Anybody fancy buying gold miners?

May 21st, 2013 | By | Category: Commodities

By David Stevenson

Anybody fancy buying shares in gold miners? Thought not. And if they’re small-cap gold miners….are you mad?!

As a fairly sophisticated readership, I’m aware that ETF Strategy fans won’t need to be reminded of the double, or even triple, jeopardy facing investors in gold mining shares, especially those in smaller, junior outfits. But just in case you do…

Anybody fancy buying gold miners? David Stevenson on gold equities and gold mining ETFs

Anybody fancy buying gold miners?

Jeopardy number 1 is that there must be a damned decent chance that gold prices could go even lower, testing first $1350 a troy ounce and then $1250. With the great institutionally driven stampede into equities only just beginning, I reckon there’s a good chance that at the margins there’ll be plenty of sellers of gold as multi-asset class investors look to trim their losses to the shiny stuff.

Jeopardy number 2 is that gold miners, large and small, are always regarded as a geared play on the underlying spot price, with the gearing currently acting as a powerful negative dynamic. The obvious logic here is that of operational gearing, with various trigger levels (many lurking around $1100 an ounce) at which point mining becomes fundamentally unprofitable. There are also some obvious market-specific issues including vast capex over spends by the gold mining majors, and increasing pressure on leading low-cost producers to shelve new projects and focus on paying their long-suffering shareholders a dividend.

Jeopardy number 3 is that smaller-cap miners face an existential challenge, powered by capital markets that have fundamentally frozen up. If you’re unlucky enough to own a mine project that is midway through development and you don’t have enough capital, your options are extremely limited. Banks won’t fund. Equity investors, especially active fund managers, are suffering from massive outflows, restricting their ability to fund projects whilst bond markets are non-existent for smaller companies except perhaps prohibitively expensive convertibles issuance, which will probably result in the asset being snatched back by bond holders.

Given this hideous backdrop it’s not surprising that gold miner funds – both passive and active – are experiencing hideous outflows. The only ray of hope is that asset flows around physical gold exchange-traded products appear to be quite resilient, with many private investors in particular looking to quietly increase their physical gold holdings as prices fall.

I’d also point to two other powerful positives. The first is that central bank demand is still strong, despite recent selling by the Cypriot central bank. These ‘official sector’ buyers bought 534.6 tonnes last year, the most since 1964, and may add as much as another 550 tonnes in 2013. The second is that investor demand from China for gold is accelerating at a frightening pace, with local investors looking for a hard currency alternative for their growing personal wealth.

Yet even with these positive drivers, I think there’s a good chance that gold prices could test that $1250 barrier, especially if the European Central Bank eventually decides that a gruelling diet of day-in, day-out austerity  is too much. Decisive central bank intervention to push the global growth rate higher could be the short-term death knell for gold prices, which could be particularly dire news for gold miners, especially those in the small-cap space.

But, in a strange and rather perverse way, despite all this grim news, I find myself looking afresh at the gold mining equity funds on the market and wondering whether now is the time to start quietly increasing my exposure.

In essence, investors face two equally dismal choices. Do they first focus on investing with an active fund manager who will ‘know’ which miners to back or do they invest in a passive ETF that holds a specified broad basket of gold equities? The second equally lethal choice is whether they should back larger lower-cost miners, such as Randgold, or bet on junior miners where the risk/return trade off could be huge?

On the passive vs active debate, I’m afraid to report that active fund managers are doing slightly less worse than their passive peers (my colleague Simon Smith reckons this is probably simply a function of active fund managers’ increased cash holdings, rather than specific stock selection skill).

In ETF land there are four main choices for UK investors (all listed on the London Stock Exchange, sorted by TER):

iShares S&P Commodity Producers Gold ETF (SPGP)
Tracks the S&P Commodity Producers Gold Index. This index provides exposure to the largest publicly traded companies involved in the exploration and production of gold and related products from around the world. Major holdings include Goldcorp, Barrick, Newmont, Newcrest and Yamana. (TER 0.55%).

UBS-ETF Solactive Global Pure Gold Miners (UC53)
Tracks the Solactive Global Pure Gold Miners Net TR Index. Down a whopping 40% over the 12 months to the end of April 2013. This index tracks a more diverse group of gold miners, including Alamos Gold, Randgold, Polyus Gold, and Alacer Gold, and tends to have a stronger correlation to the spot gold price. (TER 0.60%)

ETFX DAXglobal Gold Mining ETF (AUCP)
Linked to the DAXglobal Gold Miners Index, which is down 35% over the 12 months to the end of April 2013. The index’s top holdings include major names such as Goldcorp, Newcrest, Barrick, Newmont and Yamana. (TER 0.65%)

RBS Market Access NYSE Arca Gold Bugs Index ETF (GOLB)
Linked to the popular NYSE Arca Gold Bugs Index. The major constituents are the big name firms, such as Barrick, Goldcorp, Newmont, Yamana and Anglogold Ashanti. This index is also down 35% over the last 12 months. (TER 0.70%)

Over in the active space, there’s a slightly larger collection of funds including the CF Ruffer Baker Steel Gold unit trust gold fund. This combines the sector specific skills of the Baker Steel team (who also manage a well respected London-listed closed-end fund vehicle) and the wealth management expertise of Ruffer. This unit trust was down a slightly less ghastly 28% in the 12 months to the end of March 2013, and -23.5% over the previous twelve months. Its list of top stocks includes a ‘who’s who’ of well regarded small-cap miners (all of whom have had an absolutely horrid time in recent years) including companies like Archipelago Resources, Harmony Gold Mining and Metals Exploration.

BlackRock’s widely respected Gold and General fund is down a little less over the same period but that’s because it’s much more skewed towards the large-cap, low-cost gold miners who’ve fared slightly less worse over the last few years. Total expense ratios (TERs) for both of these funds is north of 1.75% per annum depending on what class you’re invested in, but these recent losses do suggest that some value can be perhaps added by experienced sector-specific fund managers when compared to a passive fund. The downside of that active management is that a decent chunk of downside risk control is eaten up by much higher charges.

My own sense is that when gold prices do rebound – a big if – we could see the price of gold equities shoot up sharply again, with small-cap gold miners in the vanguard. To understand just how big this swing could be, it’s worth looking at the example of the CF Ruffer Baker Steel fund, for instance, which romped ahead 69% over the 12 months following the end of March 2009. My only concern would be that if sentiment did rebound for gold mining stocks, the entire sector would move ahead, with active fund managers failing to add much value to a momentum-driven trade – at this point the passive ETFs, with their inbuilt 1% per plus per annum cost advantage and reduced cash drag, might be the better bet.

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