Rising 280% over the last eight years and resoundingly beating the S&P 500, gold has been embroiled in an epic bull market. The steady, sometimes ferocious, up move has reinvigorated gold bugs’ raison d’être, justified their eternal ravings about the coming paper money apocalypse, demonstrated to all the moral failings of buying equities, and morphed that weird uncle who socked away gold bars in his basement into the family’s version of Warren Buffett (check out Warren Buffett’s favorite stock picks).
But one player on ‘team gold’ has not quite achieved the acclaim of that uncle. One member, though performing admirably, has been forced to hold onto gold’s coattails with two fingers. We at Insider Monkey are talking about gold equities (see last year’s recap of this investment group).
In contrast to the rise in physical gold prices, gold stock indices have notably trailed in terms of performance over the same period. The blue-chip XAU gold stock index has risen only 72%. The HUI index, skewed toward smaller cap issues, has risen 112%. Sub-sectors like South African gold stocks, plagued by labor and political worries, missed the team bus entirely: AngloGold Ashanti Limited (NYSE:AU) has fallen 20% while Gold Fields Limited (NYSE:GFI) and Harmony Gold Mining Co. (NYSE:HMY) are flat. The relative underperformance of gold equities has been particularly severe the last two years as the price of bullion entered a consolidation phase and gold equities swooned.
Upon inspection, this result seems peculiar. Take for instance, the world’s largest player, Barrick Gold Corporation (NYSE:ABX). Barrick has impressively grown revenues and earnings the last six years, nearly tripling both. Hedges have been closed out and dividends increased. Yet, ABX shares, and gold equity prices in general, have not increased to the extent of what a gold bug would have imagined in the face of an eight-year, 280% rise in bullion prices. ABX shares have risen only 55% over the last eight years. The result has been a crushing of both ABX and the sector’s price-to-earnings ratios.
But as economic theory tells us, markets are forward-looking, discounting machines. What could the market be so severely discounting that ABX and gold stocks have, consequently, strongly trailed gold bullion’s performance? The answer lies in the cost of maintaining and growing gold production. From this perspective, the underperformance of the gold stock universe is understandable.
Why is this the case?
To begin, the easily recoverable gold deposits here on our planet have largely been discovered. This has led to exploration and development of costlier, more challenging geological deposits. However, the cost problem is not only a result of the natural rise in costs associated with the extraction of minerals from increasingly difficult-to-reach locations. In addition, a great irony exists in the gold stock universe: the very depreciation of the US dollar, which has stoked gold bullion prices over the past several years, has also resulted in price increases in key gold production inputs, particularly energy.
These issues can be clearly seen in Barrick Gold’s results. In order to maintain and grow production, capital expenditures at Barrick have increased dramatically in the past decade, rising nearly twentyfold since 2002. They have doubled since 2009. Understandably, this has bought Barrick little; long-term debt has tripled from 2008, yet year-over-year production was down slightly in 2011.
Barrick’s cost trends for gold production also bear out this concern. Total cash costs have risen from the $500 per oz. level in 2011 to near the $600 level at the end of 2012. Barrick is now hedging the price of oil. These facts leave Barrick particularly vulnerable to any fall in spot gold prices.
Even highly regarded Goldcorp Inc. (NYSE:GG) has not been immune to these concerns as their investment and cost levels have risen. Goldcorp’s stock price is essentially flat over the last six years. As noted earlier, for those high-cost South African producers, the market has been particularly cruel. Harmony, Goldfields, and AngloGold have faced the triple whammy of: shouldering the same cost trends as the non-South African producers, total cash cost levels already at or near $1000 per oz., and the added burden of labor strife and domestic policy changes.
Barrick Gold has done many positive things and has produced admirable results. Yet, the market has figured out a way not to fully reward the company’s shares. Gold stock-bulls argue that ABX and the gold stock sector are a buy based on cheap valuations, but market history is peppered with value traps.
Legitimate concerns remain surrounding the behavior of world central banks (see Will Currency Wars Awaken This Sector?) and I fully appreciate that line of reasoning, but arguing with Mr. Market can be a precarious endeavor. As singer/songwriter Tom Petty states in “Free Fallin”, the good girls can be left home with broken hearts. For now, I will sit back and carefully watch the sector.
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Disclosure: I have no positions in any of the stocks mentioned in this article