The Golden Rule

Gold has dropped sharply in the last few weeks, falling almost 7% from U$1423 an oz. at the beginning of 2011 to U$1325 today, Tuesday January 25th. Numerous commentators and journalists are speculating that the strong performance over the last year has come to an end and that the “bubble” in gold prices and other precious metals is coming to an end. The samelogic applies to gold stocks as well, and the decline here has been more severe, with the S&P/TSX Global Gold Index, comprised of the largest gold mining stocks worldwide, is down 12% since the beginning of the year.

This is somewhat surprising, given the relatively small size of the decline, and the fact that interest rates in most developed countries remain at extremely low levels, such as 0.25% in the US and Japan and 0.5% in the UK and the Euro area, thus making the opportunity cost of holding a non-income producing asset such as gold negligible. Whether or not one is convinced by the arguments that the very large government liquidity creation programmmes such as Quantitative Easing 2 in the US and the European Financial Stabilization Facility (EFSF) will eventually lead to inflation due to excessive monetary creation, otherwise known as running the printing presses, the continued dislike for gold and other precious metals demonstrates that most investors are very slow and unwilling to change their mind, even in the face of a long period of outperformance.

As a number of gold bugs and gold miners have noted, 2010 marked the tenth year in a row that gold had produced a positive absolute return, making it the best performing asset class over the last decade with a total return of 350% between 2000 and 2010. The next best asset over that period, by the way, was long term government bonds, with a 120% total return (half income, half capital gain from falling rates), and the worst, equities, with a 30% loss, apart from resource-based markets such as Canada and Australia, which did see equities delivering positive returns. Gold rose 30% last year alone, more than double the return from major equity markets, and over the last 5 years is up 150% against zero return from the S&P500 and 20% from the S&PTSX Composite and Nasdaq, the two best performing North American equity indices. There is no reason to believe that gold will not deliver a positive return again this year, given that central banks in the US, Europe and Japan have given no sign that are willing to raise interest rates, and that over 1 trillion dolllars of monetary stimulus is due to be injected into the system this year.

Interestingly, gold mining stocks have been laggards to the actual metal itself over this bull market. Over the last 10 years to January 2011, the S&PTSX  Global Gold Index is up less than 300% (280% at time of writing) against gold`s 400% rise, and over the last 5 years, is up a mere 30% against 150% for the metal itself. Part of the reason for this underperformance is the inclusion of South African miners via ADRs such as AngloGold Ashanti, Goldfields and Randgold listed in New York, comprising 13% of the index, as the South African rand has depreciated against the C$. The other and probably more important reason is that the stocks in the index are naturally the large miners, with Barrick, Goldcorp and Newmont being the 3 largest positions, and with the top 10 holdings comprising almost 80% of the total.

Large miners suffer from several disadvantages compared to both the metal itself and smaller miners, as they are on a constant treadmill to replace the gold that they produce each year. They are the ultimate depleting asset, and whenever times are hard in the mining industry, there is a natural, but dangerous, tendency to high grade the resource by mining those sections which have higher grades, thus maintaining the dollar value of the ore produced, while reducing the life of the mine and the profits that are produced. They also suffer from inflation of mining costs more severely than smaller mines, as the limited supply of mining equipment, trucks, mills and trained staff affects them more severely than smaller outfits. Lastly, to maintain or grow their output, large miners will buy smaller mines, with Goldcorp`s (G-T, GG-N) U$3.5 billion purchase of Andean Resources and Kinross`s (K-T, K-N) U$7.1 billion purchase of Red Back Mining last year only the most recent of the numerous examples of smaller mines being bought out at high prices to enable miners with production of over 1 million oz. p.a. to maintain their output.

Thuas large miners are more likely to be diluting their existing shareholders and reducing their returns through issuing paper, but unlike central banks, at least they receive some assets which will produce a return when they do so, even if it does not end up being as high as they originally thought. Ironically, the S&PTSX Global Gold Index was outperforming gold itself last year, up almost 40% at its high in early December against 30% for the metal, but mining stocks tend to be a more volatile, higher beta way to play the underlying commodity, going up more in bull markets, such as 2001-05, 2007-8 and last year, and falling more rapidly in bear markets such as 2006-07, 2008-09 and the last couple of months.

One advantage of using gold stocks as a way to play the bull market in gold is that you even receive an income, although fairly small, with Barrick, Goldcorp and Newmont all paying dividends around 1%, and the other 7 stocks in the top 10 holdings, which include  Kinross, Agnico Eagle, Eldorado and Yamana as well as the 3 South African ADRs, all paying a dividend equivalent to at least  a yield of 0.6%, with some (Newmont, Yamana) yielding 1.1%. Furthermore, a number of the stocks have been increasing their dividends meaningfully, with Agnico Eagle raising its dividend 256%, Goldcorp doubling its payout and Newmont raising its dividend by 50%. One other way to play the gold story without being exposed to rising costs or environmental concerns is via Franco-Nevada (FNV-T), the gold and precious metals royalty company, which receives a royalty of between 0.5% and 4% on every oz. produced by mines in which it owns royalties. Even with no increase in the gold price over the next few years, Franco-Nevada will experience rising profits as new mines in which it has interests will come on stream. It also pays a 1% yield.

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