The gold mining business has been a tough industry for investors over the last couple of years, despite skyrocketing gold prices. Gold has outperformed most other asset classes but the mining shares have not kept up with gold’s performance.
There are many theories why the shares are lagging behind, some say that frightened investors prefer the safety of gold bullion, and others say that newly launched gold derivatives and ETFs has been competing with the shares for capital.
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 gold. It is composed of the 16 largest and most widely held public gold production companies.
The chart below compares gold’s (GLD) performance against the HUI. Both gold and the HUI were neck-to-neck until the financial crisis of 2008, when gold pulled away. Until this day gold has been a far better investment than most gold stocks.
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Although the shares have been lagging behind, there are a number of developments that suggest that the mining companies might be ready to catch up and outperform physical gold and silver. First, margins between the gold price and cash costs of production per ounce have been growing steadily. This has led to vastly increased profitability. The increase in margins has been a result of higher gold prices as production cost has been increasing at a much lower rate. This chart below shows the average industry margins between the gold price and cash costs of production per ounce.
The next chart compares the price of gold and the operating costs of production. The price of gold has been increasing at a much higher rate than the production cost and as long as gold remains at present levels the gold mining companies will remain highly profitable.
Gold mining companies have traditionally not been paying much of a dividend and in many cases they have not been paying dividends at all. But with increased profitability many companies have raised their dividend payouts while others have started paying dividends for the first time. Although dividends are still quite low compared to other industries, this new development may be a precursor that leads to higher stock prices. The chart below shows dividend payments for the top ten companies listed in the Market Vectors ETF Trust (GDX), an index with holdings that include some of the biggest and best producers in the industry.
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 (GFI), have had phenomenal growth, but the stock price has generally not kept up with the fundamentals in most cases.
There is a strong reason to believe that the mining shares could stage a rally and outperform the metal itself in the near future. Rule Rule, founder of Global Resource Investments, now part of Sprott Asset Management stated in an interview on King World News that he “think[s] that one of the bright spots in this market for investors and speculators, with a 12 to 18 month outlook, is the disparity in pricing between gold and silver equities and physical gold and silver prices.”
According to Mr. Rule, there have only been two other times over the last decade when gold and silver prices were so attractively priced compared to the metal itself. Once was back in 2001 and the other time was in 2008. He went on, saying that:
if current gold and silver prices hold up, and I believe they are actually going to increase, that we are going to see a rather dramatic jump higher in the prices of select gold and silver equities on a go-forward basis.
In addition to the shares being undervalued, the HUI typically shows seasonal strength at the end of the year. The chart shows the monthly average annualized increase in the HUI over the last decade, and the shares usually finish the year strong.
The HUI is also forming an ascending triangle which may be signaling a breakout. Resistance has been around the 600 level and once the HUI clears that level with some conviction, I think we will start to see these stocks move up rather quickly.
In conclusion, I think we will see a good size rally in the gold mining stocks over the next couple of months and retail investors should allocate at least 10% of their portfolio into these mining shares. The quality stocks will probably be the first to advance and I suggest buying stocks like Newmont Mining (NEM), Goldcorp (GG), Barrick Gold Corporation (ABX), New Gold Inc, (NGD) and Yamana Gold Inc (AUY), which is really the cream of the crop and likely to breakout first.
Besides owning individual stocks, the Market Vectors Gold Miners Trust (GDX), includes 30 of the biggest and best producers in the industry offering diversification and should balance out the volatility of individual stocks.