Gold Stocks: The Ultimate Investor's Guide to Gold

Image source: Flickr user Giorgio Monteforti.  

Mankind's fascination with gold is believed to have started more than 6,000 years ago when a culture centered in what is now Eastern Europe began to use it to fashion decorative objects. Since then, it has also been used as currency and is seen as a sign of affluence. Given its historical connections to wealth, gold continues to be an object that people desire to both grow and protect their riches. 

What has changed over the years, however, is the fact that physical gold, whether it's in the form of bullion, bars, coins, or jewelry, is no longer the only option for those seeking the profits and protection of gold. In addition to those physical options, we now have gold stocks, which come in their own variety of options, including a range of gold ETFs, mining companies, and mutual funds.

Gold stocks 101
If you're thinking about investing in gold, there are basically five ways to do it:

1. Buy physical gold (bullion, coins, or jewelry)
2. Buy a gold ETF
3. Buy a gold mining stock
4. Buy a gold mining ETF
5. Buy a gold mutual fund (ex. Tocqueville Gold Fund (TGLDX))

The focus of this article, however, will only be on gold stocks, which include gold mining stocks and gold mining ETFs. We'll look at what are known as senior gold miners, junior gold miners, precious metal streamers, and a couple of the more well-known gold mining ETFs.

Senior gold mining stocks
A senior gold miner simply refers to the largest producers that have an established position, more liquidity, and therefore are considered to be the less risky of the gold producers. The chart below details the seven largest gold mining stocks by enterprise value and estimated annual production. 

Data source: Kinross Gold investor presentation and author's calculations. 

The reason an investor would buy a senior gold mining stock is to leverage upside to the price of gold. In other words, when the price of gold rises, a senior gold miner would, in theory, outperform the gold price because it is increasing its gold production. However, as we see on the chart below, when gold rose more than 400% from 2000 through 2012, only two gold miners actually outperformed.

ABX data by YCharts.

That being said, one of the outperformers, Yamana Gold (AUY) was up a breathtaking 29,770% over that time frame. To be fair, though, its size at the time put it more in the category of a junior miner, with its enterprise value at a mere $285 million.

Junior gold mining stocks
Therein lies the draw of a junior gold miner, which is simply one of the smaller producers or a company just engaged in the gold exploration and development. Junior gold miners typically have a much smaller market cap, usually under $500 million, and lack an established position, in terms of production and balance sheet. This suggests they are riskier, but also have a much higher potential reward.

There are countless junior gold miners for an investor to choose from, some that are just small producers while others are still in the exploration phase. Those in the exploration phase offer both the most upside as well as the most risk as cost overruns, debt problems, construction issues, gold prices, and a whole host of other issues could incinerate an investment in a heartbeat. Therefore, an investor in a junior miner isn't just betting that gold prices will rise but that a particular miner will strike it rich.

Precious metal streamers
One thing that I've touched on is the fact that gold stocks are risky, as not only can the price of gold impact returns, but so can company-specific issues. Building a new gold mine is very costly and has been known to cause problems for even the largest of gold producers as cost overruns can kill returns. That's why gold producers both small and large often turn to precious metal streaming companies to help them fund new mines, with Silver Wheaton (WPM 1.86%) being the most well-known streamer. The slide below shows how its business model works:

Data source: Silver Wheaton investor presentation. 

As that slide shows, in exchange for an up-front fee Silver Wheaton is able to lock in a future supply at a rock bottom price. For example, last year its fixed gold cost was just $386 per ounce. That provides Silver Wheaton with a lot of wiggle room should gold prices stagnate as it can continue to make a lot of money on its gold production. Furthermore, given all the new mines Silver Wheaton and its partners have coming on line in the years ahead, its production is expected to grow strongly. In other words, Silver Wheaton could thrive even if gold prices dive. 

Gold mining ETFs
For investors that want to invest in the stocks of gold miners, but don't know which one to choose, there are a variety of gold mining ETFs to choose from that focus on both senior and junior gold miners. Two of the top options are the Market Vectors Gold Miners ETF (GDX 1.60%) and the Market Vectors Junior Gold Miners ETF (GDXJ 2.41%). These own a basket of gold miners. The Market Vectors Gold Miners ETF, for example, currently has 36 holdings with the top 15 holdings on the chart below:

Data sources: Market Vectors Gold Miners ETF (Fund weighting as of Aug. 31). 

These names should be relatively familiar as they include the top seven producers from the earlier chart, as well as Silver Wheaton, in addition to a number of other mid-sized producers. Meanwhile, the Market Vectors Junior Gold Miners ETF currently holds 61 gold stocks, all of which are smaller gold producers and exploration companies.

The problem with both of these, and other gold miner ETFs, is the fact that they've struggled to outperform the price of gold over the long term. In fact, both ETFs have significantly underperformed gold over the past few years.

GDX data by YCharts.

A word of caution
Therein lies a valuable lesson for investors looking to profit on gold stocks. They have a problem matching the price of gold over the long term due to a combination of factors ranging from debt problems, cost overruns, labor issues, exploration issues, geopolitics, and management missteps. Even worse is the fact that gold miners, on average, have vastly underperformed the price of gold not just in periods of price weakness but in times of strong price appreciation. That's why an investor needs to be very careful in selecting a gold stock as they could be right in their thesis -- that the price of gold will rise -- but wrong in their chosen vessel.

Gold stock investing takeaway
Investors have a lot of options for investing in gold stocks. Having said that, investing in any commodity is tough and gold is tougher than most because gold miners have had a real tough time creating value for investors no matter the price of gold. That's why investors need to consider gold stocks carefully as they don't often outperform the price of gold -- for every Yamana Gold, there's a multitude of other gold stocks that will underperform. In this case, if an investor isn't confident enough to bet on the future potential of a certain gold stock, it might be better to simply invest in the physical commodity in order to at least match its return.