GDX Vs Gold Discussion

I've been having the discussion on the title lately with a client, coworkers, and last night, with Certified Users in the WSO chat.

The discussion stems from the fact that since about June 2008, the return of GDX vs Gold Spot has deviated significantly.

For those of you who don't know, GDX is the Market Vectors Gold Miners ETF. (You can find the Factsheet of the ETF Here) From the Factsheet:

The Gold Miners ETF seeks to replicate as closely as possible, before fees and expenses,
the price and yield performance of the NYSE Arca Gold Miners Index. The Index
provides exposure to publicly traded companies worldwide involved primarily in the
mining for gold, representing a diversified blend of small-, mid-, and large-capitalization
stocks. As such, the Fund is subject to the risks of investing in this sector.

I believe part of the deviation stems from the 2008 recession. However it seems logical to me that with the meteorical rise of gold price especially since 2008, margins of gold miners would drastically increase and therefore would generate more profits and increase stock price. However this didn't happen. Some reasons why miner's stock prices haven't risen even though gold price has shot up:

1. Mining production has been quite stagnant since about 2001.

2. Cost for extracting gold have shot up significantly since 2006 (Not sure why so much cost inflation)

3. Mined and reserve grades have declined since 1999-2000

What do you think monkeys? Any other reasons as to why GDX deviated significantly from Gold spot since 2008? I would love to hear from those in Global Macro/Commodities businesses.

 

Looks like you're getting ahead of yourself. First look at what events and or conditions effect gold spot as opposed to trying to justify the spread between the two from the perspective of the mining companies.

For every successful gold mining operation there are probably thousands of unsuccessful ones.

"A gold mine is a hole in the ground with a liar standing next to it." - Mark Twain

 

If you look at the commodity price vs.South African gold miners since '01 its a ten bagger.

Remember relevant cost inlfation is cost per Oz gold not cost per kilo of ore hoisted, so costs have spiralled because labour inlfation has been high but also because yields in a lot of places (like SA) have delcined.

Capital allocation has also been Sh*t - shareholders money goes into shitty long dated low return projects (not retuned through buybacks and divi's).

Also some companies hedged at the wrong time.

And gold co.'s are now trading at historic low PE ratios becasue you can now play gold through ETF's (you couldn't always).

 

I agree with Cookies with Milken. Even established Gold companies with strong production are run by some of the most dihonest/scaly management teams I have met. Reserve statements are usually a steaming pile of crap and these guys often mine the stock market more than their resource base

 

I'm confused, naive and ignorant so bare with me: doesn't gold protect against inflation? and an ETF wouldn't appear to (because they are not backed by the physical commodity itself) even though they are made up of companies that produce the gold? Would an ETF that contains companies that grow soybeans or mines copper move in step with the movement of their commodities? I guess that would seem to be my rationale as an investor.

"History doesn't repeat itself, but it does rhyme."
 

Hedge Ratio, brought this up to you. Has anyone analyzed the hedge ratio from 2005 to 2012? Any banks out there done this analysis yet?

Think about in 2008 when you hit record highs, Paulsen is all in, what CEO on earth running a miner would be caught to not be hedging future production? Are they too hedged vs rising costs of additional production?

 
Best Response

In the past, the theory behind investing in gold miners rather than gold companies was to take advantage of the operational leverage inherent in the miners. Every incremental dollar increase in the price of gold would be pure margin for gold miners. I.e., if gold increased from $1,000 to $1,500, you would realize a 50% gain if you were invested in gold. In contrast, a gold miner with cash costs of $500/oz would see cash flow double with the share price following suit.

We've seen this relationship breaking down mainly because:

(i) Most of the gold miners have experienced significant operational issues - Capex overruns and project startup delays in large important growth projects that decimate the economics of a mine (e.g., Tasiast at Kinross). This also had the effect of increasing maintenance capex requirements as it costs more to sustain current cash flows. - Labour cost inflation in-line with commodity increases as labour quite rightly realizes they have more leverage in demanding salary increases through strikes, etc. - Higher security requirements as the higher commodity prices increase the frequency of theft. - Increasingly complicated geologies as the highest quality assets are all mostly owned and operated by the large cap miners - I believe the statistic is that all high quality operating (and most developing) assets (in both gold and copper, they have similar porphyries) are all owned by large cap mining companies. - The deeper and longer you mine a mine, cash costs naturally increase as you move from higher grade to lower grade ore. Current margins can be extremely misleading as operationally issues also increase to complicate projected cash costs. - High capex requirements significantly constrains cash flow - many of the large cap gold companies have negative free cash flow because of the 'growth capex' required. This is probably the biggest gimmick in the mining business because what is defined as 'growth capex' is actually maintenance capex because in order to maintain current cash flows, you need to find and build new mines. (The second biggest gimmick in the mining business was to market a company off of cash costs and ignore the capex required to build the mine). It's also funny to see large cap gold companies paying dividends when they have negative cash flow.

(ii) Poor corporate governance - Capital allocation issues, most gold companies were happy to reinvest cash flow into terrible acquisitions with disastrous ROIC because of the limited opportunity set available and the desire to "keep growing" or to build empires (e.g., Kinross / RedBack, Barrick / Equinox). It wouldn't be uncommon to justify low digit IRR acquisitions because it was 'accretive to the company' or strategically important to maintain growth... - Almost all junior gold companies are entirely dependent on their share prices to raise cash to pay salaries, continue expansion plans, etc. This created an absurd and unhealthy focus on pumping up valuation, marketing and investor relations, after which they would continue to do dilutive equity issuances to pay salaries, spend more on investor relations and do a bit of drilling on the side. It's no surprise that one of the most successful mining company CEOs is the guy that Steve Jobs learned his reality distortion field from - Robert Friedland. As long as you can con investors long enough that you own a good mine, eventually you'll be able to find gold (and reap all the benefits as you've issued options galore). Similarly a lot of commodity companies just weren't equipped with the right corporate governance capabilities as lucky discoveries or advantageous increases in the commodity price would result in $100 million companies doubling or tripling overnight. Unsurprisingly management teams would continue to do what they had always been doing, buying new mines, exploring new geologies, building new projects regardless of the cost.

(iii) Structurally, valuations of gold companies were pretty unreasonable - Another amazing marketing gimmick was the focus on NAV when looking at gold mining companies. This was to obscure the cash flows the business actually generated. Given the high initial capex requirements involved with any mine, research analysts would start discounting back cash flows at a 5% discount rate (which is utterly absurd if you spend a second thinking about it) and value the company as a % of NAV. For the longest time, most gold companies would trade at a premium to this NAV simply because they were gold companies. I always wondered why gold companies traded at this mythical premium and never really heard a good answer. - This structural valuation problem has disappeared as people have become more aware of (i) and (ii) as well as the advent of gold ETFs which provide another way of investing in gold. Valuations have dropped to be more in-line with the super majors such as BHP, Rio Tinto, etc.

I'd note that hedging wasn't really an issue as the largest gold companies who historically had hedges eliminated them in late 2009 early 2010 (i.e., Barrick, AngloGold).

South African golds are a totally separate issue as well and that has played into the performance of GDX. South African golds have structurally disastrous operations because of how deep the mines are, poor construction, low reserve quality and grades, labour conditions etc. (look on the website of any SA gold company and you'll see multiple deaths every couple months).

 
bear396:
In the past, the theory behind investing in gold miners rather than gold companies was to take advantage of the operational leverage inherent in the miners. Every incremental dollar increase in the price of gold would be pure margin for gold miners. I.e., if gold increased from $1,000 to $1,500, you would realize a 50% gain if you were invested in gold. In contrast, a gold miner with cash costs of $500/oz would see cash flow double with the share price following suit.

We've seen this relationship breaking down mainly because:

(i) Most of the gold miners have experienced significant operational issues - Capex overruns and project startup delays in large important growth projects that decimate the economics of a mine (e.g., Tasiast at Kinross). This also had the effect of increasing maintenance capex requirements as it costs more to sustain current cash flows. - Labour cost inflation in-line with commodity increases as labour quite rightly realizes they have more leverage in demanding salary increases through strikes, etc. - Higher security requirements as the higher commodity prices increase the frequency of theft. - Increasingly complicated geologies as the highest quality assets are all mostly owned and operated by the large cap miners - I believe the statistic is that all high quality operating (and most developing) assets (in both gold and copper, they have similar porphyries) are all owned by large cap mining companies. - The deeper and longer you mine a mine, cash costs naturally increase as you move from higher grade to lower grade ore. Current margins can be extremely misleading as operationally issues also increase to complicate projected cash costs. - High capex requirements significantly constrains cash flow - many of the large cap gold companies have negative free cash flow because of the 'growth capex' required. This is probably the biggest gimmick in the mining business because what is defined as 'growth capex' is actually maintenance capex because in order to maintain current cash flows, you need to find and build new mines. (The second biggest gimmick in the mining business was to market a company off of cash costs and ignore the capex required to build the mine). It's also funny to see large cap gold companies paying dividends when they have negative cash flow.

(ii) Poor corporate governance - Capital allocation issues, most gold companies were happy to reinvest cash flow into terrible acquisitions with disastrous ROIC because of the limited opportunity set available and the desire to "keep growing" or to build empires (e.g., Kinross / RedBack, Barrick / Equinox). It wouldn't be uncommon to justify low digit IRR acquisitions because it was 'accretive to the company' or strategically important to maintain growth... - Almost all junior gold companies are entirely dependent on their share prices to raise cash to pay salaries, continue expansion plans, etc. This created an absurd and unhealthy focus on pumping up valuation, marketing and investor relations, after which they would continue to do dilutive equity issuances to pay salaries, spend more on investor relations and do a bit of drilling on the side. It's no surprise that one of the most successful mining company CEOs is the guy that Steve Jobs learned his reality distortion field from - Robert Friedland. As long as you can con investors long enough that you own a good mine, eventually you'll be able to find gold (and reap all the benefits as you've issued options galore). Similarly a lot of commodity companies just weren't equipped with the right corporate governance capabilities as lucky discoveries or advantageous increases in the commodity price would result in $100 million companies doubling or tripling overnight. Unsurprisingly management teams would continue to do what they had always been doing, buying new mines, exploring new geologies, building new projects regardless of the cost.

(iii) Structurally, valuations of gold companies were pretty unreasonable - Another amazing marketing gimmick was the focus on NAV when looking at gold mining companies. This was to obscure the cash flows the business actually generated. Given the high initial capex requirements involved with any mine, research analysts would start discounting back cash flows at a 5% discount rate (which is utterly absurd if you spend a second thinking about it) and value the company as a % of NAV. For the longest time, most gold companies would trade at a premium to this NAV simply because they were gold companies. I always wondered why gold companies traded at this mythical premium and never really heard a good answer. - This structural valuation problem has disappeared as people have become more aware of (i) and (ii) as well as the advent of gold ETFs which provide another way of investing in gold. Valuations have dropped to be more in-line with the super majors such as BHP, Rio Tinto, etc.

I'd note that hedging wasn't really an issue as the largest gold companies who historically had hedges eliminated them in late 2009 early 2010 (i.e., Barrick, AngloGold).

South African golds are a totally separate issue as well and that has played into the performance of GDX. South African golds have structurally disastrous operations because of how deep the mines are, poor construction, low reserve quality and grades, labour conditions etc. (look on the website of any SA gold company and you'll see multiple deaths every couple months).

Wow.this is very comprehensive. I just copied your comments for future references!

 

How much does a given company's operational diversification in the GDX effect the price? For instance, Barrick Gold Corp, the largest holding for GDX (about 12% according to the fact sheet) has seven business units, three of which aren't involved in gold mining/production (copper, oil and gas, and capital projects). So, it stands to reason that exposures to other commodities would cause a deviation to gold itself (in addition to the other reasons already noted) since it seems like most of the mining companies are involved in mining more than just gold.

"My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."
 

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