Mining Stocks Have a Soft Underbelly (CDE, GG, SLW, NEM, AEM, IAG, BGO, GFI)

by: Texas Hedge Report

Todd Stein & Steven McIntyre (The Texas Hedge Report) submit: For most of this month, the physical prices of gold and silver have been rising nearly every day, yet the mining stocks have been stagnating and in some cases falling. What gives? Over the last 3 months, the operational leverage that mining stocks are supposed to provide has not been seen.

To take a step back, let us reiterate that long term we are extremely bullish on the prices of gold and silver. They are the only two currencies in the world that are not someone else’s liability. In a world of fiat money chaos and destruction, the long-standing monetary stability and finite supply of both gold and silver will be increasingly desired by investors around the globe.

This latest leg of the precious metal bull market rally that began in 2000-2001 has taken gold to $630 an ounce and silver to over $13. In recent days, the rally has corrected twice, but for long-term investors, we think the U.S. Dollar’s imminent and unrelenting weakness will be the catalyst for much higher prices on both metals over time.

If one is bullish on the precious metals, the question then becomes how best to play their upcoming appreciation? Is it stocks, futures, options on futures, or simply owning the metal itself through ETFs or physical storage?

Since we first became bullish on the metals in the late 90s, we have played higher precious metal prices through long-term ownership (we are not smart enough to trade in and out) of both mining stocks and some physical ownership of the metals. Mining stocks we felt had greater upside, but also greater downside than the physical. We wanted to own the metal stocks of established miners as we were partial to the operational leverage they provided to investors. A 1% increase in the price of gold, for instance, often times meant a 2% or greater increase in net earnings for these mining companies. Junior miners were and still are too speculative for our blood – though certain juniors may offer spectacular returns, many others will go up in smoke.

To date, followers of this strategy have been rewarded pretty handsomely. While gold is up about 150% off its sub-$250 low and silver has tripled off its 4 buck low, many mining stocks are up 7 or 8 times off their lows. In most cases, owning the mining stocks to date has produced far better returns. However, over the last 3 months, the physical prices of both gold and silver have done far better than the mining stocks. Gold has tacked on nearly $100 to its price and silver has jumped even more percentage-wise recently, yet many components of the XAU and HUI haven’t budged or are barely up in the same time frame.

We think the reason for this divergence is several fold:

First, the gold and silver stocks may have gotten a bit ahead of themselves as the underlying earnings of the companies need to play catch-up with their stock prices.

Secondly, a lot of the miners have shot themselves in the foot with higher than expected cash costs due to oil and production shortfalls that have limited to some extent the EPS growth achieved with higher physical prices to gold and silver.

Third, places like Latin America with recent left-leaning presidential elections in Bolivia and Peru have turned increasingly hostile towards producers. The growth of Hugo Chavez type dictators in Latin America could conceivably be beneficial to the actual metal prices as supply is reduced, but negative towards the foreign miners that occupy Latin American mines that now run the risk of higher taxes or perhaps even nationalization.

Fourth, many mining companies are (in our opinion) extremely poorly run – perhaps more so than any other industry we follow. Most mining companies seek to grow their production profile at any cost. This means issuing a great deal of heavily dilutive shares annually to “build the business