Precious-Metals Equities: A Pocket of Cheapness in a Fairly Valued Market?

Note: This article is part of Morningstar's December 2014 Guide to Better Investment Picking special report. An earlier version of this article appeared Oct. 29, 2014.

The pickings have been slim--and getting slimmer--for bargain-hunting investors. 

But contrarian-minded sorts may be able to spot a glint of opportunity in an extremely unloved area: gold-mining stocks. 

While equity investors had a brief opportunity to scoop up beaten-down stocks earlier this month, the broad equity market has staged a strong comeback since. The average stock in Morningstar's coverage universe is now trading slightly above its fair value--not egregiously expensive, but not cheap, either. 

Meanwhile, a handful of sectors have stubbornly refused to come along for the ride. One is energy, which remains the most undervalued in Morningstar's coverage universe. Another pocket of potential opportunity is in gold-mining stocks. The sector is notoriously volatile and investors have historically done a poor job of timing their purchases and sales. But investors who are willing to look beyond the sector's ugly near-term numbers are apt to find this is a much more attractive entry point than 2009 and 2010. In those years, investors bought into precious-metals equities amid robust performance from the asset class, and steered even larger sums to exchange-traded funds that buy gold bullion, especially SPDR Gold Shares (GLD).

The Case for an Unloved Asset Class
Asset-allocation guru Bill Bernstein laid out the case for precious-metals equities in this video. His central assertion is that precious-metals equities add a diversification benefit to investors' portfolios. That's borne out by the data: Over the past five years,  Market Vectors Gold Miners (GDX)--an exchange-traded fund that is a pure play on the sector--has an R-squared (a measure of performance correlation) of just 3 with the MSCI All Country World Index. Most traditional mutual funds that buy gold-mining stocks aren't pure plays--they might own companies that mine other metals as well as gold--but they illustrate the diversification benefit of holding precious-metals stocks, too. Over the past 15 years, the typical precious-metals fund has an R-squared of 15 with the MSCI All Country World Index. 

In addition to the portfolio case for holding gold-mining stocks, Bernstein argued that the timing looks good. Gold stocks went up with other equity assets in 2009 and 2010, but they've been in the dumps ever since. In fact, stocks in the gold-mining industry have posted the worst returns of any industry group over the past three years--worse than even the beleaguered coal industry. In addition to getting hurt by the recent drop in gold prices, mining stocks have suffered from decades' worth of poor capital-allocation choices, as exchange-traded fund strategist Sam Lee outlined in this report. 

Of course, those problems won't go away overnight: Historically, poor capital-allocation choices on the part of management are one of the key reasons why most of the gold miners that Morningstar covers do not have moats--sustainable competitive advantages. And at a minimum, gold miners will be buffeted around by fluctuating gold prices, which is one of the reasons that nearly all the companies we cover have fair value uncertainty ratings of high or very high. Given the high volatility that is apt to accompany any gold-related investment, investors must have a long time horizon and should also limit their position sizes. (Five percentage points of a portfolio seems like a reasonable upper limit.) 

Those caveats aside, the stocks look fairly inexpensive to Morningstar's equity analyst team right now. Of the nine gold-mining stocks with analyst coverage, the average price/fair value is just 0.70. Meanwhile, six of the nine companies earn 4 or 5 stars currently. Morningstar analyst Kristoffer Inton, who covers gold-mining stocks, says that attractive valuations owe to a couple of different factors. One is that Morningstar's price forecast for gold--$1,255 per ounce by 2017--is higher than the current spot price--$1,226 as of Dec. 10. But that doesn't account for the entire discrepancy, Inton said. "Gold stocks appear to be pricing in worse gold prices than even today's spot. Even assuming today's price in 2017 and 2018 rather than our forecast, most of our names are still undervalued," he said. 

Bullion or Equities?
Assuming one is convinced to make a contrarian play on the unloved sector, or perhaps one wants to make a long-term investment for the diversification benefit and to get in at an opportune time, a few questions remain about how to invest in the sector. 

One of the first questions to consider is whether to invest in mining stocks--either through direct purchase of the individual equities or via a fund or exchange-traded fund--or to invest in gold bullion. Most investors have chosen the latter route in recent years: Although gold-bullion ETFs have waned in popularity as gold prices have fallen, they were among the ETF industry's top asset gatherers as gold soared during and after the financial crisis. SPDR Gold Shares currently has about $28 billion in assets, but it held nearly $80 billion in assets at its peak in 2011. The key advantages of investing directly in bullion is that it's a more precise reflection of gold prices at any given point in time. Miners, meanwhile, reflect gold prices somewhat, too, but they also pick up on company-related action, whether good or bad. "During the gold bull run that ended just last year, [bullion] ETFs outperformed gold-miner stocks, largely due to company-specific decisions that weighed on performance," says Inton. 

But investing in mining stocks can have its advantages, too. Bernstein prefers the stocks to owning bullion because they pay dividends and because an investor can hold a smaller allocation while still benefiting from the diversification. The reason investors can get away with a smaller allocation to precious-metals equities than bullion, Bernstein said, is that the equities are essentially a leveraged play on the metal and, therefore, more volatile. As a result, a 2% allocation to precious-metals equities equates to a roughly 5% allocation to bullion, he said. 

Where to Invest
Assuming an investor wants to dive into gold-mining stocks, there are a couple of key ways to go. Here's an overview of the options, as well as Morningstar's top ideas within each. 

The Pure Play: For investors seeking a pure play on the gold-mining sector, there are a few exchange-traded fund options, including iShares MSCI Global Gold Miners (RING) and Market Vectors Gold Miners, that provide diversified exposure at a fairly reasonable cost. The former is slightly less expensive than the latter, but it's also more concentrated in its top holdings. 

The Active Management Option: Alternatively, an investor might obtain precious-metals equity exposure via an actively managed fund, though most such options invest in other precious metals in addition to gold. The additional metals exposure may help curb some of the volatility of investing exclusively in gold-mining stocks, but it will also dilute performance when gold miners perform well. Among funds of this ilk, the advisor-sold  Oppenheimer Gold & Special Minerals (OPGSX) is Morningstar's sole Medalist fund, earning a rating of Silver. 

The Stock Picks: For investors aiming to hold individual stocks, Inton recommends a focus on gold miners with low production costs and a healthy pipeline for production growth. Morningstar's two 5-star rated stocks currently are  Yamana Gold and  Barrick Gold (ABX). 

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