Gold mining stocks outperform gold – can it last?

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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.

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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.

This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.