Gold Showdown: Mining Stocks Vs. GLD

| About: SPDR Gold (GLD)
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You're a gold bug. For whatever reason, for however long a time horizon, you're into gold and you want to play it. You may be right to want to do this. Our deficits aren't going away nor is the general economic malaise and the accompanying temptation for central-bank easing, and these things are happening not just in the U.S. but in Europe as well. And if you think about how much gold has advanced during the late-2000s, you have to admit (at least to yourself if you'd rather not say it out loud) that a much more substantial breather (or pullback or correction or whatever one would call it) could have been expected, thus indicating a lot of pro-gold sentiment is still out there. Imagine what might happen if a new international crisis erupts or if jewelry-related demand, restrained lately in India (a weak Rupee), and China (a sluggish economy) can at least stop falling.

So what are you going to do? Some might go for bullion, assuming you actually want to take the trouble to securely store it, or coins and the like assuming you can keep your kids' hands off the bling. If you have a strong stomach and love margin, you can try your hand at the futures market. But I suspect most investors, particularly equity-oriented Seeking Alpha readers, are likely to want something they can handle through their regular on-line brokerage accounts, either a gold-related ETF of gold mining stocks.

OK. So what will it be? The SPDR Gold Shares ETF (NYSEARCA:GLD) is the easy one-stop-shopping choice likely to be made by many. There are other gold-related ETFs, but this is probably the most well-known.

But what about mining stocks? To some, it may seem as if you could pick any, as if they are interchangeable and all tending to move in lockstep with gold. That is definitely not the case. Mining stocks are generally influenced by gold, but there is considerable room for variation from one to another based on mine production trends, changes in reserves and so forth. In a January 9, 2012 article on Seeking Alpha, I presented a strategy that back-tested well over time as being able to identify precious metals stocks that have tended to outperform GLD. I suggested at the time that much could be gained, not necessarily by picking gold miners in general but by picking the right gold miners.

Since January 9th, GLD has been just OK, having returned about 5%, less than approximately 10% returned by the S&P 500, and for much of the period, its chart has looked a bit like a bowl, high edges and low in the middle. The screen, however, was weak, down about 20%.

This could be just one of those cold periods every model periodically has. Also, StockScreen123 did switch data providers (from Thomson Reuters to Compustat) which impacts comparisons between what I see now versus what I could see back then. One noteworthy change is that I can now confine my screen to gold miners only. Under Thomson Reuters, I had no choice but to take a mixture of all precious metals miners. If I revise the screen to take advantage of this focus, the stocks uncovered by the gold-only version of the model, the one I'll be looking at henceforth, declined only 5%. (Also, I'm much more comfortable with the way Compustat handles ADRs so I eliminated a rule which excluded those, but that had no meaningful impact on 2012 performance.)

But I was curious if there may have been something more systematic about the relationship between gold miners and gold itself (as represented by GLD). Let's start by taking an overall look at the relationship between GLD, gold stocks in general (those that trade on NASDAQ AMEX or the NYSE and average at least 15,000 share per day in volume), and the five gold stocks produced by my stock screening strategy. Figure 1 depicts these comparisons (all series are indexed to 100 as of 11/18/94, the day GLD began trading).

Figure 1

We see that on the whole, gold miners (the red line) track generally close to GLD (the green line), not perfectly but closely enough to not make it worthwhile to use a dart-board approach to mining stocks as an alternative to GLD, especially in 2012, a period of relative weakness for the stocks. But the five stocks that pass my screen have, over the entire time frame, performed significantly better, notwithstanding the difficult 2012. But generally, it does look like the model is considerably more volatile than GLD.

I ran a test to confirm my visual impression. I started by comparing 20 trading-day returns for the model and GLD. These were overlapping - I looked at every possible 20-day period between 11/18/04 and 8/31/12. During periods when the GLD return was negative, the model underperformed by an average of 1.81 percentage points. On the other hand, when GLD generated positive 20-day returns, the model outperformed by an average of 2.94 percentage points. The model didn't follow the script in each and every period, but the imbalance was interesting. During the periods when GLD was negative, the model followed the script (in that it was more negative) 39.4% of the time. When GLD was positive, however, the model stayed true to form (generating larger positive returns) 60.6% of the time.

I repeated the experiment using 60-day periods. During intervals when GLD was down, the model underperformed 30.7% of the time and by an average of 5.38 percentage points. When GLD was positive, the model outperformed 69.3% of the time by an average of 7.42 percentage points.

So ultimately, we see that the visual impression to the effect that the model is more volatile is confirmed, but we also note that there is a positive skew, meaning the degree of outperformance during the good periods tends to be greater than the degree of underperformance during bad periods. The upshot: Although the mining-stock strategy is more volatile than GLD, it has the potential to deliver better returns over the long term so long as gold charts a generally positive course. Also, if you're comfortable recognizing whether gold is or isn't in an uptrend, you can be in the mining stocks during such periods, but switch to GLD at times when you'd still like exposure but have less confidence in the near term.

Whatever motivates you to own mining stocks, however, don't cavalierly pick the first one that comes to your attention, or the most well-known name. (Recall figure 1: If you're going to go for mining stocks, you need to be thoughtful as to how you choose the ones you want.) The miners are special for the exposure they give you to gold, but they are also business corporations, so the fundamental factors relevant to other stocks are relevant here as well. That's why I use a model geared toward the kinds of companies I usually like to emphasize: small (stock price at or below $10 in this case), generally favored by the market (stock's 50-day moving average divided by its 200-day moving average ranking in the upper half relative either to all stocks or the universe of sub-$10 stocks meeting the liquidity rules mentioned above), and well ranked. Among stocks passing my screening filters, I focus on the top five based on the multi-style QVGM (Quality-Value-Growth-Momentum) ranking system I created for

Here are the ones that make the list at this time in rank order (the highest ranked stock being on top):

Primero Mining (NYSE:PPP)

This Canadian miner's strong suit is basic operations. All is going well and annual output guidance was recently increased from 100,000 to 110,000 gold equivalent ounces (this includes a small amount of silver) to the range of 110,000 to 120,000 ounces. The exploration program has been highly productive. PPP just increased its estimate of probable mineral reserves to 584,000 ounces, a gain of 79,000 since year-end 2011 (the gain is net of year-to-date depletion). The balance sheet will improve given the company's repayment of a $30 million convertible note held by Goldcorp (NYSE:GG) with shares, thereby boosting the latter's stake in PPP from about 35% to 41%. An interesting wild card here is a contractual requirement that a lot of its silver be sold at fixed (below-market) prices - the issue is that the transactions are taxed at the higher market rate. PPP is trying to get the tax adjusted and thinks it can succeed. So far, PPP has been paying taxes at what it believes should be the proper rate. If the company is unable to get the authorities to see it that way, cash on hand is about triple the contingent tax liability PPP maintains in the footnotes to its financials. Obviously, though it would be preferable for PPP's efforts to have the rate adjustment to succeed. It's hard to say how the market will react once this matter is concluded. On the one hand, it seems that this should be a non-event, given that the issue has been "out there" for a long time. But despite the incredible modern proliferation of information, I'm becoming increasingly hesitant to bet the farm on the market actually knowing things it ought to know if one must look beneath the surface to find out. In any case, though, we're looking here at a company whose basic gold-mining business is on a roll.

Aurizon Mines (AZK)

This miner works in the northwestern part of Quebec. Although production this year is on track, the company trimmed its full-year production guidance a bit going forward (from 155,000 - 160,000 ounces to 150,000 ounces). But the stock reminds me a bit of what we might see with small pharmaceutical firms that have active new-drug pipelines in the way the market is reacting well to developments on the exploration front. AZK is pursuing a variety of exploration projects and presently de-emphasizing one project (Hosco) despite positive results of a feasibility study in favor of another group of properties that seems to have more potential (Heva and Hosco West). Enhancing sentiment is an announcement that the most recent analysis of the latter properties is consistent with prior favorable expectations. The company is debt free, cash per share amounts to about $1.20, and despite an aggressive capital program, the company remains cash-flow positive.

Timmins Gold (OTC:TMGOF)

The negative, here, from the vantage point of fundamental analysis is the company's short financial history: It didn't begin generating revenue until 2011. But so far, it's been doing a nice job in that respect as it works its now-producing mining properties near San Francisco. The company is looking to bump its annual production rate up from 100,000 ounces to 130,000 ounces. Ultimately, however, TGD expects to be way more than a one-mine play. It's pursuing a very active exploration and development program in Mexico and it looks like it has the financial wherewithal to pull it off. It's not debt free (it has short-term debt of $19.3 million, versus $119.2 million in equity) but it has $21.2 million in cash and equivalents. It is profitable on the basis of GAAP earnings and in the trailing 12 months, its $36.4 million in cash from operations was more than sufficient to fund its $30.4 million in capital spending.

Brigus Gold (BRD)

This Canada-based firm looks to be pretty typical of small miners. Production is proceeding as expected but the company trimmed a bit from its forward guidance as it reallocates some of its workforce to an underground project that now looks deeper and larger than indicated by prior studies. BRD will, as a result, process more lower-grade stockpiled material from an open pit. This is simply a case of a company balancing short-term operations against long-term development and tilting modestly toward the latter. The company is profitable and the balance sheet is OK, but based on the recent pace, it appears external funding will play a role in the firm's development efforts.

Harmony Gold Mining (NYSE:HMY)

This South African company, larger than the others on this list (with annual revenues above $1 billion), seems to be the least appealing. As noted above, the list includes the five highest-ranked firms among those passing the screens' filters. But the drop-off from the fourth ranked firm, with a QVGM score of 74.17) to HMY at number five, with a QVGM score of 48.75, is large. One overhang is a pending court judgment in South Africa to the effect that HMY remains liable for environmental remediation on a property it sold in 2008. The company is appealing, but the court's reasoning that HMY cannot escape responsibility for issues that arose and which it was ordered to address during the term of its ownership, cannot be made to vanish with the divestiture. I don't know South African law and cannot, therefore, guess whether an appellate court will support that logic; in terms of just-plain common sense, I can see it going either way. Labor unrest at other South African gold miners likewise may dampen sentiment toward HMY. Meanwhile, the firm is looking to diversify geographically with a major $4.8 billion Paupa New Guinea project being developed together with Australian firm Newcrest Mining. It figures to come on stream in 2019. HMY is awaiting a decision by the government of Paupa New Guinea as to whether it will come up with the funding it would need to exercise a right it has to acquire 30% of the venture. Statistical backtesting suggests one could do well by simply buying the whole five-stock list. But when company-specific analysis is factored in, I prefer to pass on HMY, where too many moving parts, although they might ultimately work well, diminish the enhanced play on gold (pricing plus production) I was looking for.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.