Few would dispute that the 12-year (and still counting) bull market in gold has been the opportunity of this investment lifetime. Even fewer have participated. From its 20-year bear-market low in August 1999, bullion has appreciated more than seven fold. That works out to a $US compound return of 18.0% compared to 0.7% for the S&P 500. There is a paltry $2 trillion of investment gold, approximately 1% of global financial assets. It is not mainstream. It is not widely held. The rationale for investing is antithetical to mainstream thinking. The opportunity has been missed by almost every conceivable category of investor including pension funds, endowments, mutual funds, and central banks, all of whom could be safely described as underweight the metal, overweight dicey financial assets. Despite the headlines, gold remains under owned.

To regard the lengthy bull market in gold as an isolated fact would be simplistic and superficial. The media and most of the financial community are captivated by daily price action, but see nothing more. To most, it is a speculation, probably an overcrowded trade, and maybe a bubble. It is seen in the narrowest of terms, as an odd curiosity that will at some point just go away.

Gold's advance is but one aspect of a much bigger picture. The collapse of the dotcom and housing bubbles, the 2008 credit collapse, the 11-year bear market in stocks, sovereign debt woes in Europe, zero interest rates, intractable sovereign fiscal deficits, and, yes, the steady rise of gold in all currencies are rooted in the breakdown of confidence in paper currencies linked only to political agendas.

Since the demotion of gold to non-monetary status by the Nixon administration in 1970, fiat money and credit based upon it have been a fundamental source of global wealth generation. What is the value in real terms of the $200 trillion of wealth denominated in currency if nobody wants the paper?

In golf parlance, a "mulligan" is a second chance to make good on a bad tee shot. Mulligans are routinely granted and gratefully accepted by every golfer at the beginning of a friendly match, after a bad first shot. In the world of investing, second chances, or "do overs" are not routine. Sideline huggers who have missed the bull market of a lifetime must "pay up" if they wish to participate in a long-established trend. Late to the party entry points are inherently more risky, as the sharp correction in bullion during the last week of August in bullion illustrates.

What follows is a table thumping, categorical, endorsement of gold and precious metal mining stocks. It is addressed not only to impatient and possibly dispirited holders of precious metals mining equities, but also to the bystanders and spectators of the past 12 years. Gold mining equities represent the closest thing to an investment mulligan as we have seen-a rational way to participate in what appears to be the end game for paper currencies on an attractive risk-adjusted basis. Gold bullion is popular. Gold stocks are not. Gold bullion has become volatile. Gold stocks remain somnolent. The two have diverged widely over the past eight months, with gold rising 29.2% while the stocks (basis XAU) have declined 2.7%. Since the 1999 bear market low in bullion, the XAU has underperformed the metal by 331% or 13% per year. Based on Lipper data, precious metals mutual fund outflows during the first half of 2011 were the largest in five years:


Reasons For Underperformance
Over the past ten years, the miners, as measured by the XAU, have barely kept pace with the metal itself. Since early December 2010, gold stocks have lagged the metal substantially. The ratio of the XAU (Philadelphia Stock Exchange index of Gold and Silver stocks) to the metal price stands near an all-time low (see Chart 2). The same can be said of the shorter lived HUI. The basket of senior mining equities monitored by our research team to the NPV (net present value) shows a similar result. This universe implies a gold price of $1372/oz, a discount of 27% to spot (as of 9/6/11), vs. a five year average of -4%.


The chart below, another measure of the unpopularity of gold stocks, tracks the discount to spot prices implied by the trading level of our index of senior gold mining equities:



There are four possible explanations for the recent underperformance of the mining stocks:

Gold ETFs
In November 2004, the World Gold Council launched a gold ETF (GLD) which now has a market cap of $72 billion. GLD is backed by physical gold and has tracked the gold price accurately. Other gold ETFs have been launched and today the aggregate market cap is $130 billion, compared to an estimated market cap for gold mining equities of $500 billion. Chart 2 shows that the valuation of the XAU relative to the bullion price began to trend lower in the years following the launch of GLD and other gold ETFs.

It appears that the gold ETFs have been a mixed blessing for gold mining stocks. On the one hand, by making gold more user friendly, ETFs facilitated capital flows into the metal. By making gold available to mainstream investors, they democratized what was previously an obscure asset known only to central bankers, commodity traders, and coin dealers. The ETFs have had a positive, but difficult to measure, impact on the gold price. In all likelihood, and with 20-20 hindsight, this impact was probably marginal. Who is to say that given the macroeconomic tail winds for gold, that the price would be any different today in the absence of the gold ETFs? On the other hand, gold ETFs have created competition for gold mining stocks, and this seems to be reflected in Chart 2. Prior to 2004, the miners held a monopoly for equity market investors wishing to bet on a decline in the value of paper currency. This monopoly translated into an extremely low cost of capital for the gold mining industry. Unfortunately this advantage was dissipated by industry management during the 1990's and through 2007 by way of excessive share issuance, unwise capital allocations, and risky hedging practices which ultimately resulted in the destruction of shareholder capital.

Relative to gold mining equities, investment in the metal is straightforward and clear cut. There is no business risk. Investing in the business of mining gold demands more complex and specialized analysis. Given the flight to safety in capital markets, it is not surprising that investors flock first to bullion.

Doubts On Gold Price
The hesitancy in gold stocks year to date reflects the reluctance of investors to incorporate higher gold prices into earnings and dividend expectations. The steep acceleration in the slope of gold prices over the past 90 days and related volatility is a near-term negative because the natural expectation is for the metal price to correct. A correction in the metal price might give equity investors the confidence to project and normalize new and previously unexpected fundamentals. The steep discount to the current spot price of $1872 (-27%) (Chart 4) indicates a level of skepticism not seen since 2008.

The rationale for investing in mining stocks is purely and simply a bullish view of the gold price. However, the fundamental that drives earnings is not the spot price but the average price over a period of time. As the chart below shows, the average annual gold price is in a steadily rising and bullish trend. This trend is a more reliable gauge of industry profitability than spot prices. Since the average price received is well below (-26%) the spot price, and the moving average is still climbing, we expect the best is yet to come for gold mining earnings.

We also expect the price behavior of gold to become ever more astonishing. As long as favorable macroeconomic conditions prevail, especially negative real interest rates, marginal capital flows into the metal will have an outsized impact on the metal price. The reason is that the available supply of investment gold increases slowly while the quantity of paper currencies and sovereign debt proliferates at comparative warp speed. The addition to the above-ground gold stock of 170,000 metric tonnes from annual mine production is only 2,698 metric tonnes or 2%. $100 swings in the daily price are likely to become routine. Those who view the metal's price as a vehicle for trading profits will in all likelihood fail to capture the full return from the substantial and permanent devaluation of paper currencies against it. The record of the high-profile pundits in calling short-term tops and lows in the price action is abysmal. We graciously do not reproduce any of their inaccurate calls as evidence. It raises the question of why anyone would want to trade in the midst of a tectonic shift in global monetary arrangements.

The basis for expecting sustained high gold prices is the erosion of confidence in central banking and fiscal and monetary policy in Western democracies. Low esteem for paper currencies has the appearance of permanence. Reclaiming confidence in paper currency will be no easy task. The challenge was discussed in our previous web site article: Another Volcker Moment At Hand? Until confidence is restored, there will be no substitute for gold. Once the point of no return for confidence in fiat money has passed, there is no self-correcting market mechanism to drive down the price of gold. Gold is unique in this respect. Unlike the price of oil, base metals, grains and other economically sensitive commodities, its price is not restricted by conventional market forces.

Margin Pressure
Pressure on gold mining margins is often mentioned as a reason for lackluster stock performance. However, the facts do not support the argument. In 2007, oil prices approached $150/bbl, and today are hovering in the mid $80's. Energy, one of the key variable cost components of producing gold, has not kept pace with the gold price. Almost all of the others that one could name, including steel, chemicals, rolling stock, and labor have not kept pace either. Given a world economy that seems to be stuck in perma-mud, we do not see input costs becoming problematic. Should inflation accelerate due to monetary laxity, we would expect the gold price to continue to outpace variable costs. The chart below shows that the spread between the global cash cost of producing gold has widened significantly since the watershed of 2008:


Prior to 2008, margin pressure was a legitimate concern. The costs of producing were outrunning the gold price. Skinny margins translated into high potential shareholder dilution if the industry was to reinvest sufficient capital to maintain production and reserves. Following the credit implosion of 2008, profit margins on existing mines have steadily expanded.

If there is a legitimate margin/return on capital issue, it relates to mines of the future. The steady decline in head grades requires disproportionate and possibly geometric increases in capital to produce the same volume of gold. More capital translates into heightened project risk. Companies that choose to avert dilution in favor of cash distributions on highly profitable existing assets are more likely to find favor with investors and will be rewarded in terms of equity valuation, in our opinion. Those that choose to pursue growth strategies that require capital intensive new projects in risky political jurisdictions may well fail to achieve the privileged equity valuations that we envision for those that don't.

Resource nationalism directly impacts the economics of existing and future mines. The term is new but the practice of nickel and diming the profitability of successful business in the commodity sector is time honored. Host countries, especially those in the developing economies of the world, have honed this practice to a fine art. The issue is most relevant for large, highly visible new mine projects and indisputably adds risk in terms of capital, time, and project economics. However, the predisposition of governments to penalize success, especially when soaring commodity prices produce "undeserved" profits cannot be used as an explanation for the recent underperformance of gold mining stocks since it has always been part of the landscape for extractive industries .


Hangover From 2008
It goes without saying that mining stocks are riskier than the metal itself. Periods of sustained equity market weakness create drag for gold mining equities, even if the gold price itself is strong or holding steady. The weak equity market in 2011 and 2008 are two recent examples. Bear markets inevitably raise concerns over the viability of a strategy of investing in gold mining stocks. Investors in gold bullion are for the most part risk averse, while investors in gold mining equities are opportunistic or risk takers.