Mining For Gold With ETFs

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 |  Includes: GDX, GDXJ
by: Bruce Vanderveen

Summary

Since January, precious metal mining stocks have seen prices soar.

Exchange traded funds (ETFs) provide the best way for investors to profit from the new bull market.

Reasons to be bullish include: undervaluation, future currency instability, and geopolitical unrest.

"There's gold here," exclaimed the grizzled fishing camp owner as he handed me the small core sample. He then went on to explain how people fly into central Ontario, drill a few holes, get the cores assayed (small amounts of gold are common throughout the area) and then fabricate an enticing story on the amount of gold the (usually new) company controls in order to promote shares to gullible investors. Mining, however, rarely takes place as costs are prohibitive - no roads, lakes everywhere, frigid weather. The promoters, make out well, not so the investors.

The moral of the story? Don't listen to those "get rich fast" schemes you often hear hyped on small-cap miners. You will likely lose your money. If the company really was that good the promoters would buy the shares themselves. Even with established companies in this sector it's very difficult for most investors to pick and time investments on their own.

Yet precious metals, especially gold, have been real, much coveted, assets over thousands of years. Invested in correctly, at the right time, they can be very profitable. I propose that, for most investors, exchange traded funds (ETFs) are one of the best ways to invest in the sector. ETFs are diversified so you avoid corporate risk and entry costs are low.

Last January I penned an article (see it here) on how undervalued gold mining ETFs were. Although I didn't know it then, the timing was right on - precious metals (and their miners) bottomed in January. Since then year-to-date numbers show Market Vectors Gold Miners ETF (NYSEARCA:GDX) up 23% and Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) up 34%.

Is it too late to buy these ETFs? No, at least not for long term - in the short term we may see a correction. Even at today's prices, however, shares have a long ways to go just to match 2011 prices. GDX (27.2 at time of writing) is still down nearly 58%. (See chart below.) and GDXJ (42.7 at time of writing) is still down 73% from 2011 prices.

Click to enlarge

(source: Yahoo Finance)

Why The 3-Year Bear Market From 2011 to 2014?

When the Great Recession crashed on to the scene in December 2008 precious metals had already been in a strong bull market for 4 years. While initially the metals fell (along with all "risk on" investments) in the panic, the advent of QE (central Bank asset purchases with the potential for rapid monetary expansion) quickly had gold bulls once again seeing blue skies forever. Well, nothing is "blue skies forever" and by 2011, the bull market in gold broke as investors realized that all the newly printed money was mostly strengthening bank balance sheets and not flowing into the general economy. As a result precious metal prices collapsed. It was a natural correction in a very tired bull market.

QE over the last few years has been kind of like shoveling dirt into an ever expanding hole. You can put a lot of it in, but with defaults and deleveraging keeping the hole growing it has little effect.

So What's Going On Now?

After bottoming in January precious metal miners have now completed the first phase up in a new bull market. The Fed is tapering and the economy seems to be slowly improving. Everyone is taking a wait-and-see attitude watching how the wind down and end of QE in October affects the economy. At this point things look more or less okay though some worries are beginning to surface in Europe and elsewhere. Nothing is yet on the scene yet which would reignite QE.

There is, however, a realization that Europe, the U.S., and Japan cannot run huge fiscal deficits forever. Sooner or later the piper will have to be paid, currencies will falter, and hard decisions will be forced. How soon that happens is open to debate, but when it does commodities, especially precious metals (and their miners, which are usually levered 2-3 to that of the underlying metals) will be the place to be.

Then there is the big rise in geopolitical instability this year. Ukraine, Iraq, China vs. Japan (dispute over the Senkaku Islands), Israel vs. Gaza, Nigeria, Sudan, and now ... the Ebola virus fears. It's all a toxic brew, which may cause investors both large and small to flee into the safe havens such as precious metals.

With the above in mind let's look once again at the two most well know precious metal ETFs: GDX and GDXJ. Both hold a diversified, global blend of gold (and silver as it's often found with gold) equities.

GDX holds 57 small-, mid- and large cap gold companies. (See top 10 holdings here.) The ETF tracks the NYSE Arca Gold Miners Index, an index which only holds companies with market caps above $750 million - thus the smaller, more volatile companies are excluded. (Investopedia says small caps are companies with a market capitalization between $300 million and $2 billion.) GDX's three top holdings are Goldcorp (NYSE:GG) at 13.7%, Barrick Gold (NYSE:ABX) at 12.9%, and Newmont Mining (NYSE:NEM) at 7.7%.

Oppenheimer analyst Ari Wald agrees that the gold miners have more potential than gold itself and sees a 40% upside to GDX.

GDXJ holds 69 small- to mid-cap miners. (See top 10 holdings here.) The ETF is benchmarked to an in-house index of the smaller miners and no one holding comprises more than 5.1% of the total so risk is broadly spread out. With precious metal prices rising the smaller companies in general outperform.

Also, in a bull market GDXJ's price may be boosted by increased mergers and acquisitions of the smaller miners and as investor optimism is high there is more investments in the smaller miners. GDXJ seems to be leveraged about 3X to the price of gold.

Conclusion

Precious metal miners saw shares bottom last January after a 3 year bear market. Although up substantially since January, the sector was so depressed it's probably the most undervalued one in the market today. This undervaluation plus the highly uncertain geopolitical situations we are now seeing will likely have investors continuing to accumulate assets in this incredibly durable asset class.

Additionally, since precious metals and their miners often move in the opposite direction of other equities the sector provides a hedge against broad market declines which some now foresee.

Investors, however, must be careful. Hype and misinformation is rampant in the sector. To invest in this field but also avoid all the noise and sleep well at night look to these ETFs.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to do their own due diligence and, if necessary, consult with a professional financial advisor before investing.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in GDX, GDXJ over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.