Gold stocks are often considered as an alternative trade to direct investment in gold. However, they are two very different types of securities, each with its own set of risks.
Whilst you would expect that the price at which gold mining stocks trade would follow the movements in the gold price, up or down, that is not necessarily the case. A movement in the price of gold may not translate into a similar change in the profitablity of a gold mining company.
Gold Mining – A Panoply of Risks
Gold miners, as with all mining operations, face an array of risks in addition to the challenges that all businesses face. These include the risks associated with exploration and discovery of gold deposits, the feasiblity of deposits found, the expected life of the gold deposit, and geopolitical risks.
Mining companies operating several mines, with long-life, high-quality gold deposits, that can be mined at a cost that compares favorably with the expected gold price, obviously present a much lower risk to the investor than, for instance, what we refer to as marginal gold mining operations. On the other hand, marginal mines enjoy greater operational gearing during times the gold price perform well.
There are a number of factors to consider, even with established gold mining companies or gold mining funds. We highlight just a few:
Production hedging
Gold mines engage in forward selling of future production, in order to manage its ability to service project and debt costs. The hedging activities of gold mining companies affect their profitability, in that their short terms profits will not fully reflect the movement in the gold price. Production hedging also marginally affects the amount of gold entering the market, albeit marginally.
Management decision-making
Management decision-making can have a critical effect on the profitability of individual gold mining companies. The capital investment, operating, and finance decisions management makes, will determine the mining company’s future profitability and share price.
Dividend yield
Unlike gold, from which you will earn no income (unless you’re a bullion holder able to lease out gold), you will under normal circumstances earn a dividend from your gold stock holding. The dividend yield will vary from company to company. Importantly, when comparing the investment return from gold with that from gold mining stocks, you need to take account the dividend yield from the latter.
Basket of stocks
When you invest in a gold mining fund or ETF, you are effectively acquiring a stake in a basket of gold mining stocks. This means that stock-specific risks likely have been significantly diversified out, but may also result in the dilution of the gains in profitability from some mining companies by under-performing companies.
Relative volatility (or risk)
Due to the additional risks faced by gold mining companies, the price of gold mining stocks display a higher level of volatility than the price of gold, as is confirmed by the following chart of the daily % change in the HUI Gold Index (of companies involved in gold mining) and the price of gold over the last 20 years:
The Case for Gold Mining Stocks
Gold mining has dramatically under-performed gold mining stocks in recent years. In fact, an investment in the HUI Gold Index would have showed a zero return over the last 20 years, whereas gold increased by some 200%:
The question then is, is there still a case to be made for investing in gold mining shares, rather than a direct investment in gold?
Relative valuation
At times, such as during the last few years, the price of gold mining stocks can diverge from their expected relationship with the gold price (based on the profitability of the mines for a given gold price) resulting in a situation where gold mining stocks present obvious value compared to a direct investment in gold.
Non-correlation and risk reduction
Gold mining stock prices are often more correlated to general stock market movements and trends. In contrast, gold and commodities prices display little correlation to the stock markets. In fact, gold mining stocks tend to move in opposite directions to the stock market. Gold mining stocks therefore potentially provide the investor with an opportunity to diversify a portfolio which still aims to have exposure to the gold market.
