Gold Mining Stocks: Pros and Cons

March 10 2015

The question that just keeps coming back; should I invest in (physical) gold or gold mining stocks? Which option is better? What are the pros and cons of investing in gold mining stocks?

Gold Mining Stocks: Pros and Cons

The question that just keeps coming back; should I invest in (physical) gold or gold mining stocks? Which option is better? What are the pros and cons of investing in gold mining stocks?

High Gold Prices Do Not Guarantee High Gold Mining Stock Prices

High gold prices do not guarantee a (further) rise in gold mining stock prices. For example, gold prices rose in 2001, while gold mining stocks dropped significantly due to the bankruptcy of two major mining companies.

Something similar happened between 2005 and 2007; gold had been rising continually while gold mining stocks dropped due to increasing costs of labor and production.

Yale: Gold or Gold Mining Stocks?

In a Yale study, Gary Gorton and Geert Rouwenhorst (2005) investigated which of these two investments historically achieved the highest returns. They compared the returns of a gold stock index and gold itself between 1962 and 2003. They applied the same procedure to several other commodities.

Which did they conclude?

Over the 41-year period investigated by Gorton and Rouwenhorst, the average rate of return on gold was higher than the rate of return on gold stocks. Even more interesting, the data show that the correlation between these two investments — gold and gold stocks — amounts to a mere 40%. Or in other words, both prices only move in parallel fashion 40% of the time.

On the other hand, the correlation between gold stocks and the stock market equaled 57%. In other words, gold mining stocks correlate more strongly to the stock market than to gold — a conclusion that would surprise many gold investors.

Gorton and Rouwenhorst concluded as follows: “[Gold] stocks behave more like other stocks than their counterparts in the commodity futures market.”

How Gold Mining Stocks Can Underperform Gold

There are many reasons you can think of why gold mining stocks have historically underperformed compared with gold and why investing in gold miners is more risky than investing in gold.

For example, mines may be depleted sooner than expected. The magnitude of the ‘underground’ gold reserves is no scientifically established fact. As long as the gold is not dug up by the gold mining company, the quantity and purity thereof remain uncertain. The estimated underground gold reserves of a mining company are a rough approximation. If you invest in a gold stock based on the estimated underground gold reserves, you may have gotten yourself a terrible deal.

It doesn’t stop here; the list goes on. The gold mining company may, of course, run into financial difficulties due to mismanagement. History demonstrates that managers are capable of ruining a company — mining companies are no exception. Another factor that may cause underperformance of gold stocks relative to gold, is also related to management. A management hostile to shareholders may destroy shareholder value by, among others, pampering themselves, paying themselves unduly high salaries and bonuses, wasting valuable company resources and overestimating future revenues. This once again demonstrates the importance of competent managers for a company.

Furthermore, for politically unstable countries — often ruled by socialist populism — there is an additional risk of confiscation for mining companies. This happened in Venezuela and other countries. These undeniable political risks can be more or less excluded by investing in physical gold because you get to decide where your gold is stored. On the other hand, mother nature decided in which countries gold mining companies have to operate. Even more common is governments appropriating profits from gold mining companies. This happened for instance in Ecuador. As you will understand, these confiscatory taxes are not really beneficial for your rate of return.

Operational costs of gold mines are of course another reason. As mentioned earlier, gold prices rose between 2005 and 2007, while gold stocks dropped due to increasing costs that depressed profitability. Cost of production and labor increased significantly during that period, among others due to the fact that other commodities also rose significantly in price.

The Leverage Effect

In theory, a gold mine is a way to profit from a rising gold price with leverage. A rising gold price can lead to a multiple increase in corporate profits considering the profit margins may suddenly increase.

It is an art (or a nightmare) to pick the right gold stock from all the available options. And we haven’t even mentioned all hazards related to junior exploration companies.

It is true that gold mining stocks, like gold, currently seem strongly undervalued. Contrary to gold however, gold mining companies may run into a precarious situation if the gold price remains ‘low’ for a longer period of time, which may result into bankruptcy or a financial restructuring. If you bought gold stock X at €20, while it currently trades at €4, don’t be surprised when a takeover bid of €5 gets accepted. It happened similarly with Dell and happens more often than we would like. The result of a takeover is that you cannot hold the stock until the gold price recovers.

Gold mining companies may go bankrupt if gold prices remain low for longer than we would like them to, while investors in physical gold can patiently await a recovery and large upward movements.

Gold Mining Stocks Are Usually Inappropriate

This means that investors in gold stocks needs to be very skilled in order to outperform gold. But just like on the stock market: 90% of investors underperform it. 90% of investors may believe that they can outperform the gold stock index, but in reality 90% eventually does worse.

I want to emphasize that gold stocks are not a substitute for physical gold. At best, it may be a complementary investment for investors who are prepared to take on additional risks associated with the management of gold mining companies. But do keep in mind that higher gold prices do not guarantee high prices for gold stocks.

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