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A Golden Cross to Bear

Why miners have lagged the price of gold.

Samuel Lee, 03/27/2013

Gold miners have been an embarrassment. A dollar put in gold five years ago would be worth about a $1.70 today; that same dollar in Market Vectors Gold Miners ETF GDX would be worth only $0.80. What explains this sorry performance? In theory, gold miners are supposed to have operational leverage, because their up-front fixed costs are much higher than their ongoing costs. It takes a colossal level of incompetence to have negative operational leverage when the price of your goods sold rises 70%.

The popular story is that physically backed exchange-traded funds like SPDR Gold Shares GLD came along and soaked up investing dollars that otherwise would have gone to miners, depressing their valuations. While there's some merit to the story, it doesn't explain gold miners' continued weakness (markets are forward-looking). It also seems to imply a ludicrously high premium on the convenience of owning gold via an exchange--gold certificates, futures, and even physical storage were feasible options before gold ETFs came along. Finally, it doesn't explain the abject failure of gold miners to provide leverage to gold prices before the gold ETF era.

In Exhibit 1, I've charted the cumulative total returns of the HSBC Global Gold Index and gold prices. Gold miners have for the most part tracked gold's price but with a lot more volatility. Even counting reinvested dividends, they historically have failed to offer a reasonable long-term spread over gold's returns.

The truth is gold miners historically have been miserable capital allocators in a capital-intensive industry. If the miners had just focused on returning cash to shareholders and keeping costs down, their total return would have been much, much higher. Exhibit 2 shows gold miners' real per-share dividend growth. For much of the 1990s, dividends persistently declined along with gold prices, but they only slowly grew as gold's price marched ever upward.

Miners kept payouts low, using their torrential profits to acquire or develop more mines. They issued shares to fund their spending sprees. From the beginning of 2005 to the end of 2012, gold miners' aggregate market cap grew by more than 16.0% annualized, while their aggregate price grew only about 7.7% annualized. The 8.0% annualized gap between market cap and price performance represents share dilution. Share issuances often signal future underperformance, in part because managers time the market to sell at peaks and in part because firms often fail to realize the expected benefits of major capital expenditures.

Samuel Lee is an ETF Analyst with Morningstar.
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