As 2011 comes
to a close, investors will reflect on one of the most tumultuous years in
market history. Though the stock markets were essentially flat on the year,
those who’ve had skin in the game probably feel like they just stepped
out of a barrel that went over Niagara Falls.
In assessing
what worked in 2011, investors can yet again take solace in “old
reliable”. For the eleventh
consecutive year gold will have returned positive gains. Not only has
gold’s secular bull delivered consistency, it
has delivered robust returns that have greatly rewarded investors. Since its
low of $256 in 2001, gold has soared 640%
to its high earlier this year. And with only a couple days remaining, gold is
looking to close out 2011 with a 9%+ gain despite its recent selloff.
But while gold
was one of the top-performing assets in all the markets this year, the same
can’t be said for the stocks of the companies that bring it to market.
You’d think that gold stocks would have been a sector that worked for
investors in 2011 considering gold’s strength, but they had a dismal
year. And this is alarming considering the nature of their business.
Exploring for
and mining gold is a risky business. Mining companies are faced with geological,
operational, and geopolitical risks among the many. On top of this they are
slave to market risk, with the price of their product at the mercy of
traders. If these companies are to be successful they need to discover
economically-feasible gold deposits, and then produce the metal at low-enough
costs to deliver profits for investors. And many quality miners are doing
just that.
But in order to
entice investors to take on the risks of owning these companies, their stocks
simply must outperform gold. If they don’t materially outperform gold,
then it makes no sense to own gold stocks. Investors would be better off just
owning the metal.
For the most
part over the course of gold’s bull gold stocks have indeed
outperformed the metal. Investors have seen legendary gains in some of the
elite explorers and producers, outperforming the metal by many multiples.
When gold is up, gold stocks are usually up big. But as you can see in the
chart below, gold-stock investors didn’t feel the love in 2011.
Gold has had a
pretty-good year overall, ascending within a relatively-tight uptrend in
which the trend channel had only been pierced twice. The first time was in
August, when gold powered through resistance to achieve an all-time high, a
high that represented the climax of a rather-unusual summer rally.
The other piercing is the current one in which gold has knifed through support,
representing an offsetting selloff that is again countertrend to seasonal precedent.
Overall
gold’s 9%+ gain on the year so far would normally have been a harbinger
of great things for gold stocks, but this was not the case. In fact, gold
stocks have been acting as though their underlying metal was down 9%+ for the year!
In taking the
pulse of the gold-stock sector we can first look at the performance of the
GDX Gold Miners ETF, represented by the red data series above. GDX is the
most popular gold-stock ETF, offering investors
exposure to the world’s biggest and best gold-mining stocks. And it had
a terrible year, falling by over 18%.
Like gold, GDX
was confined within a nice tight trend channel in 2011. But unlike gold, it
trended lower on balance despite achieving an all-time high in a September
breakout. Most of the world’s best gold stocks disconnected from the
performance of their underlying metal, and sold off hard.
We can drill
down even farther and next take a look at the performance of the junior gold
stocks. With gold up, the juniors should be flying right? In looking at the
performance of the GDXJ Junior Gold Miners ETF, the blue data series, again
this is not the case. In fact, the ETF that is comprised of many of the elite
junior gold explorer and producer stocks had a dreadful 2011, down over 40%!
As the riskiest
of gold stocks, juniors are naturally going to exhibit violent swings. On
balance when gold rises, the juniors tend to have big positive leverage. But
this leverage is seen on the downside as well. If gold falls for a prolonged
period, juniors tend to sell off faster and harder. When capital leaves the
gold-stock sector, the juniors on the front lines feel it the worst.
If gold was
down 9% on the year, it would perhaps make sense that the juniors would
exhibit downside leverage. But with gold up, the junior carnage we’ve
seen in 2011 has baffled many investors.
So what are we
to make of this gold-stock, particularly junior, disconnect? I believe there
are two angles to take on this. First is from a tactical perspective, the
“why” of what we’ve seen. And second is from a strategic
perspective, what is likely to play out in the future and what we can do
about it.
Tactically much
of this gold-stock malaise is attributable to the recent sentiment storm that
has wreaked havoc on
the entire commodities sector. And one of the impetuses for this sentiment
storm is global recession fears. Regardless of the validity of these fears,
since a recession inherently implies lower commodities demand investors tend
to aggressively sell commodities producers.
And boy have
the commodities stocks been sold hard in 2011, with the gold stocks even
getting sucked into the fray as irrational as it may be. The
“risk-off” mentality that has been trumpeted by the financial
media has created incredible fear amongst investors, which has caused serious
damage to the gold-stock sector as seen by the performances of the GDX and
GDXJ ETFs.
But this
tactical action is unfounded for a variety of reasons. As my business partner
Adam Hamilton pointed out in his “Recession Crazes”
essay last week, the commodities sentiment storm drummed up by
economists’ stock-market-driven groupthink is a psychological
phenomenon that has generated unwarranted fear, leading to the type of
recession talk that is usually seen at stock-market
lows.
For a strategic
perspective we can look to gold’s structural fundamentals. And thanks
to fundamentals
that are exceptionally bullish, gold-stock investors can look past this
anomalous tactical behavior to a bright future. As more and more individuals
add gold to their portfolios and central banks continue to diversify away
from fiat reserves, demand for this most precious of metals will continue to
rise over time. Couple this with the supply chain having ongoing issues, and
gold’s price ought to remain strong for years to come. Though the
stocks have recently disconnected from the metal, they will eventually reflect gold’s positive fundamentals.
Provocatively I
heard something the other day that for me took the gold-stock fear trade to
the height of madness. To no surprise a popular CNBC anchor said he
didn’t like gold stocks. But what was surprising was this stalwart
weathervane’s reason for not liking gold stocks. He doesn’t like
gold stocks because, get this, they
can’t find gold.
After I
finished laughing out loud, I realized that this was yet another confirmation
that the fortunes of gold stocks are due for a change. Now in a sense this
bald-headed anchor is correct, gold companies are indeed having trouble
finding economic deposits at a fast-enough pace to
renew reserves and grow production. But contrary to his logic, the fact that
the supply chain is coming up short is exactly the reason for folks to invest
in this sector.
If mine production
continues to struggle to keep up with what is expected to be growing demand,
then those select explorers and producers actually succeeding in this
business should be very much in
play for investors. As long as gold’s fundamentals remain solid and prices
stay strong, finding, developing, and operating gold mines will be a
lucrative business.
Adding to the
attractiveness of gold stocks in a strong fundamental environment is their need for investors. Though investors
have been fleeing, their return is vital for the success of the gold-mining
industry.
With such a
hefty amount of capex required to build a mine,
even the biggest and best miners that have strong operating cash flow need a
shot of capital in order to develop their pipelines. When at all possible
gold miners prefer debt over equity financings to limit dilution. But debt is
not always easy to come by, especially considering the current lending
environment birthed from the recent financial crisis. Banks just aren’t
as willing to take on the risk or offer fair terms considering the volatile
nature of commodities prices. These miners must therefore rely on selling
their shares in order to raise capital.
Juniors in
particular are heavily reliant on equity financings to meet their capex needs. For explorers that have no cash flow the only way to fund operations is to
raise capital via the sale of shares. And even those producers that are
operating a smaller mine or a group of small mines usually have insufficient
cash flow to carry out big growth projects. They also need to sell their
shares.
Throughout the
course of gold’s bull these miners haven’t had a problem finding
investors to purchase their shares. Both the issuers and subscribers were
confident that return on investment, in the form of stock appreciation, was
imminent in the very near term. And if these stocks had quality assets, they
would indeed positively leverage gold’s upside. Unfortunately this
symbiotic relationship has been broken over the last year.
Considering the
lackluster share performances, juniors especially have had a real tough time
procuring capital. As a result, those that were undercapitalized going into
2011 have been forced to get by with leaner operating budgets and/or have had
to delay exploration/development projects. And those that have pursued
aggressive financings have had to issue a lot more shares than hoped, greatly
diluting shareholders.
If these
financing woes are prolonged, the brilliant observation of that CNBC anchor
will be that much more prevalent. Less money to explore for and develop gold
mines will eventually lead to an accelerated drop in supply. While this will
only strengthen gold’s fundamentals, which will keep prices higher for
that much longer, this can be very dangerous for the health of many gold stocks.
Gold companies
already have a tough job without having to worry about funding. With the
low-hanging fruit long gone, it is getting harder and harder to find gold. In
order to sustain and grow supply the miners therefore need to look for gold
in harder-to-access locations and develop lower-grade higher-cost deposits.
They need more capital than ever to do what they do!
To encourage
miners to take on these high-risk endeavors, as mentioned the price of gold
must remain high. But they can only do so much if they are pinched for
capital. And in order to get this capital their shares need to perform in a
fashion that will entice investors.
If this sector
is to thrive, investor confidence needs to be regained. And this will only
happen via gold stocks outperforming gold. The only way to strengthen supply
and future pipeline is to restore that self-fulfilling circle of higher gold
prices, higher gold-stock prices, and ready availability of investor capital.
Gold stocks really have no choice but to fall back in line.
Investors en
masse will soon realize the foolishness of these precipitous gold-stock
declines. But the contrarians that have the gall to go against the herd, to
defy the mega talking heads of the financial media, can take hold of an
incredible opportunity right now. There are many excellent gold stocks with
quality assets that are currently radically oversold. And they will likely
see spectacular gains once their sector reconnects with its underlying metal.
But just
because we see value in gold stocks, it doesn’t mean investors
shouldn’t exercise extreme caution when deploying their capital. Now
more than ever it is important to vet the gold stocks, as there are a
dwindling number with high-quality assets, high-potential prospects, and
strong financials.
Overall with
gold stocks poised for a breakout, we wanted to know which ones had the
highest potential for success. And this prompted us to take a look at one of
our favorite gold-stock sub-sectors, junior gold producers. These juniors are
producing gold at a current annual rate of fewer than 200k ounces, and really
represent the sweet spot of the mining side of the business.
Within this
group of stocks are brand-new producers that just commissioned their mines,
mature companies that operate one or a handful of smaller mines, and emerging
mid-tier producers that are in the process of expanding existing mines,
developing new mines, and/or in pursuit of growth via the M&A path.
Scott Wright
Our expert research team looked at the universe of 100 or so junior producers
trading in the US and Canada, and after thorough analysis whittled this group
down to our dozen fundamental favorites that we believe have the highest
probability for success. Each of these stocks is profiled in detail in our
hot-off-the-presses 34-page research report that is now available for purchase on our website. Buy your copy today!
At Zeal we use reports like this to feed trades in our acclaimed weekly and monthly newsletters. And we recently issued new buy
recommendations on several of our favorite junior gold producers. We anticipate
that these stocks will see gains akin to the 51%+ average annualized realized
gains that we’ve had in nearly 600 stock trades recommended in our
newsletters since 2001, and hopefully better. Subscribe today to see our current trades and get truly contrarian
stock-market analysis.
The bottom line is even though gold continues to forge higher, gold
stocks have disconnected from the historically positive leverage that
investors are used to seeing. Not only have the gold stocks not kept pace
with gold, they’ve sold off hard, with the juniors just getting
brutalized.
But so long as gold’s bull remains intact and its fundamentals
compelling, this gold-stock fear will prove totally unjustified. The most
ardent of contrarians realize that gold stocks can’t be held down for
long, and that the carnage we’ve seen, especially in the juniors,
offers huge buying opportunities. Selling has likely reached the point of
exhaustion, so carpe diem before the herd returns.
So how can you profit from this information? We publish an
acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms
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in our market research as well as provides in-depth market analysis and
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Thoughts, comments, or flames? Fire away at scottq@zealllc.com . Depending on the volume of feedback I may
not have time to respond personally, but I will read all messages.
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Zeal Research (www.ZealLLC.com)
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