My Love/Hate Relationship With Gold Miners

By MoneyMorning.com.au

In May last year, I made the point that gold miners looked cheap. Today I want to catch up on that market, and I’ll tell you how I see the market today.

As you can see from the following chart…for a while, I was right. I was very right!

Miners whizzed up some 20% in next to no time. But since, they have been well and truly crushed. The question is why?

For sure, the gold price itself hasn’t performed well. But the mine stocks have been in an underclass all of their own.

The following chart shows the GDM index (white line) relative to the gold price over the last year. The gold spot price (orange line) is certainly at the bottom of its range. Year-to-date, it’s off about 3%. But then look at that white line – the miners…down more than six times the fall in gold!

In fact, if you were to plot the two-year chart, you’d see that gold is actually up 10%, but the mining stocks are down a massive 40%.

What’s going on?

Five Things Holding the Miners Down

• Geared to the gold price. When the gold price is on the up, the miners do incredibly well. If gold goes up 15%, miners’ profits may go up 50% – perhaps more…production costs can be quickly dwarfed by a rise in the gold price, and so increased revenues from the high gold price feed straight through to the bottom line.
• Problem is, the converse is also true. If the gold price falls, the miners may fall harder. And seeing as many in the market see the gold price falling from here, they sell off the miners in anticipation.
• Mining costs aren’t fixed. Gold production costs have escalated quite significantly – inflation in energy prices and other commodities have been a thorn in the side of the producers. On top of that, it’s becoming increasingly difficult to find decent grades to mine. The ‘low-hanging fruit’ has been picked – it’s now very hard work to refine each ounce of the precious yellow metal. Many gold miners would hate gold to slip below $1,500…and we’re pretty close to that figure right now!
• Central banks want gold – not miners. One of the reasons gold has held up relatively well is because there’s large demand coming out of the emerging market central banks. The likes of China and Russia are filling their boots – other smaller nations are dipping in too. Wisely these guys want to diversify foreign reserves. And gold is the ultimate reserve currency. Not the gold miners!
• Nationalisation fears. There’s an irony at the heart of gold investing. Gold is often bought as an insurance policy to guard against turmoil and panic in the markets. And during periods of turmoil, governments can do strange things. With so much trouble at the heart of the Western financial system, many fear a blow up. If gold is in some way the solution to this fiscal mess, then many fear that miners will suffer windfall taxes, or even forced nationalisation. Many are starting to wonder whether it isn’t safer to tuck away some gold coins than hold shares.
• Sentiment. Many investors are just plain fed up with how badly run many of these miners seem to be. A while back, many stockholders found that management had sold future gold production at what were increasingly looking like very low prices. As the gold price escalated, many stockholders didn’t benefit.

Today some miners have found other ways of messing things up. A fundamental lack of control on the cost side of things, and a poor pipeline of new resources seem to be the main (gold) bugbears.

So management is the biggest problem in the industry. Encouraged by a rising gold price, lots of miners have mined for more costly, inaccessible gold.

In effect they’ve made big bets on the gold price. That explains the ‘gearing’ I discussed above. So you need disciplined management that watches costs just as carefully as the gold price. And you need companies that operate in safe jurisdictions. But to find those stocks, you need expertise…

Gold Miners: Where Do We Go From Here?

So you’d have to be mad to invest in miners… right?

Well, no. There’s absolutely no doubt that, for the reasons mentioned, sentiment on these stocks is bouncing about at the bottom. That’s usually a good sign!

If gold finds its way back to the much safer level towards the mid-$1,700s, then I’d expect sentiment toward the stocks to change very quickly. Just look at the chart at around September and October last year to see how gold miners respond to the gold price. So there’s surely a great opportunity there if you time it right…and if you’re pointed towards the right kind of mining stocks.

And as for the great gold hoarders in the East, we’ve already seen some moves toward buying gold production, as well as gold. Although China’s plans to take control of African Barrick Gold fell through, there’s no doubt they’re sniffing around other deals.

With the miners so deeply out of fashion, it’s likely to stir more interest from the East. And if gold gets back to nearer the top of its recent trading range, I wouldn’t be surprised to see a sharp 20% mark-up in the miners.

So, hey, if you back the fundamentals for gold this could be a great buying opportunity. All you need next are some well-managed mining stocks.

But the key recovery won’t come until gold re-asserts itself in bull territory. That’s when the miners will see some serious attention. That’s the play I’m waiting for.

They say that patience is a virtue. Sit on your hands for the moment is my advice.

Bengt Saelensminde
Contributing Editor, Money Morning

Publisher’s Note: This article originally appeared in MoneyWeek

Join Money Morning on Google+

From the Archives…

Can This Indicator Predict The Dow Jones Next Move?
16-03-2013 – Kris Sayce

Seven Situations to Watch in the Pacific Currency War
15-03-2013 – Dan Denning

Stock Market Warning: Next Week Could be a Blood Bath
14-03-2013 – Murray Dawes

REVEALED: One Opportunity to Escape Your Mortgage
13-03-2013 – Nick Hubble

UK Property: How You Can Buy a House For Less Than 250 Grand
12-03-2013 – Dr. Alex Cowie