It happens to the best investors sooner or later. You filter stocks with screen after screen. You whittle the survivors down to a short list of candidates, and you crunch their numbers forwards and backwards. You nearly go blind studying the fine print in the reports of your finalists, and you consider all the possible scenarios. Finally you buy the perfect stock, and your top scenario plays out exactly as you had envisioned and hoped. The stars align, and your stock…well, it sits as motionless as a deer in headlights. In light of the historic rise in gold prices, this is the sad story of gold miner stocks lately.
This article offers three theories why gold stocks are trailing the market, even though the spot price of gold has risen faster than any of the market indices in the past couple years. I will also offer my plans for gold investing in the near future.
Background. Many gold stocks are selling at about the same price as two years ago, even though the price of gold has risen more than 50% since then. For instance, in March 2010 I bought calls in Aurico Gold (AUQ), thinking it was undervalued at $10. I was surprised to see that AUQ is still selling for $10 a share today, after upgrading their operations, increasing production, expanding their resources and adding a plum of an acquisition. Oh yes, there was also the 50% spike in the price of their product. Dilution alone does not explain why Aurico has spent two years going from point A to point A.
Many advisors have predicted that the gold stocks will soon catch up with other market segments. After all, most of the gold producers are profitable companies, all the more so with their product price near an all-time high. Nonetheless, they have been unable to keep pace with the market's bullish run, so there must be other dynamics that are holding them back.
One of my three theories, or a combination of them, may explain why these stocks are not responding as an analyst would expect:
The Ounce in Hand is Better Than Five in the Ground Theory. This theory postulates that investors would rather hold physical, refined gold than gold stocks, despite the gold reserves that those stocks represent. To illustrate the comparison we will use Aurico's fundamentals, but other stocks would yield similar results.
Aurico has proven reserves equal to about 9 grams of gold per share or 2.8 ounces for 100 shares. At the current price of $10 per share, investors can buy about 5 ounces of gold in the ground for the $1700 price of an ounce bar. If we include "measured and indicated" reserves, then you get about 9 buried ounces for the same cost as one shiny, pure ounce. A comparison of AUQ with other mid-tier miners reveals very similar ratios.
In order to get our 5 ounces out of the ground, AUQ will spend about $700 per ounce and it will take about 20 years to turn all those reserves into ingots. If we conservatively consider the price of gold will remain at $1700 per ounce for 20 years, then we have a $1000 gross profit per ounce or $5000 profit on 170 shares, which cost $1700.
Under the same assumptions, if we had purchased an ounce of gold for $1700, in 20 years it would be worth $1700 less the cost of 20 years of storage and insurance.
It would seem a no-brainer that the gold stock is a superior investment to physical gold ownership according to this simple analysis. Of course, the physical metal will last forever, and a number of issues can destroy a mine: disasters, weather, exploration errors, political upheavals, etc.
Despite the strong cash flow of gold stocks, for certain investors there is a preference for gold bars. The Chinese, Indian and other sovereign governments are buying the physical commodity to balance against their ephemeral "paper" investments. Furthermore, it has been publicized that controversial relaxation of investment banker rules from 2003 to 2008 allow the JP Morgan's (JPM) and Goldman's (GS) of the world to accumulate hoards of physical metals, which logically have contributed to the skyrocketing price of gold.
A variety of ETFs also now offer shares in physical gold for "retail investors" with concerns about paper money. The purchase of these investments has reduced the funds that would normally be available for mining stocks. The many new avenues for physical gold ownership are appealing to the people that used to buy gold stocks as insurance. It should be noted that in previous decades, the small-time gold lovers were limited to gold stocks, even though they may have been wary of Wall Street.
The Fool Me Twice Theory. This theory is based on the premise that gold stock investors have been burned by the volatility of the yellow metal in the past, and that they are reluctant about diving back into those investments as gold is peaking. The historical declines in the price of gold have been particularly deep and cruel for the bag-holders.
If we go back to 1979, we will see the price of gold peaking near $750 an ounce. It took 28 years for gold to get back to that level in 2007. That is 28 years of inflation, rising fuel costs, escalating labor costs and diminishing ore grades. Some of the most intriguing companies now are the ones that were able to pick up resources for a song from miners that threw in the towel. Gold stock investors had 28 years to become more bitter and leery of gold stocks.
Even the small rallies in gold in the intervening years resulted in multi-year bear markets in gold. After dropping back to $300, gold staged another rally to $500 with the all-too-familiar sudden spike in 1982. Of course, gold soon returned to $300 and it was five years later before investors saw $500 again. I myself was caught in that downturn, having invested in Blyvooruitzicht Gold Mining Company in South Africa. I kept the artistic stock certificate in our little ranch in New Mexico, waiting for a comeback…until my wife threw it in the burn-barrel.
We should remember that the price of gold has convincingly burst through the $1000 level only in the past 30 months, after years of disappointments. Adopting a suspicious approach, the gold stock investors are still on the sideline until the metal proves it can stay afloat at current levels. History tells them that if they jump in at the peak in gold, they may have to wait decades to recoup investments, if at all. A prolonged drop in gold spot combined with limited mine lives, escalating costs and back-firing leverage may completely destroy the miners. At least with industrial stocks you can play the "rips and dips," and hope for other developments in the specific stock to counter a down market.
The Show Me the Money Theory. This theory contends that the reason there is not much interest in gold stocks is because their managements are reluctant to distribute the profits to the investors. The four largest gold stocks pay a meager average of 1.5% yield in dividends. The majority of smaller miners pay no dividend at all. Those of us that have held gold stocks for years want to know that there is going to be a payday eventually, but it never comes. In the current low interest rate environment, more investors are seeking income from their stock investments.
Whenever a banner year is announced, monetary "attaboys" are passed around to the execs, and what is left goes into exploration. We investors get to feel good for awhile reading the press releases. I guess these companies do not believe in dividends because they are never sure of the volatile price of their product. Maybe they don't want to establish an unsustainable dividend policy. However, I have never been upset about getting a special one-time dividend from a company with a good year of profits.
This policy seems especially stingy since some of the biggest yields can be found in natural resource stocks. Petroleum partnerships and royalty companies can pay double-digit yields. Even the world's non-precious metal giants, BHP Billiton (BHP) and Rio Tinto (RIO,) pay more than the big gold miners. I think even paying out just 30% of cash flow would provide a dividend yield that would be better than the average S&P dividend. In the case of Aurico, that would be about a 3% yield.
As an aside, I would love to receive dividend payments in the mine's gold…say .01 gram per share. For every 3100 shares the stockholder gets one troy ounce each year. In the case of Aurico, that would be a $1700 dividend on a $31,000 investment…a 5.5% yield. Paying in kind would relieve the miners concern about the volatility of the metal's price.
My Plans for the Gold Market. Despite the cautious tone of these theories, I am still bullish on the gold stocks. The most important influence on their fundamentals will continue to be the price of gold. In my recent article on silver I discuss the macro factors that lead me to believe that over the long term the price of precious metals will escalate.
In the near term, I am not as optimistic about the price of gold. I have no crystal ball, but some of the dynamics mentioned that are adding demand for physical gold may also be setting it up for a decline. For instance, the rush of individuals into the physical gold market may be a contrarian indicator, since studies have shown that this category of investor has the propensity to enter the market at precisely the wrong time.
Emerging market growth is slowing, and excess funds being sunk into gold by sovereign governments may be diverted to domestic initiatives. With those buyers on the sideline, the spot price will likely drift lower.
It has been reported that the Fed is in discussion with the investment bankers to either approve the expansion of their commodity storage operations, or require them to sell off those assets and empty the warehouses. Obviously, the former would boost gold prices, and the latter could flood the market and deflate prices. A success for President Obama in November could be the green light for the Fed to take a stricter stance on non-banking operations of these bankers. Currently, Vegas bookies give Obama a fat 5 to 2 edge over any contender, and those guys are usually pretty accurate.
I think as the election nears, the price of gold will trend lower and is likely to hit $1500 before it goes to $2000. However, based on my theories, I think that some things will happen that will bring the gold stocks back to prominence:
1. Investors have satisfied the pent-up demand for the physical metal, and a substantial drop in the metal price will bring reality to retirees that this is a no-income investment.
2. The longer that gold can stay above the $1200 level the more investors will realize that the recent price increase is not just a temporary fluke. The price increase is a natural reaction to world growth and added investment demand, and gold stocks should be reevaluated accordingly.
3. Miners realize the need to increase dividends, but must finish the projects they started. As those come on line, they will proportion a higher percentage of cash flow to distributions. I would bet that even some will develop "in kind" dividend plans.
Although the near-term may be bumpy, I am not going to sell any of my gold investments, as I think the long-term prospects are attractive. I am making my watch list, and I think it may be good to outline my criteria for gold stock selection.
First, I want low-cost producers that can fund their plan at lower gold prices. Second, I want stocks that have a chance of providing some kind of a positive surprise.
The first criteria eliminates most purely exploration companies and many of the producers. I reference Aurico in this article, but their average production cost of about $700 is at the high limit of my criteria. I am looking for producers in the $500 range. The second criteria eliminates the large miners, because they are basically mining conglomerates and a positive development in one of their many operations has little impact on the stock performance.
I currently own a little Banro Corporation (BAA), and I am looking to add some more on a downturn. Unlike many gold stocks BAA has had a nice recent run on exciting news about procuring financing for a second mine to produce 10,000 ounces a month at less than $500 an ounce in 2013. They have just commissioned another producing mine in the Congo with those same characteristics.
As for a positive surprise factor, I think that Banro has down-played their production capacity. Two mines with the same pro-forma production numbers rounded off to the nearest 10,000 ounces signals a floor to me...a conservative posture. Also, as they are only now ramping up production we have a unique opportunity to take advantage of a positive surprise before monthly production numbers in mid 2012 establish the actual trend. One of the difficulties with mature producers is everyone knows pretty well their capacity, so there is not much chance of a pop.
There are risks in working in the Congo, but the recent elections seem to insure political stability for the foreseeable future. Banro also has established a substantial foundation to fund education and medical improvements in the communities where their employees live.
Another stock that meets my criteria is Sandstorm Gold Ltd. (SNDXF.PK) (SSL.V) Sandstorm takes a very different path to exploration riches. Unlike Banro, they do not actually produce the gold they sell. They cut deals with desperate explorers that need just a little more funding to get the bonanza out of the ground. At just the right time, they offer to fund the rest of the job, but the price is steep. They take a substantial cut of the mine's yield for $350 to $500 an ounce, for the rest of its life. They are a gold "streaming" company.
Sandstorm currently has funded seven miners and by year end five of those will be in production. I first found SSL when I was studying Metanor Resources (MEAOF.PK) and Briggus Gold (BRD), two small Canadian miners that I think have good prospects. The surprise factor with Sandstorm is that these mines are mostly under-explored due to financial constraints, and there are opportunities for new discoveries to add to the mine life and production numbers for SSL, at no cost to them.
The darling of silver investors is Silver Wheaton (SLW) which is the best known silver "streaming" company. I was impressed to find out that the CEO of Sandstorm was the first employee of SLW and their CFO at 26 years of age. The stock has appreciated about 35% so far in 2012 to $1.80, but in the long-term any increases in the price of gold go straight to Sandstorm's bottom line since it has no production cost inflation.
I have decided that I am going to reinvest a portion of portfolio income into two gold related investments. The largest portion will go into the Gabelli Global Gold, Natural Resource & Income Trust (GGN). This is a closed-end fund that invests in the worlds largest gold and energy companies. The fund pays about a 10% annual dividend in monthly installments. This income is derived from dividends on holdings and selling options on them...my all-time favorite income strategy.
In the past two years, GGN units have tracked the poor performance of the underlying assets. However, the nice income element softens the lack of capital appreciation. As of year-end 2011, it traded at a 4% discount to its underlying assets.
In addition to the income, if their gold stocks do come back to life, the capital appreciation element could make this a superior investment. The option selling could mute the capital appreciation to some degree, but not completely. So far this year the fund has appreciated 13% versus 9% for the S&P 500, probably due to the energy component.
The other destination for a small percentage of my portfolio income is the Central Fund of Canada (CEF). This fund invests in gold and silver bullion about equally. It sells at about a 4% premium to the value of the bars in its warehouse. I actually think this is going to appreciate slower than the stocks, but for diversification it makes some sense for me. After all, if the gloom-and-doom predictors are actually right about the US, it may be useful to have a little gold and silver tucked away outside of the country.
In conclusion, these theories may explain why the gold stocks have not enjoyed the same price appreciation as the general market. If the spot price of gold remains above the $1200, some of these stocks are trading at generational lows compared to fundamental valuation levels. The market does not always recognize in the short term undervalued opportunities, and the near-term prospects for these stocks are cloudy. However, in the long term the market adjusts for imbalances in value, and the gold stocks should outperform the general market when that happens.
Disclosure: I am long BAA, SNDXF.PK.