Fool's Gold?

 Market Vectors Gold Miners ETF (GDX) came strong out of the gate in 2014, after posting three consecutive years of negative returns--declining nearly 66% in aggregate from 2011 through 2013. Is it finally gold miners' time to shine? With a current price/fair value ratio of 0.83, GDX is currently the cheapest of all of the exchange-traded funds for which we calculate this metric. But is there real value here, or are miners stocks just fools' gold? Here's the acid test on GDX.

Suitability
Gold miners' failure to ride the gold bull market up has traditionally been blamed on the rise of physical gold ETFs, which supposedly drew away investors who had used mining stocks to obtain gold exposure. While there may a smidgen of truth to the story, it doesn't explain gold miners' continued weakness (markets are forward-looking) or the fact that miners underperformed gold even before the rise of ETFs.

A better explanation: Gold miners have historically been terrible capital allocators in an industry that requires continuous capital expenditures to replace tapped-out mines. For most of the bull market, miners kept payouts low, using their surging profits to acquire or develop more mines, the symptom of a short-sighted growth-at-all-costs mind-set. They issued torrents of new 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% annualized, while their aggregate price grew only about 7.7% annualized. The 8% annualized gap between market cap and price performance represents share dilution. History shows that share issuances tend to 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.

If the miners had just focused on returning cash to shareholders and keeping costs down, their stock returns would have been a sight to behold. It takes a colossal effort to fail to exploit operational leverage when the prices of your goods are skyrocketing. I'm sympathetic to the common opinion that gold miners are some of the worst-managed firms out there.

So, why own gold miners now after a history of epic waste, mismanagement, and, in some cases, fraud? First, the market has wised up to the sector's deficiencies. Miners now trade at very low valuations. The irony is this near-death experience is the catalyst needed to set gold miners straight, to clean out incompetent managers and hire people who'll focus on prudent capital allocation. Second, miners are now an attractive substitute for physical gold exposure. Finally, miners don't actually have to provide exceptionally high returns to be worthwhile because their low correlation to conventional stocks and bonds mean they can improve a portfolio's overall risk-adjusted returns.

Fundamental View
It's generally not a good idea to own firms that require large, ongoing capital expenditures under conditions of high uncertainty. Humans are overconfident and optimistic, so they tend to overestimate the rewards and underestimate the costs of major capital expenditures (whether it's a merger, a tunnel connecting New Jersey to New York, or a new mining complex). Managers are rewarded for short-term performance, but shareholders end up with long-term performance, so it's no surprise that managers often overstate the rewards of these big projects that don't pay out until years later.

There's also that dreaded institutional imperative at work, the tendency for managers to grow their companies just for the sake of growing. These aren't insoluble problems, of course. Oil firm  Exxon Mobil (XOM) has faced similar problems and made shareholders a lot of money. XOM achieved this in large part because of its shareholder-centric culture. XOM's dividend has steadily grown since the 1970s. Few gold-mining firms have shown a similarly obsessive focus on prudent capital allocation and sustainable growth over as long a period. Of those Morningstar equity analysts cover, only  Eldorado Gold Corp (EGO) earns the highest Stewardship Rating of Exemplary. Analyst Kristoffer Inton has written that only EGO has an economic moat as it, "boasts lower production costs relative to the rest of the gold mining industry, with total unit cash costs of just $551 per ounce in 2013, compared with the average industry figure of close to $700 per ounce." However, both firms were founded in the 1990s, whereas gold-mining has been a business for centuries--where did all the wide-moat firms of yesteryear go? They probably never existed.

David Einhorn is perhaps the most famous gold-miner bull right now (though there are plenty of others). As of Dec. 31, 2013, his hedge fund Greenlight Capital owned 8.8 million shares of  Market Vectors Gold Miners ETF (GDX), making him the fund's fifth-biggest institutional shareholder. Einhorn said in November 2011, "With gold at today's price, the mining companies have the potential to generate double-digit cash flow returns and offer attractive risk-adjusted returns even if gold does not advance further." GDX was then trading at nearly $60 a share. Now it's trading under $25 as of this writing.

Over the long run, gold miners will probably fail to offer attractive risk-adjusted returns, barring a big runup in gold prices or a cultural sea change. In the medium term, gold miners look like a decent buy. They could be a good long-term buy if managements are competent and gold prices don't take a nosedive. Two big ifs.

Portfolio Construction
This fund tracks the NYSE Arca Gold Miners Index, a modified market-cap-weighted  benchmark of companies involved in gold and/or silver mining whose common shares, American Depository Receipts (ADRs), or Global Depository Receipts (GDRs) are listed and electronically quoted on a major exchange that can be accessed by foreign investors. Although most of the fund's holdings are primarily focused on gold mining, it also includes a handful of silver miners, such as Silver Wheaton Corp (SLW). Most of the fund's holdings are based outside the United States. Because the gold-mining industry is top-heavy, the index has diversification rules. No single stock can make up more than 20% of the portfolio, and stocks that each make up more than 4.5% of the portfolio are capped at 50% of the index's total assets. Despite the rules, the top three holdings make up more than a third of assets. The index composition is reviewed and rebalanced quarterly.

Fees
The fund carries a reasonable 0.52% price tag, similar to comparable equity precious-metals funds. However, funds that hold the physical commodity are a bit cheaper. Van Eck has hired the Bank of New York Mellon as the fund's securities lending agent, who on behalf of the fund lends out the underlying shares for a bit of extra income. The funds pay "reasonable fees" and may share some of the income with the lending agent, but the annual report is vague as to how much the fund is paying the agent. GDX is probably best held in a taxable account. Its high volatility means it offers ample tax-loss-harvesting opportunities. And its heavy international stake means U.S. investors may be able to recover some of the funds' foreign withholding taxes by taking a tax credit or deduction.

Alternatives
GDX doesn't face much competition. It is by far the biggest, most liquid gold miner ETF, though not the cheapest. The second biggest miner fund is  Market Vectors Junior Gold Miners ETF (GDXJ). It charges a tad higher expense ratio--0.55%--and invests in "junior miners," which are typically focused on the exploration and initial prospecting. The lotterylike payoff structure of this market segment has historically meant low risk-adjusted returns, as investors have been willing to pay dearly for the dream of hitting it big.

The lowest-cost fund, iShares MSCI Global Gold Miners (RING), charges 0.39%, but its assets and secondary market liquidity are negligible. Unlike GDX, RING is able to own stocks listed on foreign exchanges, lending the fund a more mid-cap flavor.

Investors looking for direct exposure to gold should consider SPDR Gold Shares (GLD) or iShares Gold (IAU). GLD is more heavily traded than IAU, but its 0.40% expense ratio is higher than IAU's 0.25%. GLD can be cheaper than IAU for rapid-fire traders who turn over their positions frequently owing to the fund's narrower bid-ask spread as a percentage of price.

 

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