Gold Stocks vs. Gold: Who's Winning?

By Brad Zigler

The summer doldrums foretold for gold investors (see "The Season For Gold? Not Yet") came to an abrupt end in September, as the yellow metal broke—and stayed—above the $1,000 mark.

Gold's latest move has stoked the long-standing debate between mining stock aficionados and bullion fans. What's a better investment—gold bullion (or its proxies) or gold mining shares?

The answer to that question can easily vary, depending upon your time frame. For example, look back to the 2006 introduction of the Market Vectors Gold Miners ETF (NYSE Arca: GDX), a portfolio of nearly three dozen global mining companies; you'll find bullion earned a substantial investment advantage over equities. Since 2006, the SPDR Gold Shares Trust (NYSE Arca: GLD), which represents an undivided interest in bullion, has racked up a compound annual growth rate (CAGR) of 13.1%, while the GDX portfolio has grown at an annual rate of 7.3%.

On a year-to-date basis, however, the situation is vastly different. Even with the recent breakout move, bullion's performance lags that of mining shares in 2009. GLD shares have gained 15.5% vs. GDX's 41.5% appreciation.

This shouldn't be surprising. After all, commodity stocks have led physicals this year. Take, for instance, the outperformance of the Market Vectors RVE Hard Assets Producers ETF (NYSE Arca: HAP) over the GreenHaven Continuous Commodity Index Fund (NYSE Arca: GCC). The HAP portfolio, comprising global equities, is up 35.1% this year, while the futures-tracking GCC fund has risen just 10.3%. An even more dramatic disparity developed between the stock-based Market Vectors Agribusiness ETF (NYSE Arca: MOO), which jumped 44.2% year-to-date 2009, and the futures-based PowerShares DB Agriculture Fund (NYSE Arca: DBA), currently 2.8% under water.

Like other commodity stocks, the strength of gold mining shares depends, in part, upon the health of the broader equity market. A buoyant environment for stocks, at least, is wind at the back of gold shares. That's pretty much reflected in the price ratio of GLD shares to those of GDX.

For the first year after the GDX portfolio was launched, GLD shares traded at an average 1.6x multiple to GDX. Then, as 2007 segued into 2008, equities wobbled and collapsed, propelling the GLD/GDX ratio higher, as physical gold was sought as a safe haven. The ratio ultimately peaked in October 2008 at 4.4-to-1, before sliding to its present 2.1x multiple.

Gold Bullion (GLD) Vs. Gold Stocks (GDX)

GDX, of course, is a portfolio of individual stocks, so the question of mining shares' strength necessarily must be resolved by comparing each issue to bullion and to its equity peer group.

The top 10 issues in the GDX portfolio comprise two-thirds of the fund's capitalization and thus have a disproportionately large influence on its performance. These are, in order of size, Barrick Gold Corp. (NYSE: ABX), Goldcorp. Inc. (NYSE: GG), Newmont Ming Corp (NYSE: NEM), Kinross Gold Corp. (NYSE: KGC), AngloGold Ashanti Ltd. (NYSE: AU), Gold Fields Ltd. (NYSE: GFI), Agnico-Eagle Mines Ltd. (NYSE: AEM), IAMGOLD Corp. (NYSE: IAG), Compania de Minas Buenaventura S.A.A (NYSE: BVN) and Yamana Gold, Inc. (NYSE: AUY).

We can compare these issues for their individual performance on the basis of their CAGR over the past three years, as well as their reward-to-risk ratios, which quantify the return generated for each unit of risk undertaken over the period.

Metrics such as beta and r-squared correlations can offer insights on stock performance relative to market benchmarks. Beta describes the variance in a security's price compared to that of the GLD trust and the GDX portfolio. A beta coefficient of 1.00 indicates a direct and equal degree of price volatility with the benchmark. Readings above 1.00 signal a more volatile stock, while readings below 1.00 bespeak less variance.

The r-squared correlation, on the other hand, indicates how much of the stock's price action can be described by that of the GLD and GDX benchmarks. An r-squared value of 1.00 indicates the stock's price trajectory could be imputed solely to the benchmark, while readings below 1.00 allow varying degrees of influence by other factors. Like correlation coefficients, lower r-squared values denote dissimilarity.

Benchmark Gold Performance (23-May-06 To 16-Sep-09)

	CAGR	Rew/ Risk	Beta (GLD)	R-Sq (GLD)	Beta (GDX)	R-Sq (GDX)	Weight (GDX)
GDX	7.3%	.13	1.66	.58	--	--	--
GLD	13.1%	.53	--	--	.35	.58	--
ABX	6.6%	.12	1.71	.56	.85	.83	12.1%
GG	10.7%	.17	1.86	.54	1.06	.84	11.4%
NEM	-2.5%	-.05	1.41	.47	.83	.78	8.4%
KGC	25.4%	.38	1.91	.49	1.11	.80	5.8%
AU	-1.5%	-.02	1.37	.29	.93	.65	5.7%
GFI	-9.7%	.15	1.61	.36	1.03	.70	5.0%
AEM	25.9%	.40	1.90	.52	1.09	.81	4.9%
IAG	17.7%	.28	1.63	.40	.95	.67	4.8%
BVN	7.9%	.11	1.57	.32	.95	.56	4.7%
AUY	6.5%	.10	1.98	.52	1.11	.79	4.4%
Average (Stocks)	8.7%	.13	1.70	.45	1.00	.79	6.7%

Collectively, mining shares produced about half the annual growth of gold bullion over the past three years. Still, certain issues such as Agnico-Eagle, Kinross Gold and IAMGOLD Corp. generated outsized gains and, accordingly, earned the highest reward-to-risk ratios.

It's not surprising to see high beta values for the best-performing issues, although high volatility isn't necessarily a guarantee of big gains. Yamana Gold, for example, exhibits the highest beta against gold, but only cranks out a middling growth rate.

As a class, mining shares are clearly more volatile than gold. Sometimes, their higher risk yields compensatory rewards and sometimes not. Reward-to-risk ratios for half of the miners are below that of GDX or the miners' peer group.

Note, too, that gold's return attribution, represented by each issue's r-squared correlation to GLD, is fairly weak. This indicates that gold's influence in the stock's return lags the impact of other, more intrinsic forces.

Plainly, an investment in gold mining shares is not the equivalent of owning gold for investment. Additional layers of risk are heaped upon gold in a stock investment, and they require careful analysis. Sometimes, undertaking those risks pays off handsomely in double-digit excess returns, but from what we can see over the past three years, that's more the exception than the rule.

Comments

[markfl:]

Investing in mining companies does provide considerable leverage--IF you believe the bull market in gold is likely to be sustained. Downsides are appreciable also. Unless you have exceptional perception into the minds of FOMC members, a gold ETF or the physical metal may be a great deal less risky in the event inflation fails to manifest. That doesn't mean owning gold isn't a great hedge in the long run, it just means gold stocks may not be right for many retail investors.

Sep 18 06:14 AM

[chap08:]

One of the main reasons for holding gold is portfolio diversification. In investment terms, it is sensible to hold some % of (non gold) stocks and bonds, regardless of your market outlook. Gold then helps you because it has low correlation with stocks and bonds, and negative correlation at times of stress, when you need it most. Holding gold stocks reduces this benefit because they will always have a higher correlation with other stocks. I also question whether holding gold stocks compensates you for the additional risk over holding gold.

Because of this, I own more gold than gold stocks.

Sep 18 06:41 AM

[petersl:]

Excellent article. I now can divine the metrics behind my decision to own AEM, KGC and IAG as major players in my portfolio. I sold off all GLD, SLV and CEF just prior to reading this article and added more IAG.

Sep 18 08:26 AM

[Adam Sharp:]

Nice gld/gdx ratio chart. Interesting stuff.

Gold miners are such a specialized field, I wouldn't trust a passive index. Need someone managing it who really knows the industry. EKWAX is a good actively-managed gold/precious-metals fund. Up 521% over the last 10 years.

Sep 18 08:34 AM

[bindlepete:]

Gold Mining shares, outside of the US, can not be taken by our Federal Government . Claims on physical gold and the physical gold itself can. It has been done before.

Further, thieves and others can not take the equity in the miners and the holding costs are as low as they can get.

I prefer to own the producers rather than any claim on the physical material and keep the companies off shore, out of Sam's reach.

Sep 18 11:08 AM

[venividivici:]

I recommended Kingsgate Consolidated (KCN on the ASX) on a number of occasions on this very site in April and if you had followed my recommendations, you would have seen a very nice profit and you would have also have just picked up a 15 cent dividend, fully franked for lucky Australians.

Sep 18 11:42 AM

[Joseph L. S...:]

Thank you. A well-written article and incisive comments from readers.

For me, the investment decision matrix is rather simpler: when investors believes the entire market / economy / nation is in danger, they will flee to the safety of the physical metal. When they believe gold will rise, however, on fears of inflation and a weakening dollar, they will tip toward the producers.

Using this matrix, going forward for the intermediate term I believe the producers will be the better choice.

Sep 18 12:25 PM

[Mad Hedge F...:]

nfc Brace yourself for the impending gold shortage. Gold shortage? Yup. With the launch of the eighth gold ETF this yesterday, the ETFS Gold Trust (SGOL), total ETF holdings of the barbaric relic reached 54 million ounces worth $55 billion, more than total world production in 2008. Last year, South Africa suffered its steepest decline in gold production since 1901, falling 14%, to a mere 232 tons. It now ranks only third in global production of the yellow metal, after China and the US. Severe electricity rationing, a shortage of skilled workers, and more stringent mine safety regulations have been blamed. Choked off credit has frozen the development of new capital intensive deep mines, as it has for everybody else. Rising production costs have driven the global breakeven cost of new gold production up to $500 an ounce. In the meantime, the financial crisis has driven flight to safety demand for gold bars and coins to all time highs. Last year, the US Treasury ran out of one ounce $50 American Gold Eagle coins, now worth about $980. Competitive devaluations by almost every central bank, except Japan, mean that currencies are not performing as the hedge that many had hoped. It all has the makings of a serious gold shortage for the future. Could last year’s downturn be a blip in the eight year bull market? Now that we are solidly over $1,000, kissing $1,025 last night, the match could hit the fuel dump at any time.

Sep 18 12:56 PM

[Original Sc...:]

What needs to be said is that physical gold or silver are the ultimate insurance. If the $ and/or the banks/financial and brokerage institutions were to suddenly be recognized for the ponzi schemes that they are, no paper will be worth holding until there is honesty and confidence restored in institutions.

Sep 18 01:57 PM

[goldy:]

I think it is reasonable to hold both. But I think the main reason to hold physical bullion is, as some posters have mentioned, for that "just in case scenario" whereby fiat currencies around the world lose almost all their value. I have to admit I sold off my last bit of GLD and bought the real thing when I read that for every 1 oz of real gold, there are 20 oz worth of gold certificates. Clearly some people are never going to get paid. In fact the whole idea of fractional reserve banking needs to be rethought.

Sep 18 02:47 PM

[EMS News:]

I have a long, long family memory. Periodically, since the 1880's, ancestors of mine owned gold mining stocks. Heck, one of my ancestors went to California in the 1840's to find gold mines!

And these always ended up badly. Holding onto gold mine shares is extremely hazardous.

Sep 18 05:42 PM

[JeffDB:]

Thanks for an interesting article, and an interesting comment stream as well.

Putting it all together, it seems to me as if there are some advantages and disadvantages with each.

Gold:
* advantages:
-- better diversification for a portfolio as it moves more independently of the stock and bond markets
-- much better if needed to be used as actual money in the case of a currency &/or societal collapse
-- not taxed annually - capital gains taxes are lower when sold

** disadvantages
-- carrying costs - ie. a safe, insurance, or paying to have it guarded (ie. in an ETF)
-- transaction costs paying retail to purchase, wholesale to sell
-- possibility of being cheated as to quality of coins or quality of gold bars - need to be educated on how to tell, particularly if not dealing with a quality dealer.
-- may be less liquid than hoped if trying to sell to someone not sure about whether *they* are getting ripped off or how to discern quality/value
-- possibility of theft or less likely loss in fire/tornado etc.
-- it doesn't usually actually grow in value, but is more a store of value and increases in value vs currencies that are being devalued.
-- has been confiscated by the government and could be again in the past in times of great crisis


gold stocks

* advantages
-- can pay dividends
-- earnings can be reinvested into more mining operations
-- can be more leveraged than physical gold with greater price movements than the gold itself
-- less likely to be confiscated by one's own government
-- adds some additional diversification to a portfolio
-- provides some protection vs inflation and deflation

* disadvantages

-- political risks - ie mines can be nationalized, onerous taxes levied, or insurrections and societal turmoil can disrupt or stop mining operations
-- managerial risks - poor decision making by those running the company
-- typical risks associated with any company - costs of labor, materials, etc.
-- risks associated with mining in general - mining a finite resource that may dry up or become expensive relative to spot prices, difficulty in finding/purchasing new sites etc.
-- higher correlation to other stocks losing some of the benefit of diversification vs owning physical gold
-- double taxation - at the mining level & taxes from one's own country
-- taxation could change dramatically, particularly under circumstances when values would jump dramatically - ie. "windfall profits" taxes or perhaps even outright confiscation in a worst case scenario
------

There are probably a lot that I missed, but it does seem as if each may have a place in one's portfolio, and though similar in some respects, each has their own unique advantages and disadvantages, some of which may take precedence over a pure "expected value" in profits from an investment standpoint.

But I thought Bill Zielinski had an interesting article on here a couple of days ago seekingalpha.com/artic... about using the "K-Ratio" as a rule of thumb in deciding whether gold or gold stocks are undervalued relative to each other.

The K-Ratio is basically the BARRON'S GOLD MINING INDEX online.barrons.com/pub... divided by the (Handy & Harmon) spot price of gold. At ratios at or below 1.20 mining stocks are probably a bargain relative to gold. Ratios at or above 1.90 favor gold bullion over gold stocks, which are probably overvalued in general at that point in time.

Or so the "time tested" theory goes.

But it would seem to me that that rule of thumb may not be accurate for specific stocks which may be undervalued or overvalued to others in the field.

It apparently has been a pretty good rule of thumb, however:

"Since 1975, readings at or below 1.15 on the K-Ratio have resulted in gold stock gains 90% of the time over the next 12 months with the average gain a very profitable 40%."

FWIW, the Barron's Gold Mining Index was at 1188.29 on 9-17-09 & the spot price of gold today online.barrons.com/pub... 9-18-09 was $1012.00

If my math is correct that would give us a K-Ratio of 1.17 which would be bullish on gold stocks as opposed to bullion.

1188.29 / 1012.0 = 1.1742 K-Ratio

"Trader's Narrative" modified the formula

www.tradersnarrative.c...

you can use any gold equity proxy like the AMEX or CBOE gold indices or even an individual gold stock. I would recommend against using the XAU Phili index since it has a lot of base metals mixed in. ...

Using this simple tool you would have gotten in on every single major gold stocks bottom. The last one was in 2000-2001, by the way, just as most market participants’ attention was focused on tech stocks. At that time, the k-ratio hit an unbelievable value of 0.80! ...

I use a shorthand to approximate the k-ratio by looking at the London fix and the HUI. Right now that is 0.35 - basically where it was in late 2002 and early 2003 (as you can see above).

Sep 19 01:15 AM

[chap08:]

One other thought on the K ratio, prompted by JeffDB's excellent comment above.

The theory behind the K ratio is that gold and gold stocks have a natural ratio, and that you can trade the reversion to the mean. If this is true, then the "natural ratio" doesn't change over time. If it did, the trading rule would be invalidated. But if the natural ratio doesn't change, then this means that returns on gold must equal returns on gold stocks. They go up at the same rate over time, keeping the ratio constant. This means that there is no "excess return" for holding gold stocks. Given that gold stocks are riskier than gold, then there is no case for holding gold stocks, rather than gold, as an investment.

A point of detail: the carrying cost of gold and dividends on stocks could theoretically explain the difference, but in my view there is not enough in either of these items to make a difference.

Sep 19 06:11 AM

[Hans Gruber:]

I like that first point! A hedge AGAINST a hedge! Like the novel "Dune." "Plans within plans......."

Sep 20 12:28 AM

[Hans Gruber:]

I like that first point! A hedge AGAINST a hedge! Like the novel "Dune." "Plans within plans......."


On Sep 18 11:08 AM bindlepete wrote:

> Gold Mining shares, outside of the US, can not be taken by our Federal
> Government . Claims on physical gold and the physical gold itself
> can. It has been done before.
>
> Further, thieves and others can not take the equity in the miners
> and the holding costs are as low as they can get.
>
> I prefer to own the producers rather than any claim on the physical
> material and keep the companies off shore, out of Sam's reach.

Sep 20 12:29 AM

[Mak invest:]

Im more interested in buying silver than gold, I now that its more volatil but if you learn the cycles of it, it can give you 4X as much as gold.

Silver has many advantages, like its industrial use, and that means world economic recovery, and if you ad the safe heaven side plus the
small amount of its total anual market value (about 20 billion) if the big funds start to look at silver this commodity will be the big winner in the next years. I really se silver reaching 30 dlls next year and it could reach 80 by 2011. I love silver stocks like; CDE, SVM,SLW,BVM,PAAS, AND MVG A LOT.

I LIKE THE ETF AQG x2 ON SILVER

Sep 20 12:47 AM

[Original Sc...:]

Ted Butler makes a good case that there is much more Gold available for investment than Silver. There are many instances of slow delivery of silver both from COMEX and from traditional suppliers.

I think silver is a great play if one wishes to play in the precious metals silver should be considered fora % of those investment funds. Both physical silver and the miners.


On Sep 20 12:47 AM Mak invest wrote:

> Im more interested in buying silver than gold, I now that its more
> volatil but if you learn the cycles of it, it can give you 4X as
> much as gold.
>
> Silver has many advantages, like its industrial use, and that means
> world economic recovery, and if you ad the safe heaven side plus
> the
> small amount of its total anual market value (about 20 billion) if
> the big funds start to look at silver this commodity will be the
> big winner in the next years. I really se silver reaching 30 dlls
> next year and it could reach 80 by 2011. I love silver stocks like;
> CDE, SVM,SLW,BVM,PAAS, AND MVG A LOT.
>
> I LIKE THE ETF AQG x2 ON SILVER

Sep 20 09:08 AM

[highlarche:]

silver 25 to 30

Sep 20 01:20 PM