reflect the industry as a whole and provides an unnecessary risk with little hope for reward.

Conclusion

GDX offers exposure to the gold mining sector and by extension leveraged exposure to the gold spot price. We believe that this ETF is a vehicle for investors who do not wish to get involved too intimately with the individual players. However, for those willing to do their homework in terms of research better results than provided by GDX can be achieved.

Source: A Look Under The Hood Of Market Vectors Gold Miners ETF