There's an anomaly with gold. Whilst the gold price has shot up 20% in 2011, gold stocks the guys that explore and mine the stuff have gone nowhere.
Today I want to take a look at why that is. I'll show you why I think gold stocks could be about to move into a bull market all of their own. And I'll show you a simple way you could trade it.
The opportunity in gold stocks
Gold stocks are undoubtedly a more speculative investment than buying physical bullion. The explorers and junior miners are pioneers out there looking for this prized asset. The stock valuation is subject not just to the price of gold and what it costs to get it out of the ground but also a massive dose of luck.
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And that's precisely why many investors steer clear of the 'juniors' there's just too much risk. "Wahey We've struck gold! Now give us more money so we can get at it!"
It's one of the worst aspects of the juniors they're always coming back to shareholders looking for more money. And the original shareholders get screwed as the value of their holdings is diluted.
That's why my first bit of advice on gold stocks is that unless you know the company intimately, avoid the juniors. You don't need lottery-type investments.
But it's not just the junior gold stocks that have underperformed the gold price. The majors have struggled too. And that seems to be down to escalating costs.
A report out from ABN Amro Bank, VM Group and Haliburton Mineral Services reports a 50% spike in production costs over the past three years.
Just look at this chart. In just two years the price of getting an ounce of gold out of the ground has gone up from around $400 to well over $600. Now that's inflation!
It's the same old story. As with most commodities, the low-hanging fruit has been picked quality gold seams are getting tougher to find. Plant and machinery costs have gone up along with commodities inflation, as have labour costs in the developing world. To top it all, local governments have been screwing ever-increasing royalties out of the mining companies.
All of this has cast a shadow over the industry. And stock investors don't like shadows! But the fact that the gold price has gone up loads more than cost increases is still an anomaly.
And it brings us on to the third reason gold stocks have under-performed the gold price. Stock market investors simply don't think the current price of gold is sustainable.
To show you what I mean, take a look at this chart of a gold mining fund that I've been looking into
Market Vectors Gold Miners ETF (Quoted in New York)
Source: Van Eck Global
This is the New York-quoted Market Vectors Gold Miners ETF (NYSE:GDX). It's an exchange traded fund with a market cap of about $9bn. The fund tracks an index of 31 producers of gold, mainly quoted in the US, Canada and South Africa.
And even though physical gold is up over 20% in the past year, this chart says the miners basically haven't moved. But you may notice that the action over the last couple of weeks looks more interesting
If we can reach $2,000 gold stocks could fly
In the days of old, you would have expected gold producers to outperform the price of the metal by two or three times.
That's because of 'operational gearing'. If gold goes from $800 to $1,600 your turnover doubles. But generally your input costs don't. Profits increase exponentially. The stock price soars!
This time around the stocks haven't soared. And the chart tells me that investors simply don't believe the current price of gold is sustainable. Investors are worried that higher production costs are here to stay, but the high gold price may not be.
James McKeigue explains the best ways to buy gold coins and bars.
Well, I think that the high gold price is not only here to stay, but is set to go higher still. I think the fundamentals are in place for gold to rally.
And I reckon that if and when the price reaches the psychologically important $2,000 an ounce, things will turn up for the gold stocks.
It's not just the two or three hundred extra bucks of profit that's going to help the miners; but it's psychology. It'll say "Gold's high AND it's staying high", and it should start to convince investors of profit sustainability.
How you could profit as the miners catch up with gold
As I said, gold stocks are risky. I've outlined why the market doesn't like them and though I hope things are set to change, they might not! Things could get even worse. And also with this US-listed fund, you're exposed to currency risk.
But for me the least risky way of holding gold stocks is through the Market Vectors Gold Miners ETF. It gives you diversified exposure to that basket of 31 big miners by buying just one share that's easily traded through most brokers.
Van Eck, the fund manager,has over 50 years of history. They specialise in emerging markets and hard assets like precious metals. With over $31bn under management, this is a biggy. And the gold fund is a serious player in the precious metals markets. And because it's an ETF, all you pay is your normal broker fees and then a management fee of 0.53% a year.
Market Vectors Gold Miners ETF
52 Week High/Low: $66.98/$50.42
Market Cap: $9.62bn
Five-year performance: 2006 (from inception 16 May) +7.2% | 2007 +14.83% | 2008 -26.07% | 2009 +36.39% | 2010 +33.02% | 2011 (to 28 October) -2.19%
You can find out more information through the fund manager's website, Van Eck Global. Click on the factsheet https://www.vaneck.com/funds/GDX.aspx for details of the stocks it holds and performance data.
This article is taken from the free investment email The Right side. Sign up to The Right Side here.
An ETF's performance relies on the performance of the underlying investments. Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.
Bengt also writes our free email, The Right Side, an aid for free-thinkers on how to make money across financial markets.
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