A Golden Year: Beyond 2019

Earlier this year, we discussed the benefits of investing in precious metals, and several means of doing so (in this article). Given the strong rise in gold prices this year, we take another look at the best way to maintain exposure to this asset class. 

Investing in physical bullion can be complicated for the everyday investor, so we’ll be focusing on options 2 & 3: Gold mining stocks (GDX) which track the performance of mining companies, and physical prices (GLD), which track the actual commodity price. 

Gold mining companies are leveraged to the price of gold and are ideal when prices are rising (which has happened this year). Tables 1 & 2 illustrate how profit margins for a gold mining stock increase dramatically as a result of this leverage.

Table 1: YTD company XYZ profitability change

Table 2: YTD company XYZ profit vs gold price change

​For this example, we assume the cost to produce an ounce of gold for this mining company is $1,000/oz, which is about average. In practice, the cost generally remains unchanged with gold price fluctuations, therefore, is kept constant at $1,000. Notice how profits have increased 77% per ounce of gold since the start of this year, a profitability increase that was achieved when the price of gold itself only increased 17%. 

​GLD & GDX Performance

Figure 1: YTD GDX vs GLD performance comparison (Source: Google Finance)

​Moving forward, we determine if gold miners are still poised to outperform. The mining industry is notoriously challenging; here are some common issues:

• The industry is known for bad management. Talent is diluted across many small entities. Industry overhead (CEO salaries in particular) is thus spread across many firms.
  • The top 25 companies combined are smaller than Exxon Mobile (XOM) or Johnson and Johnson (JNJ).
• Accessible gold fields are few, and companies are limited in regard to investment opportunities.
• The industry is prone to inflows of speculative capital. Hence, stock prices are volatile under often-misguided assumptions of higher prices, increased production, and expensive takeovers.
• They lack a moat and brand. Nobody cares who produces a bar of gold or silver, and market participants have no control of supply.

These flaws have led to a loss in shareholder value over the long-term. Figure 2 shows that the price of gold is up 120% since 2006, while the mining ETF has declined 30%. With this in mind, it’s important to be intentional with this type of holding. 

Figure 2: GDX vs GLD performance comparison since 2006 (Source: Google Finance)

​Hui-Gold Ratio: One way to determine if mining stocks are worth investing in

The “Hui-Gold Ratio” (ratio of the Goldbug index to the price of gold) is a way to determine if gold miners are attractively priced, relative to the price of gold. The Goldbug index tracks gold mining companies, and the lower the value of the ratio, the cheaper the gold miners are in relation to gold prices. 

Figure 3: Hui-Gold ratio chart 2016-17 (Source: Macro Trends)

​​At a historical low of 0.10 in 2016, the index represented a fantastic buying opportunity for gold mining stocks. Gold miners exploded higher when the ratio rebalanced up to 0.20 by that summer (Figure 3). It’s worth noting that today, the Hui-Gold Ratio is still relatively low compared to the past decade, but gold miners are certainly not the screaming buy that they were back in 2016. 

Looking Forward Post-2019​

​Precious metals are often uncorrelated to traditional asset classes and are a crucial element to a well-rounded portfolio. We like to hold at least 5% of assets in this category. After the run we’ve seen in 2019, it is logical to consider shifting some gold miner profits into the price of gold (GLD). As always, diversification is key.

Past performance is no guarantee of future results.