We are taking a brief look at gold and gold mining stocks again, updating our previous reports on the sector. We last wrote about gold itself on October 5 ('Gold, positive signals emerge') and on the sector including gold stocks on August 15 and September 12. In the latter article we took note of the fact that the HUI index had broken out to a slight new high, but also commented on the flaws we perceived with regards to this breakout at the time – notwithstanding the fact that gold stocks represented and continue to represent good value relative to gold itself. We wrote:
“The HUI index has managed to break out to new highs, but it is too early to judge whether this breakout will be sustained in the short term. The index is notoriously volatile and a steep sell-off in the stock market could lead to some profit taking in the near term. There is also the fact that the sister index XAU (which has a slightly different composition) has not yet managed to break out. This disparity is indicative of the fact that although the advance in gold stocks has broadened, it remains uneven. There is not yet a move 'in concert'. As a result careful stock selection continues to be rewarded, but it also means that one must remain circumspect about breakout moves such as the one in the HUI.”
'Some profit taking' indeed occurred shortly thereafter, and as is often the case with this fairly illiquid sector, it turned into a major rout, albeit one that left the gold stocks largely within the confines of their year-long trading range.
Unfortunately for investors in the sector, it has still not managed to shake off the influence of the broader stock market in the short to medium term, which has persisted (with brief exceptions) since mid 2008. Note however that in the long term, the gold mining sector tends to be negatively correlated with the stock market, so there obviously have to be periods when it actually moves opposite to the broader market, respectively outperforms it during both up and down markets.
This is in fact perfectly logical behavior – gold stocks should directionally reflect the swings in the ratio of gold to the SPX, which is subject to large long term cyclical fluctuations. Usually the stock market and gold move in opposite directions over the long term because secular bear markets in stocks coincide with economic weakness, which in turn increases the demand for money (gold may not be our medium of exchange, but the market treats it as though it were money) and induces central banks to pursue an easy monetary policy.
The profit margins of gold mining companies tend to increase the most precisely when economic activity and confidence are on the wane, as gold rises relative to other currencies and commodities when this occurs. In short, the gold sector is the only sector of the market that actually profits from recessions and declining economic confidence. This fact is illustrated in some of the charts that follow below.
At present, gold mining companies enjoy excellent profit margins. Quarterly earnings reports that have been published over the past few weeks have on the whole been very good. Large increases in earnings, free cash flows and revenues were reported by almost all major and mid tier producers. Several companies have once again raised their dividends and in some cases announced new dividend payment policies that will tie dividends to the price of gold (e.g. Newmont has announced such a policy and Harmony is considering it as well).
Dividends have become a major bone of contention between gold mining managements and shareholders over the past year or so. After all, gold mines are wasting assets; from the point of view of a shareholder in a gold mining firm dividends are therefore essential. An exception may be made for smaller or mid tier firms that are in a period of strong growth and need to finance new mine developments, but senior producers should definitely try to offer a decent dividend return. The clamor has finally had an effect – and this has led the market to reassess the potential of the shares of producers relative to that of explorers in the short term. After all, paying higher dividends goes hand in hand with avoiding 'growth at any cost', so market participants appear to have concluded that fewer takeovers of exploration and developments projects will occur (share dilutions due to acquisitions that are not immediately accretive to earnings have also irked many an investor). To this it should be added that a large increase in development costs has also affected the share prices of exploration companies.
The dividend history of Newmont Mining (NEM) – after along time of keeping its quarterly dividend at 10 cents, NEM has tripled its payout since late 2010.
That times have clearly changed is probably best demonstrated by the gold stock everybody loves to hate (or rather, simply doesn't care about anymore), South Africa based DRDGold (DROOY). Not only does the company pay a dividend these days, it has actually recently increased it by 50%, after operating earnings improved strongly for several quarters in a row.
So there is a good fundamental/value case to be made for gold stocks at current levels (in fact, a good argument could be made along these lines all year long).
This must be tempered by the technical consideration that in the short to medium term, the sector correlates strongly with the rest of the stock market. To be sure, this should change again at some point, but it isn't possible to tell when exactly that will happen.
