Before we look at my findings, though, let's review the case for gold bullion as I see it. Put simply, I think the crisis of debt that first bit in 2007 has yet to run its course. The authorities are unashamedly trying to inflate away the problem of excessive indebtedness. Besides the resulting proliferation of paper money, savers and bondholders may also have to contend with raids on their funds such as that mooted this week by the Cypriot government.
This isn't the first time that governments have used inflation and even more brazen wealth-grabs in order to unburden themselves of indebtedness. The US and UK did the same thing to shed their debt load in the decades after World War Two. As inflation got out of hand towards the end of that era, the price of gold - and of gold miners - exploded higher. I expect broadly the same outcome this time around. Gold's bull market since 1999 has much further to run, therefore.
As a whole, the gold mining industry has proved an excellent investment over recent decades. Had you invested $100 (£66.14) in 1973 in the Datastream World Gold Mining index and reinvested all the dividends, it would have grown to $5,431 (£3,591.87) by the end of 2012. By contrast, the same $100 would have become $2,497 if invested in gold bullion or $3,270 if tied up in developed markets generally (the Datastream index isn't directly investible, but there are ways to mimic it, as we'll see).
You might think that this settles the contest once and for all in favour of gold mining. However, gold bullion has actually proved a better investment at certain key times, namely during gold booms. The price of the yellow metal went up by more than the world gold mining index during the 1970s gold boom, and then again during the 1999-2011 period. Of course, certain countries' gold mining sectors and particular individual stocks have outstripped gold. But I'm interested here in the broad trend.
Another reason why you might not choose gold miners instead of gold itself is to do with spreading your risks. Gold bullion's price often behaves differently to the stock market. This makes it great for laying off your risks on a portfolio of shares. While gold mining shares are strongly influenced by the price of gold, they are ultimately still shares, and therefore influenced by the stock market's behaviour. Whereas the average correlation between gold and developed market stocks over time has been next to nothing, gold miners and developed market stocks are somewhat correlated.
A glittering record
| Price/earnings | Dividend Yield (%) | Price/book | |
|---|---|---|---|
| Today | 20.6 | 2.1 | 1.5 |
| Average | 23.8 | 2.8 | 2.9 |
| Max | 83.5 | 10.8 | 10.7 |
| Min | 3.9 | 0.4 | 1 |
| Source: Thomson Datastream | |||
Drivers of gold mining
I've already argued that the deliberately inflationary policies of the central banks will send gold and gold miners' shares much higher over the coming years. But it's important to understand exactly how this will come about. It's not the mere existence of inflation that benefits these two, but a specific type of inflation: inflation that isn't properly compensated for by higher interest rates. When inflation is higher than interest rates, ie when real interest rates are negative, gold and its extractors tend to gain.
Chart 1: Real yield on US Treasury Bills and the 12-month change in the price of the world gold mining sector.
Chart 1 above shows the real yield on US Treasury Bills and the 12-month change in the price of the world gold mining sector. When real interest rates twice went deeply negative in the 1970s, the price of bullion and miners soared. Negative interest rates have also boosted them - although not quite as dramatically - in more recent years.
Crunching the figures since 1990, I have found that three-quarters of gold mining's performance can be explained, statistically speaking, by just three things: US consumer price inflation, the price of gold bullion and the level of the dividend yield. On its own - without negative real interest rates - rising inflation hurt the gold mining sector, while rising gold and a higher dividend yield were good for it.
Chart 2: ETFX DAXglobal Gold Mining Fund (AUCO.L) vs DS World Gold Mining Index
Weighing up gold mining today
The gold mining sector has struggled for much of the time since bullion's price peaked in the autumn of 2011. The Datastream index has fallen by more than a quarter from its peak of that year; more than the losses in the yellow metal itself. On a business level, the industry has suffered from rising production costs, which has eaten into profitability. So, is the sector now worth buying from a valuation perspective?
Global gold mining is trading below its long-term average valuation both in terms of trailing earnings and book value - see table below. Its current price-to-book value is only around half its average level of the past three decades or so. I calculate that a valuation multiple in this range has typically been followed by a return of 25.9 per cent over the following 12 months.
Wherever possible, I like to use the dividend yield as a valuation tool. Unlike earnings and book value, dividends are a hard fact, as well as being a key part of total returns. While the dividend yield on the sector is below its long-run average, it is around its highest level in the last decade. Given that I believe the bull market has yet to end, I find this encouraging.
Global Gold mining
| 1973-80 (%) | 1999-2011 (%) | |
|---|---|---|
| Gold Bullion | 1,163 | 651 |
| Australia Gold Mining | 8,828 | 2,147 |
| Canada Gold Mining | 242 | 529 |
| South Africa Gold Mining | 337 | 311 |
| UK Gold Mining | – | 4,349 |
| US Gold Mining | 207 | 326 |
| World Gold Mining | 302 | 586 |
| Source: Thomson Datastream | ||
How to buy into gold mining
The temptation with gold mining shares is always to try to spot the 'next big thing'. After all, when a small exploration company makes a lucky strike, the returns can be Midas-like. Both for spreading your portfolio risks and for tactical purposes, however, I favour taking a diversified approach, ie buying into the global sector. And, although the index that I've used in my research isn't directly investible, there are plenty of ways to purchase a worldwide selection of gold mining shares.
There are several exchange traded funds (ETFs) that track the gold mining sector internationally. ETFX DAXglobal Gold Mining Fund, (ticker AUCO.L) has the advantage for UK investors of trading on the London Stock Exchange, so you can buy and sell it through your ordinary stockbroking account. It tracks the movements in the Datastream global index very closely.
While the sector is attractively valued, it could become cheaper still. So, while longer-term, value-orientated investors may wish to position themselves, tactically minded investors may wish to hang on until the recovery begins. For making tactical entries, I've developed a systematic model that has produced a better return than buy-and-hold investing over time, but with less risk. I'll be publishing more details on this soon, but right now the model is in neutral mode.
A full report on the gold mining sector will be available shortly on our website as part of the new Market Tactics series.
