Gold Mining Stocks Undervalued - For Good Reason

Includes: GDX, GDXJ, GLD, NEM
by: Vince Martin

Back in July - and again in December - I noted the striking divergence between the ETFs of gold miners and the price of physical gold. The SPDR Gold Trust (NYSEARCA:GLD) had sharply outperformed the two major mining ETFs, the Market Vectors Gold Miners (NYSEARCA:GDX) and the Market Vectors Junior Gold Miners (NYSEARCA:GDXJ).

The miners made up some short-term ground in the summer of 2011, before the junior miners finally broke down heading into the broad market lows of early October. Mining stocks again narrowed the gap in the first two months of 2012 - benefiting from a bullish run in equities worldwide - but the divergence accelerated in March. In its fiscal third quarter earnings presentation, US Global Investors (NASDAQ:GROW) - whose stock I recommended earlier this week - pointed out that the spread between physical gold and its miners was at a decade-long high, reaching in March a level surpassing even that of the 2008-09 credit crisis:

GLD/miner spreadClick to enlarge

slide courtesy US Global Investors; data sourced from Bloomberg

Mining stocks continued to skid, however; not until mid-May did the stocks finally put in a bottom and begin to rebound. The divergence between the returns in the three ETFs, however, remains stark:

GLD/GDX/GDXJ one-year chartClick to enlarge

one-year chart of GLD (blue), GDX (red), GDXJ (green); chart courtesy Yahoo! Finance

Over the past year, while gold has seen modest gains, the senior miners are down nearly 10%, with the junior miners down over 35%. Over the same time period, the S&P 500 is actually up about five percentage points, further highlighting the weakness in miners, particularly the industry's smaller players. And despite the recent rebound in gold mining stocks, over the past three months they have still underperformed gold.

As such, the spread between GLD and the gold mining ETFs remains at literally historic levels. This isn't necessarily news to many investors - both Barron's and the Wall Street Journal have covered the spread in recent weeks - nor is the spread necessarily surprising. Rising costs continue to plague miners. According to Thomson Reuters GFMS, worldwide cash costs per ounce rose 15% to $643 in 2011. ABN Amro appears to have discontinued its quarterly Gold Mine Cost Report, but its final issue [pdf] in June 2011 showed the longer-term trends in cash costs:

ABN Amro quarterly cash cost chartClick to enlarge

With gold trading roughly sideways for the last year, the continuing increase in cash costs have likely caused some of the bearishness toward miners. There are reasons to think some of the cost issues should subside - or are already easing. In its April 2012 presentation [pdf], Thomson Reuters noted the breakdown in the 2011 increase:

Thomson Reuters GFMS slideClick to enlarge

Some of these pressures - noticeably fuel and FX (foreign currency exchange rates) - should be easing on miners. Oil has fallen sharply from its highs, and the US dollar continues to strengthen. These two factors alone accounted for 30% of the cash-cost increase, yet may even prove a tailwind for mining stocks in 2012 compared to the year prior.

But even if growth in cash costs slows, the larger issues for mining stocks are regulatory and tax concerns. As Thomson Reuters noted, cash costs rose 15% in 2011, but its "all-in" measure - which includes the costs of environmental and regulatory compliance - rose 22% year-over-year. The increasing cost of doing business for miners - many of whom have operations in less-than-stable countries - continues to be the biggest headwind facing the industry. Newmont Mining (NYSE:NEM) will see costs rise at its $4.8 billion mine in Peru due to a government review that altered its plans. Ghana has announced plans for a 10% windfall profits tax and a rise in corporate income tax for miners in that country, a move that amazingly appears to have been prompted by the International Monetary Fund. Tax hikes have recently been proposed in Kyrgyzstan, Zambia and even floated at the state level in Nevada. In 2011, consulting firm Ernst & Young named so-called "resource nationalism" the number-one risk facing mining stocks, noting that 25 countries had increased or announced plans to increase mining taxes and/or royalties. It's no wonder World Gold Council CEO Aram Shishmanian told Reuters last month, "If this continues for the next five years the gold price needs to be at least $3,000 just to stay in the business."

At the end of the day, the problem with gold mining stocks versus the metal they mine is the issue of safety. From an investment standpoint, gold is usually defined as a "safe" purchase, used to protect the investor from economic or political disruptions, inflation, or other fears. Gold miner stocks, in contrast, are hardly "safe." They are traditionally volatile investments, dependent on the whims of governments and bureaucrats in far-flung countries, and increasingly under pressure from environmental and political groups (witness the IMF's decision to squeeze miners in Ghana).

So the potential outcomes for a long-term investment in mining stocks simply don't seem all that appealing, particularly in relation to a direct investment in the physical metal or the GLD ETF. Should gold prices weaken, margins at the gold miners will compress; with no way to lower costs except closing mines, mining stocks will likely see greater losses than the physical metal. Should gold prices appreciate slowly - in the rate of, say, 8-20% over the next year - rising costs will eat up most of the miners' additional revenues, leaving earnings growth minimal and leading mining stocks to again lag the physical metal.

It's only in a high-return scenario for gold - annual returns over 20% or 25% - where mining stocks seem likely to outperform gold itself. Such a move would not only improve earnings sharply. But change the bearish investor sentiment which has dogged the sector for the last 12 months. As such, mining stocks going forward should act much like an out-of-the-money call option on the price of gold; high-risk, but high-return.

For traders, an arbitrage trade (short GLD, long GDX or GDXJ) might still have some short-term value, as the recent narrowing of the metal/equity gap continues. For long-term investors, there's simply not as much value in gold mining stocks as it appears from the charts. The reason gold mining stocks are at a historic discount to gold is that the miners themselves are under a historic amount of pressure: from labor, from government, and from the citizenry. It will take a sharp rise in the price of gold for gold mining stocks to overcome all the challenges currently facing the industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.