Hedge fund boss John Paulson has often made the conventional wisdom case for owning gold shares - that mining companies enjoy superior leverage to gold prices, perhaps rising as much as 2-3 times as much as the gold price. As noted recently in the Wall Street Journal, he’s backed up his thesis with big slugs of gold equities.
Color us skeptical.
We mean no disrespect to the likes of Paulson. But the case for equity leverage to gold is diminishing and will continue to do so until mining company executives and their bankers stop the addiction to deal-making. Until then, non-insider investors in precious metal equities will continue to bear the brunt of the penchant for financial engineering that is based on a permissive attitude to the stock register.
We’re not naive about the temptations and opportunities for stuffing scrip down the market’s throat. When you own a money printing press you tend to use it, especially when your performance is incentivized primarily through near-term movements in stock prices.
Yet, who cannot be galled to hear precious metal miners cooing and tut-tutting about profligate central bankers and leveraged sovereigns even as they issue stock at rates to make even Ben Bernanke blush, make high risk bets on the far distant future, and spend more on fees and commissions than dividends.
Let’s use a few charts to start clarifying how gold equities are losing leverage to gold prices (daily and monthly data in an interactive format is available here):
click to enlarge
The charts confirm a disturbing reality - large gold stocks have been tamed by rising gold prices.
When the gold bull market was in its infancy in 2001-2 gold stocks were experiencing massive moves relative to small changes in the gold price. That leverage has steadily eroded, and fell into a long-term downward trend in 2006.
As we have argued before, one of the primary reasons is the arrival of exchange traded gold.
Investors were given alternatives for their gold allocations, and traded the promise of equity leverage - with its large number of risks - for less complex bullion. The effect was very notable in gold mutual funds which piled into exchange traded securities, diverting a critical investment stream away from the equities that they were once literally forced to buy for lack of options.
Click for detailed metrics over time per company
We are now at a remarkable point where aggregate gold equity market values are underperforming the gold price by 5% and the leading Gold ETFs by 20%.
Put another way, for every $1 increase in the gold price, the gold ETFs are drawing $0.16 in additional investment. This has held very steady since June when the European debt crisis began to accelerate. Likewise, note in Chart 2 how aggressively investors switched from equities to ETFs through the unfolding and peak of the credit crisis. In contrast with the gold ETFs, equities are only getting $0.95 of additional value from every $1 improvement in the gold price.
As Mr. Paulson has stated, this is not the conventional wisdom about gold stocks. It simply is no longer valid to assume that a gold stock will automatically provide leverage to the gold price.
Looking at chart 4 you’ll see just how poorly the senior gold stocks have performed since early 2006.
As represented in our market capitalization weighted MineFund Gold Equity Index, the group has struggled to break through levels seen when gold was trading at $600/oz. The gold price has more than doubled since then, but the senior group is just 20% more valuable. It’s a pernicious variation of inflation for long-term shareholders.
Some might argue that this just strengthens the case for owning junior mining stocks. Really? The primary premise - and price driver - for owning junior mining stocks is that they will be bought out by the seniors. If you own a junior miner because you think its value will come solely from finding a mineral deposit and developing it into a modern mine under its own capital structure... well, we have a bridge to sell to you.
The senior miners are critical because they are the most visible face of natural resources investing. When they get it wrong, the entire sector suffers.
Blaming the gold ETFs is only part of the problem. The larger issue lies in boardrooms obsessed with boasting a veneer of growth.
For commodity stocks, this inevitably boils down to producing more stuff and accumulating larger inventories of that stuff. There is a modicum of respect for earnings per share, but even that metric has been neutered by accounting gimmickry. Besides, investors have no power over earnings except through dividends, of which there are precious few in an industry whose business it is to mine cash from the ground.
The very bottom line is that the senior gold group is guilty of diluting its shareholders; relying on higher metal prices to mask the full effect on earnings.
The market is not fooled though, and precious metal equities have been derated as a consequence. The primary whip is mineral resources per share and gold production per share, weighted toward the market’s expectation for future years. The table below represents the last six years; we’ll spare you the full horror of the ten-year results.
As chart 6a below illustrates, the group has been very successful in growing its reserve base in aggregate. Unfortunately, nearly all the new reserves come from mergers and acquisitions funded with stock. As a result, there has been a shocking 23% decrease in reserves per share (-12% on a production weighted basis).
Companies have been much less successful at growing production since the steep add-ons of 2006 after a rash of mergers in prior years. Quarterly gold production per share has crashed 42%, as illustrated in chart 7a.
Managers would likely argue that investors have been made whole because the increase in the price of gold has been more than enough to offset dilution effects. And that is true - reserve value per share has more than doubled (chart 6b), whilst production per share has almost doubled (chart 7b). However, let’s not forget that the argument for buying equities is superior leverage to the gold price. Just look how poorly equities have done compared with bullion though, especially the gold ETFs.
Is it any wonder that so much money has flowed into physical and securitized products compared with equities? As chart 8b makes clear, in just 6 years an investor in a basket of the leading gold stocks has suffered a 40% dilution in the value of proven and probable reserves per share; it is considerably larger over a decade.
What would you recommend to your children or clients when faced with these facts?
The primary culprits are the Boards of Directors. They have failed to restrain their executive managers who have been seduced by merger and transaction games. A gold stock’s leverage to the gold price is, nowadays, entirely dependent on the attitude of the Board and senior executive managers.
As is abundantly clear from the charts above, M&A is not a failed strategy for large precious metals companies. Rather, it is a failure for investors in those companies; but it has been a bonanza to company executives, bankers, brokers, vendors and consultants.
There are exceptions in Agnico-Eagle (NYSE:AEM), Randgold (NASDAQ:GOLD) and Eldorado Gold (NYSE:EGO), respectively, (Yamana’s (NYSE:AUY) past is catching up with it as evidenced by its faltering market value), but they are truly exceptions. We will wait to see if those companies will resist the temptation to go for the “big one”. Indeed, Randgold investors are likely very thankful that it never prevailed in the takeover war for Ashanti Goldfields (NYSE:AU), whose assets never turned around in a way that justified their price.
For the majority of investors in mining companies, wealth is created over time and by participating in the company’s cash flow through dividend distributions. Retail investors are especially vulnerable because they lack the inside dope to be consistently successful at timing trades in the short-term. They are forced to the long end of the curve by default. The most rewarding outcome for investors is when key assets and free cash flow per share increase over a long period. With compounding, it’s a potent wealth builder, and mutually beneficial to all stakeholders.
Alas, dividend flows in the gold sector have a miserable record. It’s all the more dismal given that sell-side analysts award a “premium” rating to gold heavy stocks. Well, what does this comparison tell you about the appropriateness of the premium?
There is a very clear value message for retail investors who are being offered the proverbial VW Beetle for a Rolls Royce price. Why not switch or diversify the trade until the balance of risk and reward is restored?
If there is a conclusion to be drawn here, it is that there appears to be abuse of the premium rating afforded gold companies. It creates a perverse incentive for executives and their enablers to issue scrip and do deals to fulfill the growth obsession. It also shows up in the fact that executives are content to compete with their own shareholders for cash extraction. Gold company executive compensation in 2009 was equivalent to a hefty 16% of total dividends paid.
When companies are struggling to pay serious dividends with gold prices above $1,000/oz, what is going to happen when the cycle ends? Now is the time that precious metals stocks should be raining dividends and share buy-backs on their investors. Wishful thinking.
Compare chart 11 below with chart 1. You’ll notice a rough correspondence between free cash flow yields and leverage to the gold price.
Is it not astonishing that free cash flow yields have slumped so dramatically until recently given consistently rising gold prices? And there is reason to fear that yields may be on the way down again as input inflation starts to bite.
This should alert investors to another reality for precious metal stocks - they are steered by the weather vane of the US dollar, and will be for as long as that currency is the denomination for most commodities.
That doesn’t absolve mining company executives of their stewardship. They have the ability to stop their stocks from being capsized through serial issuances and lavish compensation. Start by putting a hold on the breast-beating transactions. Exchange financial engineering for fundamental wealth creation. Reward your shareholders.