How the Big Guns Are Playing Gold Mining Stocks

How the Big Guns Are Playing Gold Mining Stocks

You could argue only fools would buy gold mining stocks today. If that’s the case, there may be a lot of idiot savants out there.

The Direxion Daily Gold Miners Bull 3x Shares (NUGT) exchange-traded fund, which uses leverage to amp up exposure to mining stocks, is down more than 90 percent over 12 months, yet assets have risen from $460 million to $642 million. The Market Vectors Gold Miners ETF (GDX), down 51 percent, has seen assets jump from $2.5 billion to $6.7 billion. Gold bullion, meanwhile, is down 25 percent.It’s easy to chalk up the funds’ growth to the contrarian kookiness of gold bugs. The truth is more complicated. Institutional investors see unusual opportunities in gold mining stocks. Some figure the gap between the prices of gold bullion and mining stocks is so wide that they can make profitable bets on that valuation gap narrowing. Others see improvements in management and operations of miners. A third group likes mining stocks simply because they hope to profit from the stocks’ volatility.

Valuation Gap

The essential thing to understand about gold mining stocks is that the price of the miner’s shares has fallen much faster than the price of gold itself. This has opened up a valuation gap between gold and bullion that has sent gold-seeking money managers away from holding gold and into the (now much cheaper) mining stocks.

As gold miner funds gain assets, the SPDR Gold Shares ETF (GLD) has shrunk from $72 billion to $31 billion. To get a sense for the relative value of gold miners and bullion, John Llodra, partner at New Harbor Financial Group, compares the price of the Philadelphia Gold and Silver miner index to the spot price of gold. The miner index is at 85 while gold bullion is at $1,226 an ounce — a ratio 0f 0.07. Over the last 30 years, the ratio was typically just above 0.2.

Even if bullion falls another 50 percent, miners would still be attractive, says Llodra. He owns about 415,000 shares of the Market Vectors ETF and has been adding shares, according to Morningstar.

Not only are the stocks cheap, their prospects are improving, says Jason Cross, co-manager of the $380 million Whitebox Tactical Opportunities Fund (WBMIX). “There’s a sea change going on in terms of capital expenditures,” he says, with corporate boards tiring of the freewheeling ways of CEOs always looking to dig the next mine. Miners including Barrick Gold Corp. (ABX), Newmont Mining Corp. (NEM) and Kinross Gold Corp. (KGC) have replaced top executives with more conservative, cost-conscious types.

By closing nonproductive mines, putting expensive projects on hold and reducing labor costs, companies will do well even if the gold’s price goes nowhere, Cross says. His fund has 3 percent in miners though two Market Vectors funds.

Cost-cutting will help short-term, though it’s too soon to see its long-term effects. So argues Dan Denbow of the $886 million USAA Precious Metals and Minerals Fund (USAGX). That’s why he favors individual mining stocks with solid long-term records instead of diversified ETFs.

Denbow’s favorite: Randgold Resources (GOLD). “Randgold’s Mark Bristow is the CEO every other mining executive wishes they could be,” he says. “He hasn’t made any dumb acquisitions and he’s been very methodical in how he’s built the company.” The stock’s down 35 percent in the past 12 months, beating peers by more than 19 percentage points.

Options Bets

Other managers are making bets that have little to do with a company’s fundamentals. For example, Eric Metz of the RiverNorth Dynamic Buy-Write Fund (RNBWX) bought a 4 percent stake in the Market Vectors Gold Miners ETF not because he loves gold mining stocks, but so he can sell options on his position and make money on the stocks that way. In return for $1 per share of the ETF Metz gives buyers the right to buy his ETF shares at a price of about $21.50.

At Metz’s purchase price of $20.40 a share, the payments translate into a 4.9 percent yield over a period of about seven weeks. Annualized, that’s a 36 percent return. His tradeoff: If the ETF rises above $21.50 he may have to deliver his shares to the options buyers.

No doubt there are other complex trades being made. Andy O’Rourke, managing director of Direxion Funds, hears that some traders are buying the leveraged gold miner ETF and shorting bullion. That way they can capture the difference between the prices with less downside if gold keeps falling. “A lot of our investors use very sophisticated strategies,” he says. With his fund down 90 percent one would hope so.