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Gold
Stocks vs. Gold Bullion
By
Steve Saville The
Speculative Investor
February
2, 2010
Below
is an excerpt from a commentary originally posted at www.speculative-investor.com
on 31st January, 2010.
It is widely believed that gold stocks offer leveraged exposure to
changes in the gold price, but this belief is false. At least, the
historical record suggests that it is false on a long-term basis. As
evidence we include, below, a chart of the BGMI/gold ratio covering
the past 50 years (BGMI is short for Barrons Gold Mining Index).
The long-term BGMI/gold chart shows that there was a huge rally in
gold stocks relative to gold bullion during the 1960s. This massive
out-performance on the part of the stocks occurred for two main
reasons. First, the gold price was fixed at $35/ounce at the time,
but it was becoming increasingly clear that relentless monetary
inflation was going to make it impossible to maintain 'the fix'.
Consequently, the stock market began to discount the large rise in
the gold price that would likely occur once the last remnants of the
Gold Standard were abandoned. Second, US citizens were not permitted
to own gold bullion at the time, so the only way that people in the
US could speculate on a future rise in the gold price was to buy the
shares of gold-mining companies.
The huge BGMI/gold rally of the 1960s was followed by a 12-year bear
market that bottomed in 1980. In other words, the gold bull market
of the 1970s was accompanied by a BEAR market in gold stocks
relative to gold bullion. One of the most important drivers of this
bear market was the fact that gold stocks had previously been bid up
to extremely high levels relative to gold in anticipation of a large
rise in the gold price.
Since 1980 the BGMI/gold ratio has oscillated within a horizontal
range. Note, though, that it briefly moved below the bottom of this
range towards the end of the 2008 market crash. In fact, in October
of 2008 the BGMI/gold ratio hit a 50-year low!
The
BGMI/gold ratio reflects the performance of a basket of larger-sized
gold producers relative to gold bullion, so the above chart makes it
clear that larger-sized gold stocks, as a group, have not provided
their owners with leveraged exposure to gold over long time periods.
A well-selected basket of junior gold stocks could have outperformed
the BGMI by a wide margin and could potentially have provided the
leveraged exposure that gold-stock investors typically seek, but the
juniors tend to be a lot more risky and are therefore not
appropriate for many investors.
This prompts the question: why aren't gold mining companies able to
leverage gains in the gold price over the long-term? After all,
shouldn't an X% gain in the gold price lead to a gain of more than
X% in a gold miner's cash flow?
A number of factors have contributed to the lacklustre long-term
performance of the BGMI/gold ratio, one being that the costs of gold
mining tend to rise. Due to rising costs, only part of any increase
in the gold price flows to miners' bottom lines. Other factors
include political issues, environmental issues, and management
errors, but in our opinion the single most important factor is
simply that gold mines deplete. Due to the fact that gold mines
experience depletion, gold mining companies must devote a lot of
cash each year to exploration to prevent their total quantity of
in-ground reserves from declining. Alternatively, a mining company
can maintain or grow its reserves through acquisition, but this will
also be costly in terms of cash or new shares; and it won't prevent
reserves from declining on an industry-wide basis.
As we've mentioned in previous TSI commentaries over the past six
years, the proven inability of large gold-mining stocks to leverage
long-term gains in the gold price means that people who plan to hold
a gold investment for many years, and who do not want to take-on the
risk inherent in junior mining stocks, should accumulate gold
bullion as opposed to gold stocks. From time to time, however, the
major gold stocks become very under-valued relative to the bullion
and therefore become good candidates for intermediate-term TRADES.
October of 2008 was a classic example.
It's all a question of relative valuation. In general, for an
investment in a gold stock to be justified the stock must be
under-valued relative to gold bullion by enough to warrant taking on
the additional risk inherent in the stock. To put it another way: a
lot more things can go wrong with a gold mining company than with
gold bullion, so investors should only favour the stock over the
bullion if the stock's valuation implies that its additional upside
potential is more than enough to compensate for the additional risk.
The major gold stocks are not as cheap relative to gold bullion
today as they were in October of 2008, but in gold terms they are
still close to their lows of the past 50 years. Also, in nominal
currency terms they are becoming sufficiently oversold to be of
interest as short- or intermediate-term trades. Having said that, we
much prefer the juniors.
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