Gold mining stocks outperform gold – can it last?

There have been two big developments in gold recently. The first is that the metal itself is reaching new highs: this week, it passed $3,500 per ounce for the first time. The other is that gold mining stocks are outperforming gold, which is something we have not really seen in this cycle.

Gold miners are a geared play on gold. When gold goes up, they rise higher; when it goes down, they fall further. This is because they have operational leverage: relatively high fixed costs mean that they make weak profits when gold prices are depressed, but higher prices can translate into a strong increase in margins.

Of course, this depends on input costs not going up too much, but recent trends have been positive. Gold miners have been seeing huge improvements in free cash flow for a while, yet the shares only began to move this year.

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Investors are sceptical about the gold mining boom

You can view this in a few different ways. One is that buyers of gold have different motivations to buyers of stocks. Gold is going up because some investors are nervous and see it as a useful hedge against the kind of risks that could cause a stock market slump. Gold stocks are still stocks, and if they are worried about the market as a whole, they would logically rather have gold than any kind of stocks. Conversely, buyers of stocks are excited about the bull market in areas such as artificial intelligence. They are not interested in the bull market in gold – and hence not interested in gold stocks – because they see racier opportunities elsewhere.

Another possibility is that investors are doubtful about the quality of gold miners in particular, based on memories of the last cycle.

Yes, they are making plenty of money now, but will they be disciplined enough to hand that back to shareholders? Or will they squander it on higher-cost or riskier projects to expand production, or indulge in empire-building mergers and acquisitions?

Certainly, the sector has a remarkably poor long-term record. The MSCI ACWI Select Gold Miners index has a gross total return – ie, with dividends – of 3.3% per year in US dollar terms since 2003. That’s a compound return of just over 100%. One nuance here is that after gold had been in a long bear market during the 1980s, many gold miners took to hedging their output in the 1990s and early 2000s, which worked against them once prices began rising. Still, the record of the NYSE Arca Gold Bugs index, which tracks stocks that did little hedging, is not that impressive either.

However, hedging is now minimal so producers are fully exposed to rising prices. Gold miners will be very profitable with gold anywhere close to here. They also tend to have low correlation to the wider market, which may be useful if the AI boom turns to bust. A tracker such as iShares Gold Producers (LSE: SPGP) or the even more operationally leveraged Van Eck Junior Gold Miners (LSE: GJGB) is a simple way to follow the trend. Just don’t treat it as a long-term core holding. History suggests that it isn’t.

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