Why Are Gold Stocks Not Rising When Gold Prices Are? Unveiling the "Leverage Failure" of Gold Mining Stocks

Why Are Gold Stocks Not Rising When Gold Prices Are? Unveiling the "Leverage Failure" of Gold Mining StocksIn the investment world, it's often said that "when gold prices rise, gold stocks will follow suit." However, this isn't always the case

Why Are Gold Stocks Not Rising When Gold Prices Are? Unveiling the "Leverage Failure" of Gold Mining Stocks

In the investment world, it's often said that "when gold prices rise, gold stocks will follow suit." However, this isn't always the case. In recent years, gold stocks have significantly underperformed gold prices. Why is this happening? This article delves into the reasons behind this phenomenon and reveals the truth behind the "leverage failure" of gold mining stocks.

Gold Stock Performance: A Look at the Data

According to Koyfin data, since November 2009, the SPDR Gold Shares (GLD) ETF, which tracks physical gold, has seen a cumulative gain of 99%. Meanwhile, the VanEck Gold Miners (GDX) ETF, tracking the three gold mining giants (Newmont, Agnico Eagle, and Barrick Gold), experienced a cumulative decline of 17.9% during the same period. The VanEck Junior Gold Miners (GDXJ) ETF, focusing on smaller gold mining stocks, saw a cumulative drop of 40% during this timeframe.

This data clearly shows that gold stocks have significantly lagged behind gold's performance. Although gold has displayed some "store of value" functionality over the past decade, investing in gold mining stocks doesn't guarantee returns.

Gold's Actual Rate of Return: Not as Impressive

Not only are gold stocks underperforming, but gold itself hasn't been as dazzling as some may think. According to Macrotends data, after adjusting for inflation, gold prices have only increased by less than 300% over the past 100 years, resulting in an annualized real rate of return of only about 1.34%.

This means that gold's rate of return isn't particularly high, even falling short of some other asset classes.

"Operating Leverage" of Gold Mining Companies: The Gap between Theory and Reality

A significant reason for gold stock underperformance lies in the incomplete realization of the "operating leverage" effect held by gold mining companies.

What is Operating Leverage?

Gold mining companies' operating costs primarily comprise fixed costs and variable costs. Fixed costs (such as equipment, administrative expenses, etc.) remain unaffected by gold production, while variable costs (like labor, fuel, etc.) are directly proportional to gold production. When gold prices increase, the fixed costs of gold mining companies are spread out, leading to a substantial increase in profit margins, amplifying the impact of gold price fluctuations on company earnings. Conversely, when gold prices decline, gold mining companies' profits also significantly drop.

Simplified Example:

Suppose a gold mining producer can produce 100,000 ounces of gold annually, with a cost of $1,500 per ounce, resulting in a total operating cost of $30 million per year.

Gold price at $2,300 per ounce: The miner earns $230 million in revenue from selling gold, deducting $150 million in costs leaves a gross profit of $80 million. After subtracting operating costs, the pre-tax profit is $50 million.

Gold price drops 20% to $1,840 per ounce: The miner's gross profit decreases to $34 million, leading to a pre-tax profit of only $4 million.

Gold price increases 20% to $2,760 per ounce: The gold mining company's pre-tax profit almost doubles, reaching $96 million.

This example illustrates how, with a 20% fluctuation in gold prices, the gold mining company's profits fluctuate by over 90%, demonstrating the leverage effect of mining companies.

Why Does "Leverage Fail"?

Theoretically, gold mining companies' operating leverage should amplify the impact of gold price fluctuations on their share price. However, in reality, this leverage effect doesn't fully translate to the gold mining companies' stock price.

Analysts point to the following main reasons for this discrepancy:

Poor Management: Some gold mining companies face issues like excessive executive compensation and improper capital allocation, leading to inefficient operations and impacting profitability.

Geopolitical Risks: Gold mining companies face risks from geopolitical turmoil and high mining taxes in certain regions, affecting production and operating costs, further weakening profitability.

External Regulation and Scrutiny: Beyond understanding reserves and production, gold mining companies must also navigate external regulation and scrutiny, adding to operating costs and limiting the leverage effect.

Gold Stocks "Underperforming the Mine": A Similar Phenomenon in the Bitcoin Realm

It's worth noting that, besides gold stocks, the Bitcoin realm has witnessed a similar "miners underperforming mining" phenomenon.

The Valkyrie Bitcoin Miners (WGMI) ETF, tracking Bitcoin miners, has experienced a cumulative decline of 12% since its launch in February 2022, while Bitcoin itself has gained 29% during the same period.

This phenomenon reiterates that the "leverage" that seemingly should exist on paper is difficult to achieve in practice.

Investing in Gold Stocks: Rational Thinking and Risk Management

Despite the instability of gold stocks' "leverage" effect, gold, as a safe-haven asset, still holds some investment value. Investors need to think rationally and manage risks when investing in gold stocks.

Here are some recommendations:

Thorough Company Research: Before investing, carefully research the target company's operating performance, management team, mineral resources, cost structure, and other aspects to assess its profitability and risk.

Geopolitical Risk Awareness: Pay attention to the political environment and policy changes in the mining area to mitigate the impact of geopolitical risks.

Diversified Investment: Don't put all your funds in a single gold mining company. Consider a diversified investment portfolio to reduce investment risk.

Cautious Leverage Use: Leverage trading can amplify both gains and losses, so use it with caution.

Valuation Awareness: Pay attention to the valuation levels of gold stocks, avoiding chasing price increases or selling blindly. Be a rational investor.

Conclusion:

The "leverage failure" phenomenon of gold stocks highlights the complexity and uncertainty of the investment market. Investors need to conduct in-depth research, think rationally, and manage risks effectively to achieve success in their investments.