Mining Stocks or Physical Metal?
Investors often own gold mining or exploration stocks in addition to physical metal because they expect these companies to benefit more from an increase in the price of gold than the actual metal. Why then, have gold miners drastically underperformed the gold price as a whole? From January 2010 to January 2012, the gold price increased 40% , whereas the AMEX Gold BUGS Index, which tracks 15 of the largest gold producers worldwide, rose only 14% in the same period . You would have been better off with the physical metal.
I asked Michael Kosowan, who has been an Investment Executive at Sprott Global Resource Investments Ltd. since 2000, if he could offer an explanation.
“The senior gold mining companies’ mindset has been to grow for growth’s sake,” says Michael. “The seniors were richly rewarded in the past for their optionality or leverage to gold prices with little competition. That investment position has been challenged, in my view, by three big investment themes which were not previously with us:
- 1. Precious metals ETFs and gold funds: These new alternatives diverted much of the investment capital away from mining stocks as investors sought direct investment into precious metals while side-stepping the risks associated with the general equities markets and poor management.
- 2. Corporate Governance: The Seniors were willing to sacrifice growth for return. This was not a bad strategy as long as the financial and credit markets remained accommodating. Large projects could get funded principally with debt. Today, tougher financial markets are bringing a reckoning upon a lot of these ill-advised and risky undertakings. The senior gold companies have not been adhering to the strictest guidelines with respect to risk adjusted returns or return on capital, and they are paying the price. Instead of trusting the gold companies to redeploy free cash flow, investors have been demanding the prompt return of funds generated by the mining enterprise in the form of dividends. Based on the poor recent track record of the seniors, they would rather make re-investment decisions themselves. Doug Casey once described dividends as ‘External manifestations of internal grace’ and what I believe investors are implicitly saying is ‘show me how graceful you are … today’.
- 3. Leverage – ‘perceived vs. real’: Not that long ago, the market was rewarding size and growth irrespective of economics. The market rewarded this bad behavior because it was focused on this concept of leverage while ignoring the overall economic judiciousness of the acquisitions that the seniors undertook. In turn, the gold mining industry delivered exactly what the market wanted, with a series of large, low grade deposits that were only economic at $2000 gold. In mining economics, it is low grade that makes for the absolute best leverage. After the decade-long run-up in gold prices, investors were willing to pay up for the optionality the senior companies’ shares represented. Put another way, investors were more comfortable with the expectation that the price of gold would double when it was selling at $400 per ounce than they are now with gold selling above $1600 per ounce. On top of that, the current rash of multi-billion dollar write-downs and top executives being ‘thanked and excused’ indicates very poor leadership among the senior names. The market believes that their ability to grow any larger may be hindered. A large gold company that is already producing 2 million ounces of gold per annum will have a hard time keeping up with its current production, let alone grow by a significant margin. A combination of these factors has only heightened the investing public’s apprehension towards these stocks and this sector as a whole. In the meantime, gold mining stocks are in competition with the rest of the stock market. Large, liquid, household name companies such as Coca Cola and Johnson & Johnson have appreciated in share price lately, making them seem like more sound investment choices. This view is further reinforced by general market analysts and technicians.
The market’s coolness to gold mining stocks, as evidenced by the subdued share price moves, is both justified and healthy. It will challenge the industry to improve earnings, profitability and, most importantly, exhibit discipline. Gone are the days where gold companies were ‘the only game in town’ when it came to gold investment and leverage. This lower share performance, recent rash of dismissals, and lack of growth among the top ranks of the senior mining companies should serve as a very tangible sign that investors believe that the industry can do more to enhance returns.”
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