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Minding Miners' Beta and Leverage

Gold miners or bullion given uncertain U.S. debt circumstances.

Abraham Bailin, 08/09/2011

Even though U.S. politicos appear ready to reach an agreement on the debt-ceiling front, the fiercely polarized debate has introduced uncertainty into what was previously thought to be an obligation with certainty. Some no longer consider U.S. government debts to be risk-free. Some foreign central banks seem to be speaking with their feet by diversifying away from the U.S. dollar and are considering gold to be a safe-haven asset, and its price has continued on an upward tear. Many speculate that the last-minute compromise might avert technical default, but given the inability of the political machine to reach any pre-emptive agreement, several key questions are raised for gold. For those interested in exposure to the shiny yellow metal, we discuss the primary ways to access this market in the equity-based or bullion-backed paradigm.

Both leading up to and following the market crash of 2008, gold was looked to for a number of reasons. For ages, the metal served as currency and is still likened to a monetary relative. On this basis, the crash prompted disillusionment with financial markets and an immediate interest in gold for use as a safe-haven asset and as a portfolio diversifier. Further, gold is a limited commodity that retains purchasing power even under strong inflationary pressures. The loose monetary stance adopted by the Federal Reserve only prompted renewed interest in the metal as an anti-inflationary play.

The General Consensus
When an agreement is reached, the gold price may see a correction in the short run, as the juice provided by technical default worries is sucked out of the market. The emphasis here is on "the short run," given that the market uncertainty and sputtering macroeconomic circumstances that drove gold over the last years still remain.

The proliferation of exchange-traded products, or ETPs, opened the door for investors to use varying methods to gain exposure to the precious metal. The discussion of gold exposure for investing purposes now boils down to one question: Should you use equity-based or physically backed ETPs to procure exposure?

Equity- vs. Bullion-Based Gold Exposure
Physically backed precious-metals offerings such as SPDR Gold Shares GLD or iShares Gold Trust IAU actually maintain physical holdings of bullion. In this way, the prices of their shares are backed by their respective commodities. The physical backing leads to near-perfect tracking of the price performance of the commodity, as the supply and demand for gold is the sole determinant of the value of the shares. Such razor-sharp tracking makes the physically backed offering a great tool for those looking only for gold price exposure.

This level of tracking does not, however, exist for equity-based offerings. These exchange-traded funds, or ETFs, like Market Vectors Gold Miners ETF GDX, hold the stocks of a basket of gold-mining companies. The holdings are subject to equity-specific price pressures that fall outside of the supply-and-demand construct of the target commodity, so their tracking of gold prices tends to be loose, in most cases. The reason that we consider equity-based offerings better suited to more-speculative ends in many cases is that they offer a level of operational leverage at normal gold price levels.

A small position in physical gold can make sense as part of a long-term asset-allocation plan because of the diversification it can add to your portfolio. Stocks, however, have an additional layer of equity-market risk. So, while you might invest in gold stocks for the long run, they play a different role in the portfolio than physical bullion.

Operational Leverage: Seen at 'Normal' Price Level ...
For illustrative purposes, let us assume that the current price of gold sits just below the break-even price per ounce produced for a particular mining firm involved solely in gold. Imagine that the price of gold increases to some level just above the firm's break-even price. Though the marginal increase in the price of gold may have been very small, the impact on the firm's bottom line may be quite substantial. Not only does the firm move into cash flow positive territory, but it is also able to profitably ramp up the volume of production. In this way, investors inclined to speculate on a rally in the price of gold over the short run may get a bit more bang for their buck using an equity-based offering. On the other hand, the same move in the opposite direction can provide accordingly large negative price pressure.

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