Any Glitter Left in Gold Miners?

It's been tough to be a gold bug during the past several years. Since September 2011, the yellow metal's price has plummeted by about 24%, while many mining stocks have fallen even further. But as gold investors know, returns can rebound in an instant. Between Jan. 14 and Feb. 11, 2016, the commodity's price climbed by 16%, and is up 23% year-to-date as of this writing. The NYSE ARCA Gold Miners Index, which includes many of world's gold producers, has skyrocketed by a whopping 91% this year as of this writing.

Gains like these don't go unnoticed: Investors have been flocking to gold-related products. According to Morningstar, $16.8 billion has gone into gold ETFs and precious metal funds this year. That far exceeds inflows into every other commodity subsector. It's also a major reversal from last year. In July 2015, about $1.54 billion left the sector, while this past July, $1.51 billion came in.

Clearly, a lot of money has already been made this year in gold, but there could still be some upside for the yellow metal. However, rather than just investing in a gold price-tracking ETF, some say investors should consider owning the mining companies instead.

Go With Gold Miners Several years ago, when gold prices were marching toward their near-$1,900 peak, the stocks of gold mining companies did well, but they didn't climb by as much as the gold ETFs. Between Jan. 1, 2009, and Sept. 2, 2011, when gold reached its all-time high, the popular SPDR Gold Trust ETF jumped by 114%, while the NYSE ARCA Gold Miners Index rose by about 94%.

Why is it different this time around? Because over the past several years, gold companies have dramatically altered the way they do business. During the the commodity's bull run, miners had no problem adding debt to their balance sheets and covering rising labor and equipment expenses. Cost cutting was not part of their vocabulary, says Shanquan Li, portfolio manager with Oppenheimer Gold and Special Minerals OPGSX. As gold prices started to fall, though, these businesses had to do something to stay alive.

Many slashed costs and began focusing on margin expansion and debt reduction.

"They got better at operating," says Dan Denbow, co-manager of USAA Precious Metals and Minerals USAGX. "They've spent the last few years focusing on themselves and they've been successful in bringing down costs." It's also helped that fuel costs have fallen and currencies in major gold producing markets, like Canada and Australia, have declined against the U.S. dollar.

Since 2012, companies on the NYSE ARCA Gold Miners index have reduced capital expenditure levels by 54% on a per-share basis, while net debt is down 28% per share from its 2013 high. Gold producers have pulled such a reversal in how they operate that they can now produce an ounce of gold for about $1,000 less than what they were able to produce five years ago, says Denbow.

Though their prices move in tandem with the price of gold, gold miner stocks are leveraged plays against the commodity's price, says Kristoffer Inton, an equity analyst at Morningstar.

"Any given change in the gold price is magnified via operating leverage," he says. "So a 1% increase in the price of gold doesn't necessarily mean an increase in free cash flow of 1% for a miner--it's usually much higher." In other words, in a normal environment of rising gold prices, gold miners should outperform gold prices, he says.

Price Potential? Of course, investors will enjoy the benefits of that leverage if gold prices continue to rise. Unfortunately, it can be notoriously difficult to know where gold prices may go, because much of the gains and losses depend on investor sentiment. Generally, if people think the economy is in trouble, gold prices will rise and vice versa. That's what we've seen this year. Alina Lamy, a senior analyst of market research with Morningstar, points out that inflows into gold-related managed products spiked in both February and June this year, the former being right after stock markets tanked in January and the latter happening during the same month as Brexit.

Lamy thinks the sector could continue to see inflows for the rest of the year at least, in part because there's still a lot of uncertainty about global growth. A rise in the Fed Funds rate could impact prices negatively--if yields climb, people may be more inclined to buy bonds than gold--but some investors think the U.S. can't handle another rate increase, which may then be a positive for gold prices.

"Gold may be perceived as a safer asset now," says Lamy.

Inton, however, expects gold prices to fall in the short-term, especially if rates rise. He thinks gold should be closer to $1,100 today and that, at some point, investor sentiment will change, driving the price down. According to his calculations, which includes rising retail demand for gold from China and India, the price of gold should reach $1,300, and stay there, by 2020.

Stock Selection Depending on where one thinks the price of gold is headed, adding a few gold stocks to a portfolio may be a good idea. Plus, because of gold's tendency to move in the opposite direction of stocks, it's long been seen as a good portfolio hedge. Gold also tends to hold its value against inflation, so if you think prices will rise, but rates will stay low, then that could be another reason to own gold or gold-mining stocks. For these reasons, many experts suggest that investors keep a small portion of their portfolio (say, 5%) in gold.

However, Inton isn't keen on gold stocks at the moment. If gold prices fall, stock prices, which have been run up and are leveraged plays on gold's price, will tumble.

"There's a lot of near-term risk, and we expect to see what we saw in December when the Fed raised rates last time," he says. "Gold prices and gold stocks took a major beating." But if the price of gold falls to about $1,100, gold stocks could slip into buying range.

One company that Inton likes during a pullback is

"It's really showing a commitment to lowering costs and being slimmer," says Inton. The stock is trading in 2-star range as of this writing, which suggests its overvalued today.

Denbow likes Randgold Resources RGORF, which doesn't use leverage, is careful with shareholder money and, unlike some other companies, hasn't been diluting stocks with equity raises. It's also a low cost producer and can continue making money in a $1,000 per ounce environment, he says.

Ultimately, whether or not one adds gold stocks to a portfolio depends on whether one wants to use gold as a hedge, where he thinks the price of gold is headed, and if he wants an extra boost that gold-mining stocks can provide. With today's miners running much smoother operations than they have in the past, now may be the best time in a long time to own a gold stocks.

"In the long term gold stocks will win the race," says Denbow. "But don't be greedy, and be patient."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.