HUI and Gold Price: Best Future Return Likely In Junior Miners

Includes: GDX, GLD, IAU
by: Thomas Tan, CFA

This is to continue my previous post on HUI and Gold.

If my view on 1:1 return in % between HUI and gold are correct, then investing in HUI doesn't generate any leverage of return, as many people would have expected, and we won't see the same movement or % gain again during the previous $38-$250 run. It is obviously incorrect to expect return of an in the money call to match an out of money call due to the different risk profile.

On short term basis, HUI has deviated from gold from time to time. The longest deviation happened and lasted for the whole year of 2004. Gold was able to creep new highs, but HUI couldn't and lagged behind. I think the main reason is due to the lack of arbitrage mechanism between HUI and gold. In order for option arbitrage to work, we need put call parity, or c-p = S-X. For example, if call is undervalued, we can buy call, short put, short stock, buy U.S. treasury to generate a risk-free arbitrage profit. However, this is not true for HUI, since there is not a good basket of companies or index which correlates perfectly but inversely to gold.

Why is the deviation in 2004 then? I believe HUI reflects people's expectation and perspective on gold. In 2004, even gold rose slowly and made new highs, no one believed that gold would stay at that level of $400-$450 very long, the general public view was that gold would eventually go back down to $300-$350 level (again near the strike price). HUI as a composition of gold miners, correctly reflected the mass view at that time by discounting the future earnings, and traded at "discount" to gold. This, however, won't happen in stock option due to the arbitrage discussed above. Will this deep discount happen today? I don't think so. The public consensus has accepted gold price in the range between $550-$650, at the current level, a much more positive sentiment than 2004. As a result, I expect very little downside and risk by holding HUI at this point.

Will HUI trade in premium to gold in the future? My view is that's unlikely, for these reasons:

1) Companies have too many risks such as geopolitical (foreign government, manpower, unions, environment, health and safety, regulation), reserve uncertainty, capacity limitation, management, operating issues, capital and refinancing - especially costs - as we see, HUI is currently depressed by the high energy costs.

2) Reserves are depleted assets, and will eventually run out. Finding and securing new reserve is always the biggest challenge and risk.

3) Gold miners can only excavate gold so much and so fast each year up to the longevity of reserves, reflecting profit or earnings based on an average gold price in many years substantially less than the peak price. Even reserve estimates might increase with higher gold price due to low grade ore becoming profitable, but no matter what the peak gold eventually reaches, HUI will reflect a much lower average gold price due to operational constraints.

However, I am only talking about the large and mid tier gold miners in HUI. For small miners, exploration and early discovery companies, I view them as events-driven, similar to biotech firms finding drugs. If a jackpot is hit by finding a new mine with good quality and large reserves, the return can be unimaginable; whether gold trades $1000 or $2000 makes little difference.

When HUI is more in the money, the market will evaluate gold miners less by earnings or P/E ratios, and more by the values of their reserves minus excavation costs, and likely assign very little value of their ability to hit future jackpot due to the scarcity and low probability of finding new mines. So the best return in the future is likely in the juniors with high and good quality reserves - targets to be acquired by XAU/HUI companies.

In my portfolio I have already seen: ABX's unsuccessful bid to NG; FCX's successful bid to PD; WKR.V merges with UXG; BGO.TO becomes KGC. This consolidation phase of the mining sector has a long way to go, in the future, I believe most of the many juniors in my current portfolio will disappear and be part of much larger miners. Especially for heavily hedged large miners in XAU, it makes perfect sense to acquire juniors, increasing reserves at the same time reducing hedging.

I expect in the future, which I call phase III, when gold reaches avery high level, the % return between HUI and gold will drop gradually from the current 1:1 ratio. The risk associated with owning gold as monetary last standing currency is much less than all the risks associated with owning mining companies. I believe that gold offers a better risk/reward profile than HUI, and is a better investment vehicle than HUI in the future, which I will discuss further next month on my long term projection of gold price.