“A gold mine is a hole in the ground with a liar on top.”

--Mark Twain

“There is no rationale for owning gold mining equity.  It is as close as you get to insanity.”

--Hugh Hendry

Considering the opportunity cost of owning stocks, gold has been worse than awful for investors over the past eighteen months.  Furthermore, as a result of operating leverage, gold miners have performed significantly worse than gold.  During the past twelve months, gold prices have declined by 15%, while the HUI index has declined by 40%+.  During just the past three months, the HUI index has declined by 25%+.  As a result, relative to gold and relative to book value, gold miners are currently trading at a ten year low of Price/Book value. 

Rather than recommend an individual miner, I believe a basket approach to owning gold miners makes the most sense.  That way your business risks, exploration risks, and political risks are diversified.  My recommendation is to buy the GDX ETF.  I expect that gold prices rise from current levels and the price of gold mining stocks relative to the price of gold normalizes, resulting in more than a double from the current price. 

Why would anyone want to invest in Gold Miners?

Gold mining is an unattractive business to own in most environments.  Gold mines are capital intensive with high fixed costs.  Gold miners are price takers, with no competitive moat.  Many are run by management teams who historically have not run their businesses in the interests of shareholders.  As a result, historical capital allocation has been poor.  Over the past 10-20 years dividend payouts have been low to non-existent, and companies have issued new equity through secondary offerings to finance projects, many of which have not turned out well.

Other problems include the fact that all of the easy to find gold, for the most part, has already been mined.  Just as oil drillers are exploring tar sands and the bottoms of oceans to find oil, gold miners are drilling mines ever deeper into the ground at ever higher extraction costs.  As a result, the average all in cash costs of mining gold is currently ~$1,100/ounce, which is not far below the current price.  If the gold price continues to decline, many mines currently operating will be unprofitable.  Considering depreciation, exploration costs, interest, and taxes, all of which are not typically included in all in cash cost calculations, most gold mining companies will likely not be able to operate profitably at current gold prices.

Finally, political risk is high.  Political risk could take the form of a miners’ strike, such as what happened in South Africa recently, or government expropriation in the form of outright nationalizations and/or higher taxes.   Unfortunately, it is when the gold price rises the most that these risks become elevated. 

But then, isn’t there a price that even these horrible businesses are an attractive buy?  My argument to purchase GDX is not based on the attractiveness of the gold mining industry.  Instead, I am recommending investors buy GDX because the price is so compelling despite the unattractiveness of the industry.  To use Warren Buffett’s term, this is a cigar butt investment.

HUI Index/Gold Price

Because gold miner profits tend to go up and down with the price of gold, a useful valuation indicator is the HUI Index divided by the price of gold.  Today, the HUI/Gold ratio is lower than the level reached during 2008 and near the level that was last seen in October 2000.  I can’t figure out how to insert a chart into this report, but here is a useful chart of the HUI/gold ratio since 1997.   http://pricedingold.com/gold-stocks/  Given the volatility of gold miners and the desire to obtain a margin of safety to protect downside risk, I believe the prudent approach is to buy GDX only when the price of gold is depressed and the HUI/Gold ratio is also depressed.   Right now is one of those times. 

Gold is trading below $1,400/ounce and the HUI/Gold ratio is below 0.20.  History suggests that the risk/reward profile of the HUI index at current prices is quite favorable.  The lower the HUI/gold ratio, the more likely that future returns will likely be higher.  The last two times that the HUI/gold ratio bottomed were on 12/11/2008 and on 11/1/2000.  In both cases, the HUI/Gold ratio declined below 0.20 for a short period of time.  In both cases, HUI/Gold ratio’s decline below 0.20 coincided with a bottom in gold.  In both cases, the return on the HUI Index was over 70% in the following year.  While past performance is no indicator of future results, it makes sense that when the gold price is near a bottom, gold miners profits decline to $0 or below, and the gold miner/gold ratio would be very low as a result.

To make money on GDX, you have to see a higher gold price.  Without making any forecast as to timing, I think we probably aren’t far from a bottom in the gold price today.    JCP21’s call to short GLD back in September 2012 was a brilliant short-term trade in hindsight, but I wouldn’t want to remain short gold at the current gold price.  As I already mentioned, gold miners cannot operate profitably at current gold prices, which means that we will soon start to see supply decline without an increase in the gold price.  Furthermore, investor sentiment related to gold could not be more bearish.  And the long-term fundamentals are extremely supportive of rising gold prices, including $80bn/month of Fed bond purchases, negative real interest rates, and foreign central banks expanding their gold reserves.  Anyway, I say all this because if you are not bullish on gold at current prices, you shouldn’t own GDX.

Gold Miner Valuations

The median Price/Book value on the main constituents of the GDX Index is currently 1.1x.  In contrast, the median Price/Book value on the main constituents of the GDX Index over the past ten years has averaged around 2.8x.  Assuming a regression to the mean Price/Book value, the GDX should more than double from current prices.

 Price/Book value vs. 10 year average

Looking beyond account book value and to the value of the gold in the ground, I lean on John Doody.  Doody is a gold bug’s value investor and has a track record (audited) since 2000 of picking ten gold stocks which have significantly outperformed gold and also the XAU Index.  He writes a monthly newsletter called the Gold Stock Analyst where he picks his ten favorite gold stocks based on valuation.  The two valuation metrics he relies on are market cap/proved and probably ounces and market cap/operating mine cash flow.  According to Mr. Doody, gold mining stocks are currently trading at a deeper discount (44%) than the low of the 2008 crash in gold based on a gold price of $1,388/ounce.  For example, the average market cap/operating mine cash flow ratio is at a ten year low of 3.7x today vs. ~7.9x since 10/2008 and ~10x since 2003. 

Risks

The primary risk of this investment is that the gold price goes lower from current levels and stays there while gold miners go out of business.