In 1924 John Maynard Keynes referred to the gold
standard as a "barbarous relic", but we think the new barbarous
relic is using gold stocks as a trading or investment vehicle in an attempt
to benefit from rising gold prices. This isn't the 1970s. One can buy GLD call options
from a laptop in bed or take a long position in gold futures with a few taps
on a smart phone whilst in line at a coffee shop. The days of having to call
a broker and hopefully buy some gold shares that will hopefully go up if the
gold price goes up are over. There is no longer any need to take the risk
that your gold stocks will not go up with gold.
First
off let us say that the aim of this article is not to discredit any gold
mining or exploration company, or the efforts of the industry. We are not
saying there isn't money to be made in the gold mining industry,
we are simply saying that gold stocks are unsuitable for trading gold and
unsuitable for investing in rising gold prices. Many companies may be worth a
buy on their own merits, but we do not think they should be bought to gain
exposure to rising gold prices. There may be many undervalued gold companies
out there, but then the reason for buying them is more on a valuation basis
and not as a ploy to profit from rising gold prices. A gold stock may be a
good investment, but using it as a vehicle to benefit from rising gold prices
is a poor trading strategy. We are not saying that there isn't money to be
made from investing and trading gold stocks, but that is a separate issue
from using gold stocks to play upwards moves in gold prices.
Why
do many people continue to think gold mining/exploration stocks are a good
investment to play rising gold prices? Even investors with stellar
reputations such as John Paulson have large holdings in gold equities as a
way to play rising gold prices, which is puzzling to us. One may be able to
defend holding gold stocks if one is managing a mutual fund where by the
mandate may prevent you from investing in physical gold or trading
derivatives, but with ETFs even this is a very weak argument. This makes
Paulson's choice all the more bewildering since he runs a hedge fund and so
can trade futures, options or whatever he likes (and in fact he came to fame
by trading credit default swaps).
Investing
in gold exploration stocks built purely on the premise that gold prices are
going higher is a poor reason to place a trade. The price of the exploration
stocks depends far more on whether or not they have the gold, much more than
the gold price. If a junior exploration stocks successfully finds a
great gold deposit then their stock price will rise, whether the gold price
is $1000, $1500 or $2000. In addition to this it might be 10 years before
they actually get the gold out the ground to sell it and who knows what the
gold price will be then. It may be the case that the gold bull market has
come and gone long before the explorer gets to sell just one ounce of gold.
Picking
undervalued stocks is a separate process and area of expertise from that of
trading commodities such as gold. If one thinks one can pick gold exploration
plays that are going to do well, then one can apply the same reasoning to
silver, copper and other metal explorers. If one is good at this it doesn't
matter so much if the underlying metal price is going to rise in the next year,
as if a company makes a great find it will usually do well regardless.
An
argument often cited by those investing or trading gold stocks is that they
could outperform the gold price. The argument goes something like if it costs
the company $500/ounce to mine gold and the gold price rises from $1000 to
$1500 then the company is making twice as much, whereas the gold price has
only increased 50%. It sounds fairly logical. However in reality the costs of
mining are most often rising too.
What
most is important about this is that many of the costs of mining gold are
actually often positively related with the gold price. For example oil prices
and gold prices are somewhat positively related so if the gold price is going
higher in coming years, chances are that oil prices may well be higher too,
leading to increased fuel costs involved with gold production. Plus if you
are holding gold investments as an inflation hedge, then holding gold stocks
isn't as good a deal as it first may appear as the gold miner's costs base
will be inflating too.
 
On
top of this gold is getting harder to find and more expensive to extract when
it is found. This is one of the reasons why the gold price has been
increasing, the supply side is constricted, and yet it is often cited by
people who then go on to recommend investing in the mining industry.
It
is somewhat ironic that one would believe gold prices would rise in part due
to mining becoming increasingly difficult and more expensive, but then invest
in companies that will suffer from those very factors. The same applies to
explorers. If one believes that gold is getting harder to find and that will
contribute to higher gold prices, why would one invest in companies that are
trying to find gold? Why not just in gold itself?
Our biggest problem with owning gold stocks is this: Where is the
compensation for the extra risks? The follow list identifies just some
of the risks involved in mining and exploration that we do not think are
being adequately compensated for.
·
Where is the compensation for Geo-political risk?
Examples: Nationalization of mines, disruption of mining due to conflict
·
Where is the compensation for managerial risk?
Examples: Management may make poor decisions that have an adverse impact on
the stock price, say by acquiring another company at an unfavorable price.
·
Where is the compensation for labor risk?
Examples: Labor costs may increase, work force may
go on strike.
·
Where is the compensation for technical risk?
Examples: Difficulties mining, problems with the deposit, downwards revision
of resources estimates
·
Where is the compensation for environmental risk?
Examples: Adverse weather or natural disasters affecting the project(s)
·
Where is the compensation for tax risk?
Examples: Changes in the tax structure of the country the project is in which
reduce its profitability, such as higher taxes or mining specific royalties
being imposed.
These
risks are not properly compensated for by the performance of mining stocks.
Therefore one should not take these risks and should not use gold stocks in
an attempt to profit from rising gold prices.
In
order for gold stocks to be worthy of an investment, they must outperform the
gold price to compensate for the extra risks the investor is taking on.
Out-performance is very different from leverage. Gold stocks must increase
more when gold prices increase and decrease by less when gold prices
decrease. At present even if the gold stocks manage to squeak out larger
gains than gold when gold prices increase, they fall far further than gold
when prices decrease. This isn't out-performance, this is simply leverage and
in this modern financial world leverage is cheap and easy. One doesn't need
to take the additional risks that gold stocks bring to get leverage to the
gold price; one can buy an ETF using margin, buy a leveraged ETN or even a
leveraged ETN on margin that will track the gold price almost exactly with a
large degree of leverage. Not to mention one could use futures and options to
add leverage too
Of
course there are some star performers in the junior sector and talented,
experienced veterans of the industry may be able to pick some great winners.
However overall as a sector it has severely underperformed in our opinion,
especially on a risk adjusted basis. Having a few juniors that rise tenfold
isn't good enough for us, since if one is investing in gold explorers, you
should own more than a few in order to diversify your risk. Also if you hold
less exploration stocks, you have less chance of holding the one that hits
the mother lode. One cannot have it both ways.
This
bull market started in 2001, so perhaps there were periods of out-performance
by gold stocks. Actually gold stocks stopped outperforming around 2002-2003.
The only other period that one would have enjoyed some outperforming is
measuring from the 2008 financial crisis low to date, but virtually every
stock has done well measuring its performance from then.
We
cannot understand why many people will still insist on gold stocks as a
viable vehicle for gaining exposure to rising gold prices. Maybe the
reasoning was sound 30 years ago, but it isn't now. A possible reason is that
gold stocks are interesting to talk and write about. Well something being interesting
doesn't interest us; we are interested in maximizing our profits - even if we
do not produce reams of research on a myriad of junior explorers for our
subscribers. We use options to trade gold, options on GLD which are easily available and
viable for the majority of investors. Our model portfolio has grown at an
annualized rate of 117% and we have only used options on gold stocks twice,
both of which were bearish and profitable trades. Through using options we
can create the leverage we require and through our own efforts at timing the market we believe we offer
out-performance as well, since options can allow one to profit if the price
goes up, down or even sideways...
In
conclusion we do not think gold stocks are a suitable vehicle for trading
gold and we also do not think gold stocks make a suitable investment for
those wishing to profit from higher gold prices. Gold stocks do not offer
adequate compensation for the extra risks involved. They do not outperform.
They barely offer leverage and even if they do, that is not enough. Of course
there will be exceptions and opportunities for savvy investors to make money
in this industry. However as a whole the entire premise of investing in gold
stocks as a way to gain exposure to rising gold prices is flawed, outdated and
quite frankly a "barbarous relic".
Randy
ECONOMICROT
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