Gold Is Good, But Gold Mining Is Better ~ market folly

Friday, June 18, 2010

Gold Is Good, But Gold Mining Is Better

Prominent hedge fund manager John Paulson started a gold fund as a bet against the US dollar. While he invests in some gold derivatives, he is mainly placing his bet by taking stakes in various gold miners. Conversely, we've covered how John Burbank's hedge fund Passport Capital owns physical gold. So while many hedge funds agree that precious metals deserve some allocation of capital, the dispute comes down to whether you buy the actual metal or those who mine it.

The following is a contribution from Vedant 'VK' Mimani, founder of Atyant Capital, a macro fund focused on precious metals. The below article focuses on why tomorrow's fortunes will be made investing in companies that excavate the yellow metal. Here is Mimani's rationale which originally appeared on Absolute Return + Alpha:

With gold currently trading around $1200 per ounce - an increase of almost five fold from 2001 - it is only natural to wonder how much gas is left in this tank. The fact is, we don't know and we sort of don't care. We've said it before and we'll say it again: the real opportunity for wealth creation in the years ahead lies in the business of gold mining.

The world is in the midst of a credit contraction, of the kind that always follows credit expansions. We have found from historical study that these contractions in credit tend to run about twenty years. During every single prior credit contraction, the real price of gold, as measured against all commodities and assets, had increased. This increase in the real price of gold represents expansion in profit margin for the gold mining industry.

The last major credit contraction occurred during what we now refer to as the Great Depression. During that time, gold miners such as Homestake Mining were among the few companies to reward its shareholders. The Financial Crisis of 2008 stayed true to form. Starting September 2008, gold once again has started to outperform all commodities and assets.

It may seem counterintuitive that gold mining represents the best wealth creation opportunity over the next several years. After all, in 1971, the price of gold was $35 per ounce. An investor could have bought gold bullion in 1971, buried it in the backyard, and have a thirty-five fold return and counting as of today. Yet despite the price of gold increasing thirty-five fold over the last four decades, gold mining itself has been mostly a crummy enterprise in terms of all basic business metrics during that period. This is simply because the input costs increased faster than the price of gold, resulting in little to no profit margin for the industry as a whole.

That all changed in September 2008 when private credit growth peaked. Since then, the price of gold has increased steadily, while the costs of mining gold have decreased significantly; the real price of gold, as measured against all commodities and assets, has increased. Today large cap miners have robust 40%+ operating margins as they are benefiting from the increase in gold prices relative to the costs to mine gold. A quick glance at the last two quarters of operating results for the major miners shows that the increase in the real price of gold is resulting in strong financial performance. As far as we are concerned, we are only two years into a twenty year trend. It's not late; it's early early early.

Are gold miners cheap right now? Examination of gold miners on traditional metrics such as price to net asset value or price to book value, reveals that the miners as a whole are not underpriced on an as-is basis. This is not a "buy $1 for $0.80" type story. Gold mining today is a value creation play in which the macro variables, increased real price for gold and decreased input costs, have aligned and the sector is now experiencing a tailwind instead of a headwind. When the real price of gold increases linearly, mining profits are likely to increase exponentially. (MarketFolly sidenote: This is the main question at hand in the precious metals complex. Can mining stocks outperform the actual price of gold over time? Investing in individual miners entails taking on company specific risk. But of course some of that risk can be mitigated by taking stakes in a basket of miners.)

From March 2009 through mid-April 2010, gold and gold miners have underperformed most other asset classes. In the second half of April 2010, we witnessed a turn from relative weakness to relative strength in gold and gold mining shares. Gold miners are the new leaders and have once again started to outperform all asset classes. In May alone, gold miners outperformed the S&P 500 by 9.5% (as measured by the Gold Miners ETF, GDX, versus S&P 500 SPDRs, SPY). The real price of gold is now never looking back; but from a technical perspective, in the short term, gold's relative strength is overbought and may need some time to work this off. (MarketFolly sidenote: Their highlight of gold miners' performance in May is relevant since it shows outperformance in a period of market volatility. But then again, aren't precious metals seen as an asset class that moves independently of equities, sort of acting as a volatility dampener or hedge in the first place? To play devil's advocate, we'd point out that the gold miners ETF, GDX, underperformed the S&P 500 throughout much of 2010 up until May.)

In conclusion, whether we have deflation, inflation, or pick your favorite 'flation, we ought to remember history's record that in a credit contraction, the real price of gold increases relative to all commodities and assets. This increase in the real price of gold results in margin and profit expansion for gold miners as the spread expands between the price of gold and the cost to mine gold. Gold mining will be one of the few, if not only, sectors to enjoy this type of tailwind in the years ahead.

The last cycle's mega fortunes were made mostly in real estate, computer technology and finance. Tomorrow's mega fortunes will be made mostly in gold mining. Of course, the road from here to there will continue to be volatile and laden with pitfalls, but the trend remains our friend.


So, interesting thoughts from Mimani and Atyant Capital. Their thoughts continue to highlight the debate between owning gold versus gold miners. We've long detailed this debate through copious amounts of hedge fund resources. As we touched on in the introduction, we've taken an in-depth look at John Paulson's gold fund. Additionally, we've covered how prominent investor David Einhorn favors physical gold and John Burbank likes physical gold as well. Lastly, Eric Sprott launched a gold trust but has also taken stakes in various gold miners as well. So while many fund managers disagree on the particular investment vessel, they all seem to agree in principle that capital should be allocated to the precious metals complex.

The above article was a contribution from Vedant 'VK' Mimani, founder of Atyant Capital. If you or other investment managers you know would be interested in contributing an article or latest investor letter to, please send us an email.

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