Gold Stocks vs. Gold ETFs: A Free Cash Flow Horror Story

by: Mycroft Friedrich

Gold has been an amazing investment over the last five years and has made stars out of many Investment Advisors and Brokers who put their clients in the precious metal. Over the last couple of weeks I have had a few requests from my clients to see if it would be better for them to buy a Gold ETF like SPDR Gold Shares (NYSEARCA:GLD) or to invest in Gold Stocks?

Being that I am a Quantitative Equity Analyst by trade, it is very hard for me to analyze the actual commodity itself, as I base all my work on Price to Free Cash Flow and FROIC (Free Cash Flow to Invested Capital) and you can’t get a free cash flow result from a commodity. Thus, I went and analyzed a group of Gold Stocks and found some very disturbing results from a free cash flow point of view, a real horror story. I only analyzed stocks where I could actually get clear P/FCF TTM and FROIC TTM results. TTM means Trailing Twelve Months for those who don’t know. And for those who want to know more about Price to Free Cash flow you can read my 58 year backtest of the DJIA by going here (.pdf).

And for those who want to know what FROIC is, you can learn about it by going here.

Here is a table of the stocks I analyzed:

As you can see from the results, the list is far from inspiring to the investor who bases their decisions on how a company operates on Main Street. The gold industry has by far the worst results as a group of any of the 600 Industries that I track. I track 600 industries as I am creating a unique actively managed index called the Mycroft 600, which will soon be available here, where I will pick only the best stock in each of 600 separate industries based on their Price to Free Cash Flow and FROIC. But that’s a story for another day.

The reason that these stocks are reporting such terrible numbers is that it is very hard to get gold out of the ground and process it into the final bars that everyone invests in. Free Cash Flow remember is “Cash Flow from Operations” minus “Capital Expenditures” or “Capital Spending” and when your capital spending exceeds your cash flow you get a negative result.

In the 1860 Gold Rush in California those who made their fortunes were not those panning for the gold, but the ones that sold them the tools and supplies. So after looking at the table above it is quite a scary scenario for anyone investing in Gold Stocks vs. Gold itself. Another problem with Gold Stocks is that they are not a hedge against market volatility like the commodity is. I took the three stocks from the table above that had the best results, FCX, GSS and NEM and compared them to GLD over the last five years in a chart using the Yahoo Finance Charting tool and got the following results ;

From the chart above the results speak for themselves and clearly show that GLD was a rock during the last market crash while the stocks themselves went down along with the market. Thus, the results clearly show that GLD is the stronger candidate to have if you expect a market downturn.

But what about in good times, like this past year? What would have happened if you came in and bought the three stocks after the crash vs. investing in GLD. Well, if we go to the Yahoo Finance Chart program and punch in the data we get a totally different result:

So Free Cash Flow investing in normal times would have resulted in quite an amazing return for the two best stocks from our original table. While NEM, which had average results, did quite poorly. Finally, let's plug in the first five stocks from the original table that had terrible free cash flow numbers and see how they did.

As you can see they all performed on average with the ETF GLD, but did as a group underperform the S&P 500 (^GSPC) . So in conclusion, my findings show that in down markets there is no advantage to owning Gold Stocks vs. the commodity, but if you believe that the markets will be strong for the next few years, then those with strong free cash flow numbers may outperform. It all depends on your viewpoint of where you think the market is heading. My job here is not to tell you that, but to just present the data as it is in the real world of Main Street. To see the FROIC numbers for each of the S&P 500 stocks as well as the index as a whole (weighted and un-weighted) you can find them by going here.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.

Disclosure: No positions in any of the stocks mentioned in the article.