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Recently several well known hedge fund managers, such as David Einhorn, have discussed the growing disconnect between the price of gold and the gold miners. For the conspiracy theorists, the hedge funds are not trying to sucker investors into the trade only to bet against them, rather they are talking up their own books (not necessarily altruistic, but it always adds credibility when the “promoter’s” interests are aligned with the investor’s). ZeroHedge has published the holdings of the 50 largest hedge funds, and both Newmont Mining (NYSE:NEM) and Barrick Gold (NYSE:ABX) are high on the list.

Gold mining companies have underperformed gold over the last several years; however, these trends have a tendency to revert to their mean at some point. As is illustrated in the chart below the ratio of gold to the gold mining index (XAU) is now close to nine, the historical average is closer to five. This is higher than two weeks ago when I wrote about Barrick Gold, then the ratio was closer to eight. In theory mining companies should outperform gold as they are leveraged to the price of gold. For example, if a mine has a total cost of $800/oz and gold is at $1000/oz, a 20% increase in the price of gold will double the mine’s profit margin from 25% to 50%. To wit, Newmont Mining’s margins have increased by 90% since Q1 2009 compared to a 65% increase in the price of gold.

To invest in gold mining companies today, you need to believe in two things:

(1) that gold is not in a bubble and the price over the long term will move higher and

(2) the ratio between gold and the gold miners will narrow and revert closer to its mean

Over the next few years I think gold will be heading higher, simply due to the debasement of the currency e.g. Uncle Ben and friends running the printing presses. The amount of gold being produced is much less than the amount of money being created. Central banks are lowering reserve requirements (China), lowering interest rates (Australia, Brazil) or printing money outright via quantitative easing (USA, UK). It looks like the ECB (European Central Bank), at some point, will have to follow suit in order to the save the Euro. All of these are positive for the price of gold.

The second point is easier to address if we consider why this divergence has occurred in the first place. Several explanations are available:

(1) Mining companies are still equities and they have been dragged down with the general market.

(2) Gold has risen so far so fast that many investors do not believe it will stay at this price.

(3) The rise of the gold ETF makes it easy to invest in gold without having to hold the physical bullion and not having to worry about operational or political risks of a producer.

Once there is more stability in the market, gold miners should move substantially higher and start to reduce the gap between their price and the price of gold. When additional printing occurs this will also be positive for the yellow metal and the gold miners as, at the very least, it will drive the perception that inflation will be forthcoming in the future. Over time people will become more comfortable with gold at these prices and this should also move the ratio lower. The third point is the most difficult to address as gold ETFs do provide another option for an investor that previously did not exist. However, it also does not allow the investor to participate in the leverage and potential upside from a strong development pipeline. Look for companies with diverse operations and strong growth prospects, such as Newmont Mining and Barrick Gold.

Let’s look at Newmont, since I have discussed Barrick in the past. Newmont has a healthy pipeline and is projecting a 35% increase in gold production by the end of 2017. As means of comparison, by 2017 they estimate they will be producing ~7 million ounces of gold per year and 400 million pounds of copper, which are both equivalent to what Barrick produces today (and is an 80/20 split between gold and copper). Interestingly, Newmont has recently linked their dividend to the price of gold: the dividend increases by $0.30/share for every $100 increase in the price of gold. Today the yield is ~2%, but if gold increases to $2000 the yield doubles to 4% (assuming a constant share price). Over the past decade, revenue grew at a compound annual growth rate (CAGR) of 21% and the dividend increased at a CAGR of 17%.

You can invest directly in these companies, or if you prefer to invest in these firms at lower prices you can also write puts. It is an ideal time to write options as the volatility is high, resulting in higher option prices. If the price drops below your strike price at maturity you will purchase the shares at the strike price and keep the premium. If the price stays above your strike, you keep the premium but do not own the shares. Another option is to simply buy a gold miners index such as XAU.

Source: Gold Miners Finally Ready To Follow Gold Upwards