The Disconnect between Gold Mining Stocks and the Gold Price
The Disconnect between Gold Mining Stocks and the Gold Price
Gold mining stocks are often quoted as being a cheap way to gain exposure to the gold price. Certainly over the longer term, gold stocks tend to trade with the gold price, but there are times when the correlation between the two comes out of sync.
There are many reasons why the prices of gold mining stocks might not follow the path of the gold price. For example, companies that mine gold have cost to bear such as wages, the cost of land and property, rents, transportation, accountancy and regulatory fees, etc. But again, over a long period of time, these costs are inherently accounted for in the gold price: if they were not to be, then presumably gold mining companies would run at a loss. After all, the costs mentioned are all, in fact, costs associated with the exploration and extraction of gold from the earth’s surface.
But according to the Price Waterhouse 2012 Gold Price Report, gold mining stocks fell by around 11% during 2011 whilst gold itself rose by about 11%. Through the first half of 2012 this diverging price relationship continued. There are, perhaps, a number of reasons for this that, when understood will help investors make a better informed decision as to the timing of gold stocks purchases.
The first and most overlooked reason for the disparity is that gold mining companies tend to pay dividends. For example, Barrick Gold (traded on the New York Stock Exchange under the symbol ABX) paid a dividend in 2011 of around 2.3%. So one would naturally expect an underperformance on the share price of the same amount. But that still leaves a huge gap between the gold price and the price of gold stocks.
This brings us to the second reason, and that is when the market believes that margins of gold mining companies will decrease. This is really a question of two factors. The first of these is rising costs. If it is felt that wages, fuel, and exploration costs are increasing at a greater rate than the price of gold, then earnings will be expected to be negatively impacted.
Last year, and probably in response to the rapidly rising gold price, miners around the world took industrial action in support of higher wages. Several companies were eventually forced to raise wages, including AngloGold Ashanti, Gold Fileds, and Harmony in South Africa, and Freeport McMoRan’s operations in Papua New Guinea. These increased wages impact directly on the bottom line, the dividends a company can pay, and the capital value of shares.
Margins also decline when the gold price falls, and this bring us to the third reason why gold stocks have diverged from the gold price.
Gold mining companies make their profits from mining and selling gold. If costs are steady or rising and the gold price is falling, then margins will decrease and earnings suffer. But in a market where the gold price has run up, as it has over the last ten years or more, the feeling that gold prices will either take a breather or fall back will be enough to depress gold stocks. Why buy shares in companies that are geared to the gold price if you believe the gold price will fall?
Some investors consider the ever rising costs of mining gold a good enough reason not to own gold mining stocks. This attitude is not a new phenomenon. In 2004/ 5 gold mining stocks underperformed gold just as they are today. Then over the next 18 months the once underperforming stocks went wildly bullish, outperforming gold and closing the pricing disparity.
In conclusion
Perhaps the key to profiting from gold stocks is realising that periods of price divergence are commonplace and part of the cycle of investment. Sometimes gold stocks will outperform gold, and at others they will underperform. But over the longer haul gold stocks, by their very nature, are likely to correlate strongly to the gold price, save for, perhaps, the income they give by way of dividends (which could be another valid reason to own such stocks rather than physical gold).
When gold stocks have been through a period of underperformance, with expectations that gold will fall, or at least not rise, and margins therefore decrease, then if gold rises the stocks of gold mining companies could bounce even more strongly and outperform as they did in 2005/ 6.