Five Reasons Why Gold Stocks Make Sense

Gold mining stocks have soared approximately 30% so far in 2019, based on the performance of the NYSE Arca Gold Miners Index (GDM) as of November 15.1 Over the last 12 months, the sector is up nearly 50%. Some investors may assume that gold stocks have run their course. On the contrary, we think that the gold mining equities still have a great deal of upside to offer.

In brief, we think we’re in the early stages of a prolonged bull market for gold. While the relationship between the prices for gold bullion and gold stocks isn’t a linear one, rising demand for the yellow metal commodity has historically driven stock performance. Moreover, despite the recent rally, gold mining stocks have yet to recover from the beating they suffered starting in 2011. Still, recent outperformance — coupled with improving fundamentals — creates momentum, a key factor in many quantitative strategies.

Gold has been a store of value since the beginning of civilization, and yet the nuances of investing in gold — be it the metal or miners —  is still a source of confusion. As we see it, that also means opportunity.

Here are five reasons to consider investing in gold equities now.

REASON #1. Rising Gold Prices Drive Demand

Figure 1. Gold Bull Market is Just Getting Started

Source: Bloomberg as of 11/15/19. Gold was $1,514 on 11/1/19, and $1,468 as of 11/15/19. 

Gold recently broke past $1,500 an ounce for the first time since 2013 (Figure 1), as global political and macroeconomic trends are driving demand for the yellow metal. Along with other strategists, we think gold bullion could surpass its all-time high of $1,900 within the next couple of years. Key factors driving long-term demand for gold as a store of value and defensive asset, especially among central banks and institutions, include low-to-negative interest rates, rising debt levels, trade tensions and intensifying geopolitical risk.

Price movements for physical gold and gold-mining stocks aren’t perfectly in sync, but the relationship between them is strong and persistent, across economic cycles.

Historically, rising (and falling) gold prices have a three-times multiplier effect on gold stocks: If the value of gold bullion increases by 10%, mining stocks tend to increase by 30%, and vice versa. The reason: Miners have significant fixed operating costs and high operating leverage, meaning big swings in physical gold prices have a larger impact on miners’ profitability.

This relationship cuts both ways, as we saw after physical gold prices peaked in late 2011. As the value of gold subsequently declined (Figure 2), the value of gold stocks plummeted even more. Between 2011 and 2018, the sector posted negative returns in six out of eight calendar years. Even with recent gains, gold mining stocks have yet to recover relative to historical valuations. Since the sector peak in April 2011, gold mining equities are still off by more than 60%.

Figure 2. Gold Mining Equities are Very Undervalued

Sprott: Gold Stocks are Undervalued

Source: Bloomberg as of 11/12/19.

Figure 3. Gold Demand Has Rebounded: Purchases by Central Banks

Central banks have been net buyers of gold over the past 10 years. Gold plays an important part in central banks’ reserves management, and they are significant holders of gold. According to the World Gold Council: "Today, central banks own almost 34,000 tonnes (t) of gold, making it the third-largest reserve asset in the world. The increase in central bank demand for gold reflects current geopolitical, political and economic conditions, as well as structural changes in the global economy. Gold is both a liquid, counter-cyclical asset and a long-term store of value. As such, it can help central banks meet their core objectives of safety, liquidity and return." 

Source: Metals Focus, Refinitiv GFMS, World Gold Council. As of June 30, 2019.

REASON #2. Gold Stocks are Severely Undervalued

Given the amplified volatility of gold stocks relative to gold, investors need to go in with their eyes wide open. Nevertheless, multi-year declines may now set the stage for significant upside.

While miners as a group still trade below their net asset values, the discounts of smaller, “junior” miners are especially extreme, as much of the recent rally has been driven by the largest, “senior” gold miners. In fact, the valuation gap between North American junior and senior gold miners is the widest it’s ever been.

Figure 4. The Valuation Gap Between Senior and Juniors is at Historic Extremes

Sprott: Senior Miners vs. Junior Miners

Source: BMO Capital Markets, FactSet. North American senior vs. junior gold miners. As of 7/19/19.

Reason #3. Supplies are Limited

Most investors grasp the importance of investing in companies whose business models are protected by “competitive moats.” Gold miners have this in spades, as it can take 15 years from discovery of a new gold mine to successful ore production. The barriers to entry are enormous for newcomers in this sector, given the need for expensive and specialized equipment, environmental regulations and political considerations.

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