Minding Miners' Beta and Leverage
Gold miners or bullion given uncertain U.S. debt circumstances.
Gold miners or bullion given uncertain U.S. debt circumstances.
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.
The current price of gold sits well above the break-even price for most firms within the industry, which tends to fall within a rough range of $500 to $700 per ounce. At around $1,600 per ounce, even a 20% decline in the price of gold will leave most miners deep in profitable territory. Under current circumstances, it is likely that much of the operational leverage that miners can offer existed at much lower price levels.
The Short-Term Case for the Miners
There are a number of reasons for those interested in exposure to gold to consider an equity-based offering. First, the equities appear a bit cheaper than bullion on a relative basis. While gold equities have appreciated nearly 50% over the last five years, the physical metal's price has gone up 3 times more.
Indeed, our equity analysts believe that the stocks in the gold-mining sector are approximately fairly valued at this point. The quirk, however, comes in their long-term forecast for gold prices. Along with several other analysts on the street, they are using more-conservative gold price estimates a few years out than the spot price is showing today. To get to their price estimates of the equities, our analysts are using a gold price estimate of just $1,100 over the longer term. If that price proves too conservative, the equities should perform better relative to bullion.
While the gold-equity ETFs lost some of the gearing properties that made them great speculative tools, the absence of operational leverage at these price levels may provide them with a valuation ballast. When a debt plan is passed, gold is likely to see a correction. So long as that correction leaves the price of gold well above break-even ranges, however, the equities are likely not to see a leveraged move to the downside.
We also ran a statistical test to determine how much each of two factors contributed to the "gold miners" index (AMEX Gold Miners Index). We ran a regression on the performance of this index against both the broad market (S&P 500) and the price of gold (London Fix). Using the past 10 years of data, we find that the miners have maintained a coefficient of approximately 0.5 to the broad market and 1.5 to gold bullion. What this shows is that gold prices are more important to the performance of the miners, but that the performance of equity markets still matters considerably.
These figures provide another point of support for the downside protection that the gold equities may provide. While the miners' long-term tracking of gold is diluted by exposure to the overall market, that exposure should prove beneficial given a debt resolution. If a resolution passes, the broad equity space is likely to rally; and while the price of gold may see a bit of a correction, the downside to the miners will be dampened by their beta to the overall markets.
Abraham S.H. Bailin does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.