With the spot price of gold at just over $1,600 per ounce, and the price of gold rising from $650 from August 2007 to the present, one would have expected gold stocks over the last five years to have been on fire. However, nothing could be further from that case. As illustrated by the chart below, contrary to gold's 146% price increase, the majority of major gold producers -- including Barrick Gold (ABX), Goldcorp (GG), Kinross Gold (KGC), Yamana Gold (AUY), and Freeport-McMoRan Copper & Gold (FCX) -- have significantly underperformed, and have even had negative returns over the same five-year time frame.
Only the Spider Gold Trust ETF (GLD) has kept pace with a 147% price increase. In contrast to the ETF, the best-performing major gold producer is Goldcorp, with a 47% price rise. It is nearly humorous that the best-performing company on the list would have had to have doubled in price to keep pace with the price of the underlying commodity. The largest player in the industry, Barrick, was basically flat in a period when the commodity rose 147%. This is an industry that has been in some trouble.
A key component for the relative success of Goldcorp (compared to its peers) is attributed to a low-cost strategy and having the lowest average costs out of the major gold producers. The strategy has obviously showed especially when compared to competitors, which perused growth and expansion strategies. The rising costs of the industry have had a large impact on those that already operated at higher costs.
Rising industry costs have undoubtedly caused challenges to the gold producers. However, this issue is a supply problem and has nothing to do with the actual demand for gold (other than a rising gold price.) The cost issue has not impacted the demand for gold; it has just hurt the profitability of the gold producers. This is demonstrated when examining Goldcorp, the leader of the industry (in terms of performance on the stock market out of the group of stocks listed above). Goldcorp has had relatively flat EPS for the last four years when you discount 2009
Goldcorp Annual EPS
- 2008: $1.81
- 2009: $0.15
- 2010: $1.43
- 2011: $1.98
It could be argued that in a truly commodity-based industry, a 147% increase in that commodity would equate to a percentage increase for the producers of over 147% of that commodity, as the companies are supposed to be leveraged to the price of the commodity they produce. The fact that Goldcorp is the lowest-cost producer in a rising-cost environment, and has had these sorts of annual earnings when the price of gold has appreciated by 147%, suggests that the companies in the gold industry are not trading as traditional commodity-based companies would -- or we would have seen higher returns.
Gold has been trading more like a currency than a traditional consumable commodity with a high correlation to the U.S. dollar and the euro. When examining the euro and U.S. dollar, the euro's depreciation against the U.S. dollar has caused U.S. dollar appreciation. That has kept the price of gold in check. The more valuable one U.S. dollar is, the fewer number of U.S. dollars are need to buy an ounce of gold. Therefore, to offset the change in the appreciation of the U.S. dollar, the price of gold goes down and there is no change in purchasing power, as gold is denominated in U.S. dollars.
Over the last year the euro has been on a steady decline against most currencies. If the euro was to stabilize and the U.S. dollar was to depreciate, then the price of gold should appreciate. However, it is not only the U.S. dollar remaining strong, which is having negative implications for the commodity and the mining companies. For the last year people have been dumping their euros and, unlike the past when a safe heaven might have been a gold-producing stock, people are investing in the ETF's.
A relatively new investment vehicle, although popular, there is a flaw in the ETF (exchange-traded fund) system from the gold companies' perspective. The issue with the ETF is that it may hold property interests on a given quantity of gold in different forms, but it is taking away the key investment dollars that gold companies used to use to expand operations. The ETFs are taking investment away from the gold companies. Some ETFs also invest in the shares of major gold stocks, but not all.
The futures and physical market for gold provide alternative investments than the stocks. Because of this, gold companies are financing their operations from revenues or debt and not capital investment they might have received had those dollars not been invested in the ETF. The amount of new projects and ability to fund more expensive projects become more difficult. If the current trend continues, then the producers will simply be as cost efficient as possible and fund only those projects that, under a cost benefit analysis, warrant the risks of development. The conclusion is that the investment money that traditionally went to the gold companies and was used to find/purchase more gold is being tied up to the ETFs, making the life of the gold companies more difficult.
For investors or central banks as opposed to individual consumers of gold, the gold is bought as a store of value, or currency or inflation hedge, and is not turned into gold jewelry or other products. Thus the supply and quantities of stored gold through the physical metal or the ETF grow, and the traditional supply and demand rules of a commodity being consumed are just not applying. The gold isn't primarily being turned into items people use or wear or in economic terms consume. Gold's value seems to be determined not by how many earnings and bracelets people want, but rather by the stability and amount of relative currency that is in circulation. There is a big difference between trading gold and trading the gold stocks. The value of gold is appreciating as a commodity and so should the stocks, but that hasn't happened yet.
To illustrate the difference between gold and another consumable commodity, consider that if a surge in production in wheat or corn were to occur, there would be an excess amount of supply and the prices would fall. Similarly in wheat or corn, if there was a temporary shortage then the prices for those commodities would rise. With gold, if a surge in production or if a new mine is found the price of gold is little changed. If there was a temporary shortage of gold production, the price of gold would be little changed. The amount of gold in the mines is already accounted for. The amount of gold the ETFs hold is accounted for. The price of gold changes predominately not based on the differences of how much or how little gold the miners are producing at margin, but on the changes of the quantity of paper money (fiat currency) in circulation. In economic terms, the price of gold is elastic relative to the changes to the value of currencies and inelastic to the negligible discoveries/shortages of gold.
Here is how it plays out for gold stocks. Right now, the P/E multiples across the board are low for the major gold producers. If gold stays at current levels then the producers will trade flat. Maybe if costs can be contained or the industry multiples increase, then we may see share price appreciation for the gold miners. If gold appreciates than in the short, medium, or long term we should see the price of the gold companies' stocks increase at a somewhat unpredictable level. (As the last five-year 147% price appreciation didn't do much for those stocks.) An increasing established dividend policy from the industry in the short, medium, and long term will help demand for the stocks. However, it could be argued that with all of the risk in owning the gold producers, an alternative investment in the physical metal, ETFs, or even futures seems like a more ideal way to play gold than owning a stock for a modest dividend with all the risks that investment entails.
Consider, however, if the price of gold were to decrease. If the status quo remains intact and if the U.S. dollar appreciates behind a stronger recovering economy, or a crumbling European economy causes the U.S. dollar to rise, the price of gold could decrease. The fact that new mines will no longer be perused to the same extent as in the past because of higher costs and a lower gold price could cause gold to depreciate further. These factors, combined with foreseeable lower stock prices, might be what the industry needs to increase demand for gold stocks. The supply of gold will eventually start to get tight (after the decrease in the price of gold occurs) both because of the above factors and on the demand side where gold is cheaper for the hedgers and jewelry buyers alike.
In this type of scenario, the gold producers might attract investment because not only do they offer a dividend, but once again the prospect of acquiring gold mines for production is the reason people will buy gold stocks. Right now that is not the environment we are in. The gold is there, but the costs, foreign governments, legal issues, rebels, and other risks are very prevalent. Nobody is paying any attention to the gold stocks because the risks are too high compared to the dividend and moderate capital gains to be expected. The above scenario with gold depreciating the gold stocks, and not the metal, might demand a significant rise in P/E multiples, for the prospect of finding new gold will again be the reason that people demand gold shares -- not for a 2% dividend.
The euro, which has been battered over the last year, has been the only thing saving the U.S. dollar. People have been selling their euros and buying U.S. treasuries and other U.S. denominated monetary instruments. This demand for U.S. dollars (from a financial crisis in Europe) has kept the U.S. dollar level with most currencies, and has appreciated against the euro. Later this year when Congress meets to discuss the debt ceiling, people will start asking questions about their money. People will consider if it is safe holding their life savings in U.S. dollars under the economic environment we are in. All of those who sold euros and purchased dollars may start to regret their decision. If the U.S. debt ceiling and general doubt about the currency grows, the risk of unstable fiat currency might send gold to levels only thought possible by the most optimistic dreamers.
If the Federal Reserve uses monetary policy to increase the amount of dollars, gold will take off. If the U.S. government before the election uses fiscal policy to increase the amount of dollars, gold will take off. If nothing happens with either monetary or fiscal policy, and the euro doesn't appreciate sending the U.S. dollar down and gold up, then the stock market may lead us into a recession where gold should have its day. If in the short term gold depreciates for the reasons mentioned above, in the long term there is only one direction for this metal and it's not down. Either way, gold's outlook looks bright.
Disclosure: I am long KGC.