Whether The Straggling Gold Stocks Are Finally Ready To Catch Up

by: Robert Hallberg

Gold has performed extraordinary well, gaining almost 30% in just a few months, and making new all time highs. With such as strong performance of gold, a question on almost every gold investors mind is; why are gold stocks doing so poorly?

Gold stocks offer leverage to gold and should in theory outperform gold in a rising market. However, it seems that in the current environment of fearful investors seeking a safe haven, gold is favored over gold equities.

Until recently, many gold equities had been in a multiyear trading range with flat stock performance despite increasing revenues and substantially higher profits. The gold bugs index (HUI), is a good benchmark to see whether gold stocks in general are outperforming or underperforming. It is composed of the 16 largest and most widely held public gold production companies.

The table below shows revenue growth and stock performance over the last three years of all stocks listed in the HUI. All companies in the index with the exception of Gold Fields (NYSE:GFI) have had phenomenal growth, but the stock price has generally not kept up with the fundamentals in most cases.

HUI Index
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The chart below compares revenue growth against stock performance.

HUI performance
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The chart below compare gold’s (NYSEARCA:GLD) performance against the HUI. Both gold and the HUI were neck-to-neck until gold pulled away in 2008, and further increased the gap during its recent breakout, starting in July. Until this day gold has been a far better investment than most gold stocks.

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The Case for Gold Stocks

The poor performance of most gold stocks has disappointed many investors that correctly predicted the rise of gold prices. However, there are a number of bullish factors for gold stocks listed below that suggest that this trend might be about to change.

  1. With substantially increasing cash flows most gold equities are beginning to pay dividends or increasing their dividends.
  2. The run-up in the price of gold has substantially increased profit margins as production costs for most companies remain constant.
  3. As the general stock market has underperformed, professional fund managers may be looking for other sector with stronger fundamentals and start to divert money into gold. Most funds and institutional investors are underweight gold and many have no exposure at all.
  4. The largest input cost for mining companies are energy costs and the recent dip in oil prices has reduced cost while the value of inventories are going up.

Furthermore, the stock price of many quality gold stocks has finally started to advance and it appears that they may finally be ready to make a move and catch-up with physical gold. The HUI was struggling for the longest time to break above 600 on the chart, but it has finally broken above that level and it appears that it will continue its ascent.

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The 600 level on the HUI has been strong overhead resistance and once this level is cleared the upside advance could be very rapid according to John Embry, Chief Investment Strategist at Sprott Asset Management. When he was asked about the HUI on an interview at King World News he responded: “I think the HUI when it breaks, once it clears the 600 level with a little gusto, I figure 50% higher in a short period of time. At some point in this move there is going to be the collective realization that these stocks (mining shares) are just staggeringly cheap and because of some of the activity that has gone on in these algorithm programs, not only is there the buying, but there is the natural short covering that has to happen. That’s an explosive combination.”

Investment Implications

Most quality gold stocks, especially those traded on the HUI should be ready to outperform in the near future. For those that do not want to pick individual stocks, index investing might be a better option. The two indexes listed below offers exposure to both major production companies as well as more speculative exploration companies.

Market Vectors ETF Trust (GDX) attempts to replicate NYSE Arca Gold Miners Index. GDX represent a mix of 30 small, mid tier, and large capitalization gold mining companies. GDX’s holdings include some of the biggest and best producers in the industry and are far better positioned to withstand a downturn than many other gold mining companies.

Market Vectors Junior Gold Miners ETF (GDXJ) is made up of 72 junior gold miners. The index provides exposure to a wide range of small to medium capitalization gold mining companies globally, that generate at least 50% of their revenues from gold and silver mining. Because of its holdings, GDXJ is more volatile than most other ETF’s invested in precious metals. This ETF is suited for investors that wish to speculate on price movements in gold, but refrain from holding individual junior minors.

Disclosure: I am long GDX, GDXJ, GLD.