Gold Equities versus Bullion

By Dave Brown – Exclusive to Gold Investing News

Last week, Gold Investing News examined the case for Gold Equity Funds versus Gold ETFs, and as an obvious extension it seems fitting to investigate the case of owning gold equities versus physical gold.

Return on investment (ROI) in gold equity funds serving as a proxy for gold equities have underperformed the return from holding physical gold over the past five years.  This might be the result of a number of contributing factors underscoring the basic premise that many gold mining companies have been unable to turn higher gold prices into increased earnings. As a result, the gold equities have underperformed the price gains realized by owners of gold bullion.

“The trend is your friend”

The average price of physical gold 5 years ago was $603.46 per troy ounce and has climbed to approach a trading range with closing prices on the London Metal Exchange (LME) of $1534 per troy ounce for the current month. This appreciation represents a compounded annual growth rate of approximately 21 percent. According to Morningstar, the average compounded annualized growth rate for equity precious metal equities over the same time period was 13 percent.

Historical context

In his most recent interview on Business News Network, Don Coxe, the world renowned strategy advisor for BMO Financial Group, offered his perspective, “Gold and gold stocks offer a protection that is going to become more valuable in the period of months ahead. It’s possible that the long-awaited period, when gold stocks outperform bullion, is coming soon. During the 70s, it took years for gold stocks to catch up to the performance of bullion. Silver and silver stocks are not for the faint of heart, as they remain in the speculative category, relative to gold.”

Within the present world of increasing market volatility and future uncertainty, gold bullion provides tangible, predictable wealth protection for currency-denominated investment portfolios. Over the past several years, as fiat currency creation has reached unprecedented levels, gold, silver, platinum and palladium have occupied their conventional role as a store of wealth.

A continued rise in gold prices will certainly translate into higher leveraged profits for gold mining companies eventually, unless the substantial costs of gold mining exceed the increase in gold prices. Inflation is rapidly rising as central banks continue to flood the global economy with cheap money. A continued rise in general inflation and energy costs might even counteract any benefits resulting from increased gold prices for gold mining companies.

Seasonal appetite

At the end of last month investors were cautioned about the well understood and general track record of the market applying a premium for physical gold, in addition to a less well followed correlation regarding the potential for increased geopolitical action after September.

Institutional investing

According to ETF Securities the recent gold price volatility has largely been driven by speculation that Greece may be forced to restructure its government debt as well as outstanding concerns for European sovereign risk and its impact on the Euro. “Similar to incidences in 2008 and 2010, during periods of extreme stress, both the gold price and the US dollar often rally together. Additionally, interest rate expectations fell back this week on moderate US growth data, which also supported the growth price.”

Cautionary guidance

Investors should note that if the investment decision is between gold mining equities and physical bullion, it is critical to remember that these are separate asset classes with entirely different risk and reward attributes.

An argument that is often made is that gold could be considered currency, since the store of value denominated in any fiat currency is becoming increasingly irrelevant.  Some industry stakeholders suggest bullion should be the cash component of every portfolio; with rising global sovereign debts and the potential of a bigger crisis that may await.  In a NY Times editorial feature, Warren Buffett, the world famous investor and Chairman of Berkshire Hathaway, noted that “Fiscally, we are in uncharted territory. Because of this gigantic deficit, our country’s ‘net debt’ is mushrooming… no one can know the precise level of net debt to GDP at which the United States will lose its reputation for financial integrity.” In his book, The Ascent of Money, Niall Ferguson adds, “It is absolutely inevitable that the US will have to ‘default’ on part of its existing liabilities, since the long-run trajectory of government borrowing is clearly unsustainable.”

Gold mining equities and physical gold perform quite differently when the global economic environment is in disorder, as in the present case. Trillion-dollar deficits, impending credit default contingencies, and accelerating depreciation of many of the world’s major currencies have never generally been positive conditions for equity markets, which is one reason that investors are fleeing to the safety of physical bullion.