Time to buy the hated gold miners?

Warning: This is one of my occasional articles on active investing. Most people – perhaps even me, when the counting is done – will be better off using index trackers. Just read this piece for “fun”, the same way you’d read an article on space travel or robot surgery.

The price of gold has been falling faster than you can say “Fiscal Armageddon”.

And believe me – gold bugs can say “Fiscal Armageddon” pretty quickly.

From its peak of $1,913 in August 2011, the price of an ounce of gold has approached $1,200 in the past few months. That’s a drop of more than 30%. As I write it’s recovered to around $1,280, but who knows what will happen next.

My belief remains that with no yield and few practical uses, gold is basically impossible to value. Paradoxically, I now believe this is one of the reasons why it can make a good portfolio diversifier.

Logically or not, gold is also considered good to hold during a crisis. So it’s probably worth having some before the next crisis rolls around, if only to sell it to someone who believes that it’s useful – even if you’d rather have a shotgun and a tin of spam in a tight spot yourself.

Preciousness about metals

Over the years I’ve developed a grudging respect for asset allocations that acknowledge this sort of investing realpolitik, such as The Permanent Portfolio, the gold-heavy asset allocation that enjoyed a renaissance with the yellow metal’s return to favor.

It all adds up me envisaging a future where I hold 3-5% of my portfolio in gold.

Now that might not seem very controversial, but to a gold bug – and a relatively reasonable gold bug at that – it counts as “ambivalence and antipathy” and adds up to a “monumental blind spot”, according to his comments the last time I wrote about gold.

This commentator advocated going 100% long in gold, which might sound crazy, but was probably only enough to get a seat by the toilets at the annual Gold Bugs Bash. (I don’t think he mentioned Bernanke or the “global conspiracy” once. Poor show!)

Bottom line: Gold is weird stuff, the price behaves oddly, and it brings out strange beliefs in otherwise seemingly sane people.

For me it adds up to a reason to hold some gold, but carefully and ideally somewhere where I don’t look at it much. We’ve all seen the effects of cradling a ‘precious’ metal in The Lord of the Rings.

Nobody wants to be a gold Gollum!

Mining value

So am I building up my modest position in gold then? Err, not yet.

My account with Bullion Vault has spare cash in it ready for deployment, but I’m dithering. I really do hate buying the stuff.

I’ll probably bite the bullet sooner rather than later with a small purchase, but what I’m slightly more interested in currently are gold miners.

As the stock market has continued to rise, I’ve seen some of my unloved holdings such as UK house builders and commercial property come back into fashion. While I’ve strenuously attempted not to sell everything to soon as usual, my focus is shifting more to what’s next rather than what’s already delivered.

That means finding stuff that’s cheap and unloved. And that’s almost the definition of the mining sector these days, especially at the smaller company end.

Gold mining’s fall from grace has been spectacular. But even the best commodity companies are notorious for getting cheaper and cheaper when the environment is against them, so you rush into declining gold miners at your peril.

It’s all to do with the hard-to-value nature of their assets.

For all that precious metal diehards argue about fiat money and unsustainable consumer spending and the rest of it, the fact is that the price of a box of Persil or even of 23 Acacia Avenue doesn’t change much from month-to-month, or even year-to-year.

Sure you get broad trends, but by comparison commodity price changes can make them look about as speedy as a glacier pausing for a breather.

These volatile prices are tricky if you’re a miner. What you sell is whatever you dig up, and hedging aside, you get what the market will pay you for it. Apple can try to jazz up its fortunes with a new graphical user interface, say, but there’s not much innovation in a lump of iron ore.

Worse, mining costs are pretty sticky, too. It takes a lot of work to set up a mine. It takes a lot of energy to operate them, and unless you have your own power source on site (such as a hydroelectric generator) then the cost of all that energy is out of your hands, too.

Then there are labour costs.

In most of the world, mining is hot, dangerous, fairly wasteful, and very labour intensive. It takes a lot of people to work most mines, and they’re the sort of people who tend to get the hump if you don’t pay them or fire them. They aren’t afraid to show it with a violent protest or two.

Who can blame them, as often they’re pretty poor. In many countries, they also have politicians who are willing to back them in a scrap with foreign-owned extraction firms, too.

Leveraged misery

One consequence of all this is that mining companies are usually said to be geared or leveraged plays on the underlying commodity. Because their operational costs are fixed, their resultant profits – or losses – can be hugely magnified as commodity prices fluctuate.

Consider the simplified example of Mr Micawber-Miner, who can produce 100,000 units of some particular commodity a year.

• Fixed costs £1 million. Commodity priced at £15 a unit. Result £500,000 profit a year! And happiness.

• What if the commodity price fell to £10 a unit? Then there’s no profit. Result, misery.

• And if the commodity price fell to £8? Result: Potentially bankruptcy.

It’s this mathematics that also makes debt and mining such a noxious combination, by the way.

Cash flow can be great in mining companies (though in the boom times a lot of it goes back into capital expenditure) so interest payments are usually pretty easy to cover from profits. The trouble is as I’ve just shown there’s already leverage built into the operations of the company, without magnifying that leverage with debt.

Things can get ugly quickly.

Canaries in the gold mines

All this makes buying mining companies at least as difficult buying the commodity itself.

The big integrated miners such as BHP Billiton or Rio Tinto have the breadth and depth to soften some of the blows for you by changing their focus (although they can’t escape the costs and the writedowns from doing so) but small cap miners can and do go to the wall like flies to sticky blue death paper when prices move persistently against them.

At this point another quote from The Lord of the Rings may comes to mind, this time from Gimli the Dwarf.

Gimli quips:

“Certainty of death. Small chance of success. What are we waiting for?”

He’d love the small cap mining sector right now.

While gold bugs have been struggling to understand why the gold price is falling when most of their bugbears – US national debt, money printing, Europe in crisis – remain in play, over-optimistic followers of small cap gold miners have endured a longer and even more painful wake-up call.

The graph below plots the US Market Vectors gold miners ETF (Ticker: GDX) against the major US gold price tracking ETFs (Ticker: IAU):

What this graph shows you is that in the years immediately following the nadir of the financial crisis in late 2008, the price of gold and the stock market value of gold miners tracked each other pretty closely – shown by the lines moving up together.

This progression in tandem was already a bad sign for gold miners. Remember, they are a meant to be a leveraged play on the gold price – so their share prices should have risen much faster as the price of the commodity rose.

At the time people blamed this on the rising costs of mining and poor cash control by management for scaring away would-be investors. But in retrospect it looks like gold mining investors were accurately predicting a fall in the price of the metal, by bidding down the price of miners.

This isn’t so fanciful if – like me – you believe that the ease of buying gold through an ETF is one factor that drove the price so high in the first place.

I think savvier money was likely in (or rather getting out of) the miners than in the gold ETFs.

Anyway, around the start of 2012 things got much worse for the gold miners. Their share prices, as captured in aggregate by the GDX ETF, began to tumble. As you can see from the graph the gold price only really caught up with the pace of this decline at the start of 2013.

Some of the falls have been dramatic. The gold miners ETF is down 60% from mid-2011, but flakier individual mining companies – those with little cash or too much debt or a focus on exploration or in dodgy countries – have lost much more.

A discount or a value trap?

Huge share price falls, near panic among the weaker holders, and likely forced liquidation from indebted commodity funds caught on the wrong side of the trade? This sort of car crash gets a wannabe value investor’s pulses racing.

The time to buy is when people are fearful, ideally. You then sell when people get their appetite back. This sentiment cycle is fairly obvious in most sectors – the tricky bit is getting the timing right.

For a cyclical sector like mining, you can lose a lot of money extremely quickly if you buy too soon. And you can forego a lot of profit if you sell too early.

So is now the time to buy into gold miners? I’m not fully convinced, but some of the signs are good.

The following graph shows how sharply the price-to-book ratio of gold miners has fallen – from over 2x in 2011 to under 1x now.

Source: Datastream / Hargreaves Lansdown

In simple terms, what this means is that purchasers were prepared to spend £2 for every £1 of a gold miner’s assets (which should principally be gold, but in some cases will be accounting nonsense like goodwill) in 2011.

But now they’ll only buy at a discounted price – about 95p for every £1 of assets, according to this graph.

As you can see this is the first time the price-to-book value has fallen below 1x since 1980. Surely an amazing opportunity to buy cheap?

Not so fast!

As we’ve all noted from countless gold-promoting articles over the years, the turn of the 1980s marked the end of the last bull market for gold. Prices of the metal yinged and yanged for 20 years, but the general direction was down, down, down until the turn of the century.

If that sort of fall is about to happen again, then the £1 of assets you’re buying with your 95p might be worth say 70p in a few year’s time. Not such a bargain, in that case.

This second graph shows that book values – the green line – hasn’t really budged even as the price of gold miners has plunged.

Source: Datastream / Hargreaves Lansdown

I was sent these two graphs by Hargreaves Lansdown, and I get the impression their analyst thinks this latter graph is a bullish sign.

However I think it’s potentially a negative, in that it probably shows that mining company’s book values are yet to catch up with the reality of a lower gold price.

Cautiously creeping into gold and other commodities

This is already a very long article, and I haven’t even gone into the big issue with gold miners, which is the all-in ‘cash cost’ of getting gold out of the ground.

Briefly, there are deep gold mines around the world where workers toil to crush 3-4 tons of rock just to get one ounce of gold. This is just as expensive (and philosophically pointless) as it sounds. With oil prices rising and a falling gold price, these mines will quickly become uneconomical.

Industry experts seem to consistently argue that $1,250 is around the breakeven cost of production for the gold mining industry as a whole.

If this is true – and to be honest it’s a pretty dubious number, given the price of gold was far lower just a few years ago – then an optimist might say we’re approaching some sort of fundamental value for gold (not me, really, given I don’t believe it can be valued).

But a pessimist might worry that a lot of miners are about to go bust when the price falls further!

So what am I doing? Not much so far.

I’ve not yet stocked up on my Bullion Vault gold horde, and only the very biggest gold mining companies look at all sensible for individual stock picks. (Newmont Mining in the US is one I may research further).

I have had a nibble though of a long established commodities investment trust, City Natural Resources High Yield Trust (Ticker: CYN).

It’s only partly a play on gold (roughly 20% of assets) but much of what I’ve written above applies to the commodity sector as a whole currently, so I’m buying a little bit on that wider theme, too. The trust pays a dividend, which is good if you have to wait a long time for a recovery, and its focus on income means it should be more invested in producing assets (and in some cases debt) rather than on blue sky exploration outfits.

Note that the name of the trust – “High Yield” – is not indicative of the dividend yield on offer. Even after its share price has fallen well over 50% from its highs, the yield is still just 3.6%.

The “High Yield” in the name is a clue that commodities used to be a stodgier sector when this trust was set up, not the go-go sector of much of the past decade. We could well get there again, with gold but also with many of the other commodities that rode the super-cycle story.

Hence I’m cautiously buying a bit, but no heroics.