Dominic Picarda CFA, CMT [email protected]

Take your pick: gold or gold miners? Why, when and how to invest in the gold mining sector

Contents The outlookforbullion

2

Gold&miners:therecord

3

Diggingfurtherback

5

Whenbullionisbetter

6

Spreadriskw/gold&miners

7

Thedriversofminingshares

9

Caratcrunching

10

Timinggoldmining

12

Howtoinvestingoldmining

14

Conclusions

17

thanviainvesting iStockphoto

Tacticalmodel:NEUTRAL

As a gold bull, I often get asked whether buying gold mining shares is a better way to invest in the yellow metal than via investing in bullion itself. After all, gold miners reputedly offer geared exposure to the price of gold, as well as a potential dividend stream. In this in-depth report, I explore:

Valuation:BULLISH

Long-term: VERY BULLISH

    

The main features of gold mining shares as an investment The key drivers of gold mining shares Its relationship to gold and to stocks more generally Whether now is a good time to buy into this sector A new momentum-based model for outperforming the sector

The outlook for gold bullion The bull market in the yellow metal since 1999 has not yet ended The crisis of excessive indebtedness that first erupted in 2007 is far from over. While world’s leading central banks have brought the crisis under control for now, the problem of excessive indebtedness has not been solved. To bring down leverage, the central banks will continue to create inflation, for which cash savers and bondholders will not be properly compensated. The same policy of deliberately holding interest rates below the rate of inflation was deployed in the decades after the Second World War in order to inflate away the debt burden.

Deleveraging in the US hasn't even started!

140 120

Deleveraging by inflation after WWII

100 80 (%) 60 40 20 0

20

20

20

19

19

19

19

19

19

19

19

19

19

19

19

19

12

06

00

94

88

82

76

70

64

58

52

46

40

34

28

22

Gross US Federal Debt/GDP; usgovernmentdebt.us

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As interest rates fell below inflation in the 1970s, the price of gold bullion soared. Its price only came back to earth once the Federal Reserve hiked rates to well above the rate of inflation. Gold’s present bull market really got underway in 2001, as the Fed and other central banks began to pump mega-liquidity into the system in a bid to keep the show on the road. These policies have far to run, in my view. Deleveraging has yet to begin in any meaningful way, as evidenced by America’s ratio of gross federal debt to GDP. This picture is repeated around the developed world, including in the UK, across much of Europe and Japan. Any significant rise in real rates would be extremely painful for governments and consumers across the world. Once the inflationary inevitability of this situation becomes more apparent, the price of gold should resume its mighty uptrend.

Gold & gold miners: the record How gold miners have fared vs gold bullion and the wider stock market Gold bullion has no yield. In fact, it costs money to own, including storage, insurance. This puts it at a serious long-term disadvantage vis-à-vis equities, whose income can be reinvested. That said, gold has held its own over recent decades. An investment of $100 at the start of 1970 would have been worth $4726 by the end of 2012, despite its lack of reinvested income, but ignoring storage, insurance and other costs. A holding in the MSCI World Index since 1969, meanwhile, would have become $4749, including the effect of reinvesting dividends.

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Gold vs developed market equities since 1969 10000

BULLION 1000

MSCI WORLD (TR)

100

10 1969

1974

1979

1984

1989

1994

1999

2004

2009

Source: Thomson Datastream

Of course, this comes after a bull market in gold lasting more than a decade and a secular bear market in equities for much of that time. The nature of the way in which these returns have occurred is markedly different. Gold’s lack of yield really counted against it during its long bear market between 1980 and 1999, when its price fell from $875 to $253.

However, you would have been better off still had you invested entirely in world gold mining equities, so long as you’d reinvested the dividends.

Effects of investing $100 in 1973

Gold bullion MSCI World Index Global gold mining stocks

Capital return ($)

Total return ($)

$2497 $1023

$2497 $3270

$1775

$5431

Source: Thomson Reuters Datastream; 1973-2012

While gold bullion produced the best capital return of the lot between 1973 and the end of 2012, with $100 becoming $2497, gold mining stocks went from $100 to $5431 on a total-return basis. This underlines the terrific power of dividend reinvestment over the long run.

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Gold miners: digging further back Gold mining stocks go back not just decades, but centuries What about gold miners' performance over the very long run, though? The most complete total return series I have for gold mining stocks is the data-set I have already mentioned, compiled by Thomson Reuters. (We will look more deeply into its make-up later on.) However, there are longer running price series, such as the Barron’s Gold Mining Index (BGMI), which goes right back to 1939. A $100 investment in the BGMI in February 1939 would have grown to $324 by the end of 1972. By contrast, a holding in the S&P 500 index went from $100 to $1057. Still, the BGMI addresses only US- listed gold mining companies, whereas I suggest investing in the sector globally. The US gold market was also one of the worst performers of the leading gold markets over the 1973-2012 period, producing a capital return of 471.5 per cent, compared to 1675 per cent for the global sector.

Lacking dazzle: US gold miners since 1939 100000

S&P 500 10000

BGMI 1000

100

10 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

Barron's; Investors Chronicle

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When bullion is better Gold mining shares have beaten bullion in recent decades, but not at all times We have seen that the total return on global gold mining has beaten both gold bullion and developed market equities as a whole since 1973. This stems from the reinvestment of dividends, and gold miners’ potential for gains when stocks are rising but gold is falling. However, it is important to note that during an actual gold bull market, the yellow metal has done better than the companies that dig it out of the ground. In the 1970s boom, gold bullion went up by 1163 per cent, compared to just 302 per cent for world gold miners, after taking reinvested dividends into account.

Gold Bullion Australia Gold Mining Canada Gold Mining South Africa Gold Mining UK Gold Mining US Gold Mining World Gold Mining

1973-80 (%) 1163 8828 242 337 207 302

1999-2011 (%) 651 2147 529 311 4349 326 586

Source: Thomson Datastream, returns in USD

This situation has been repeated during the present bull run. Measured from the absolute low in the summer of 1999 to the peak in September 2011, bullion rose 651%, whereas the total return on world gold miners was 586%. What about picking an individual country’s gold sector instead of the world index? The only major nation whose gold mining sector’s total return has exceeded the performance of the gold price during both gold booms is that of Australia. Gold mining in Canada, South Africa, and the US has done worse than the yellow metal itself during both gold booms. Rather than trying to pick winners from the individual gold markets, seeking global exposure is my preferred approach.

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Spreading risk with gold & miners Gold bullion is better for spreading portfolio risks than gold mining equities Owning gold is a great way of spreading risks elsewhere in one's portfolio. The yellow metal has very much tended have a life of its own, sometimes even moving in the opposite direction to the stock market. This chart shows the rolling two-year correlation between developed market equities (the MSCI World index) and gold bullion. Over time, there has been pretty much no correlation between the two - an average of 0.09. (1 represents perfect correlation, 0 no correlation, and -1 perfect negative correlation.) Bullion-stocks relationship P o vits e ylc o re la te d

1.0 0.8

Positively correlated

0.6 0.4 0.2 0.0 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 -0.2 Negatively correlated -0.4 -0.6 -0.8 -1.0 Thomson Datastream.

The global gold mining sector is strongly correlated with the price of gold bullion. The average correlation over time has been 0.7. During the present bull market, this relationship has become strengthened.

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Gold mining is also somewhat correlated with developed market stocks, as measured by the MSCI World Index. The average correlation over time has been 0.3. So, while adding gold mining stocks to a portfolio of developed-world stocks does offer some diversification benefits, those benefits are less than those available from adding gold bullion to the same portfolio. Gold miners-MSCI World correlation

0.9 0.7 MODERATE CORRELATION 0.5 0.3 0.1 -0.11975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 -0.3 -0.5

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The drivers of gold mining shares The key forces that influence the performance of the gold mining sector Among the main forces that drive the price of the gold mining sector are: Changes in real interest rates - negatively Changes in the Trade-weighted US dollar - negatively Changes in the price of gold bullion - positively Valuation (the level of the dividend yield) - positively The next chart shows the influence of real interest rates on the sector's performance. When real interest rates plunged in the early and late 1970s, the world gold mining sector soared. Rising real rates in the 1980s and 1990s caused the sector to struggle, even though stocks more generally were gaining strongly.

Real rates and mining's moves 15.0

200 DEEPLY -VE REAL RATES, SOARING GOLD MINERS

150

RISING +VE RATES, FALLING GOLD MINERS

100

50 0.0

13

10

07

04

01

98

95

92

89

86

83

80

77

74

0

20

20

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-5.0

G o ld m in in g (% )

5.0

19

R e a l in te re st ra te c h a n g e (% ), 1 y r

10.0

-50

-10.0

-100

Thomson Datastream

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Since 1990, around three-quarters of the gold mining sector's price movements can be explained by just three factors: US consumer price inflation, the price of gold bullion, and the level of the dividend yield. Its performance has been negatively related to US inflation – most likely because 1980s and 1990s was properly compensated for with positive real rates - and positively related to the gold price and the dividend yield.

Carat-crunching Weighing up the valuation of the global gold mining sector World gold mining has performed poorly since reaching an all-time high in September 2011. The correction in the price of bullion, tighter real interest rates, and lately, the stronger US dollar are some of the macro factors that have contributed to its lousy showing over the past 18 months or so. As a result of this, the sector now rates as fairly good value by two metrics. Its trailing price/earnings ratio of 20.6 is below the long-term average of 23.8. The sector looks especially cheap based on price/book value, with today's multiple of 1.5 - around half the long-term average of 2.9. The dividend yield of 2.1 per cent is admittedly below the long-term average of 2.8 per cent, but is well above the all-time lows of 0.4 per cent.

Price/Earnings

Dividend Yield (%)

Price/Book

Today

20.6

2.1

1.5

Average Max Min

23.8 83.5 3.9

2.8 10.8 0.4

2.9 10.7 1.0

Datastream

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The dividend yield is also at its highest level in a decade.

Gold miners' dividend yield 1973-present

12 10 8 6 4 2 0 1973 1978 1983 1988 1993 1998 2003 2008 2013 Thomson Datastream

While I like to focus on the dividend yield as a measure of valuation - being a real, unmanipulable metric, as well as a key component of returns - I am particularly drawn to the bullish valuation case based on price-to-book value. Based on the relationship over time, there is an 85 per cent probability of global gold mining achieving a positive return - greater than zero - on a one-year view. The median twelve-month return when the price-to-book ratio has been between 1.15 and 1.63 has been 25.9 per cent.

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Timing gold mining Our momentum model has beaten buy-and-hold but with far less risk Global gold mining's outperformance of the MSCI World index since 1973 underlines the case for buying and holding this industry over time. My focus here, though, is upon seeking tactical long positions at the best possible times, with the goal of increasing returns and better controlling risk. For this purpose, I have built a momentum-based model that aims to capture the best of the upside in global gold mining. Since its first signal, it has delivered slightly better annualised returns than simply buying-and-holding over the same period: 7.97 per cent vs 7.50 per cent. This outperformance was delivered with less than half the risk of buy-and-hold. Smoother returns from gold mining

2000 1800 1600 1400 1200 1000 800 600

BUY-and-HOLD

400 200

SYSTEM

0 1979 1983 1987 1991 1995 1999 2003 2007 2011 This is best understood when seen on a chart. Notice in particular how the system dodges most of the worst falls in the gold mining over time, as represented by the flat-lined periods at the times where the sector is dropping hard.

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The main element of risk control is a stop-loss set 15 per cent away from the opening price. I have not assumed that interest is earned during those flat, "out of the market periods", so returns could clearly be enhanced by investing in T-Bills or the equivalent while awaiting the next buy-signal. Clearly, the performance of this system would have been very much enhanced during the 1980s and 1990s at the prevailing rates of short-term interest at that time. Our model's buy- and sell-signals

Metastock chart

The system's last signal - a sell - was generated in July 2011, as the sector was effectively forming a major top. Since then, it has been out of the market, while buyand-hold investors have suffered a drawdown of some 27 per cent. The last four signals are shown on this chart. The buys occur once the uptrend is somewhat established, while the exits occur ahead not far off the top of the market.

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A more complete summary of the system's performance next to buy-and-hold is shown in the following table.

SYSTEM

BUY & HOLD

Annualised return (%)

7.97

7.50

Annualised volatility (%) Annualised excess rtn (%)

4.31

9.54

5.63

2.10

Sharpe ratio

1.31

0.22

Trades (#)

15

1

Wins (#)

11

-

Median/ave. return (%) Maximum return (%) Minimum return(%) Median wks per trade Longest trade Shortest trade

14.1/23.3 86.0 -16.0 22 1190 14

-

Thomson Datastream

How to invest in gold mining Diversification is the best route and it has never been easier to achieve There is always a temptation to try and pick the "next big thing" in gold mining, perhaps more so than in most other sectors. Unexpectedly successful exploration or production can lead to sky-high returns, especially in the small-cap domain. This report has focused on the effects of taking a broad, internationally-diversified approach and this would be my preferred approach for investing in the sector. For the purposes of my research here, I have used the Datastream World Gold Mining index, a creation of Thomson Reuters, a financial database provider. The index is made up of entire countries' gold mining sectors from a basket of leading and lesser stock markets around the world.

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Who's who in DS Global Gold Mining

UK 7.3%

US 11.5%

Others 0.4%

Turkey 1.6%

Australia 9.4% China 0.9%

South Africa 8.1% Canada 52.9%

Russia 2.9% Peru 5.0% Thomson Datastream

While this index gives a good idea of the performance of gold mining stocks from around the world over time, it has the major drawback of not being directly investible. Fortunately, there have never been more easily-accessible vehicles that offer diversified exposure to the global mining sector as there are today. These include funds that closely track the DS World Gold Mining Index.

ETFX DAXglobal Gold Mining Fund (AUCO) Market Vectors Gold Miners ETF (GDX) iShares MSCI Global Gold Miners ETF (RING) Market Vectors Junior Gold Miners ETF (GDXJ) Global X Pure Gold Miners ETF (GGG)

Tracks

Exchange

DAXglobal® Gold Miners Index

LSE

NYSE Arca Gold Miners Index (GDM)

NYSE Arca

MSCI ACWI Select Gold Miners Investable Market Index

NYSE Arca

Market Vectors Global Junior Gold Miners Index

NYSE Arca

Solactive Global Pure Gold Miners Index

NYSE Arca

Providers’ websites

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To give just one example, ETFX DAXglobal Gold Mining Fund USD is an ETF that trades on the London Stock Exchange under the ticker AUCO.L AUCO's performance versus that of the DS World Gold Mining sector can be seen in this chart.

310 DS WORLD GOLD MINING

260

210

AUCO

160

110

60

10 2006

2007

2008

2009

2010

2011

2012

2013

Thomson Datastream

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Conclusions While gold mining is already cheap, we are awaiting a tactical buysignal

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Gold bullion is set to benefit from central banks’ deliberately attempts to deleverage by inflation



The global gold mining sector has beaten developed market stocks generally over the last 40 years on a total return basis, as well as gold bullion.



The very long-term price performance of the US gold mining sector has not been impressive, but this has few implications for global gold mining as a whole.



Gold bullion is a better bet than gold miners during a gold bull market, such as I believe we are currently in.



The Australian gold mining sector has beaten gold bullion in both the 1970s boom and since 1999.



Gold mining is strongly correlated with the gold price.



Gold bullion is better than gold mining for diversifying a portfolio of developed-market equities.



Three-quarters of the variation in world gold mining stocks can be explained, statistically speaking, by the gold price, US inflation and valuation.



World gold mining currently looks cheap based on its price/book multiple, while its dividend yield is at its highest level in a decade.



Our momentum-based tactical model has outperformed the gold mining sector over time, but with far less risk. It has been out of the market since July 2011.



An ETF that tracks with the global sector is the best way to get exposure to the sector once the next tactical buy-signal occurs.

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© The Financial Times Ltd 2013. Investors Chronicle is trademark of Financial Times Ltd. “Financial Times” and “FT” are registered trademarks and service marks of the Financial Times Limited. All rights reserved. No part of this publication or information contained within it may be commercially exploited in any way without prior permission in writing from the editor. Material (including tips) contained herein is for general information only and is not intended to be relied upon by individual readers in making (or refraining from making) any specific investment decision. Appropriate independent advice should be obtained before making any such decisions. Financial Times Business Limited does not accept any liability for any loss suffered by any user as a result of any such decision. Do remember, particularly if you are new to stock market investment, that the prices of shares and other investments can fall sharply. You may not get back the money you originally invested. Past performance is not necessarily a guide to the future. In comparing the investments described in this publication, you should bear in mind that the nature of such investments and of the returns, risks and charges differ from one investment to another. Smaller companies with a short track record by their nature

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