In June we explained why we were constructive on gold. We outlined the deep relationship between gold and real interest rates and showed how that relationship has appeared to change as the marginal buyer shifted from Western investors to Emerging Market central banks.

Much of the central bank buying is secretive. While the increase in officially declared purchases has been relatively modest, there are fingerprints to suggest that EM central banks have been mopping up supply though other channels. In particular, Chinese buying outside of the central bank has stepped up significantly as other state institutions have tapped the market.

While we laid out the case for why we like gold, our current positioning is via gold miners rather than physical gold. We think investor concerns about the miners are misplaced when making a proper comparison taking all relevant factors into account. There are two major reasons why long-term historical analysis comparing physical gold to miners is often flawed.

Firstly, there is a lack of accounting for dividend accrual on the miner side. When you compare one equity market to another, or two individual stocks, it does not matter hugely so long as both have similar dividend payouts. This is especially true for short-term comparisons. When comparing gold to gold miners, however, you are comparing a zero-payout asset to one with high cashflows, which becomes increasingly important as you extend the period of analysis.

Secondly, gold miners have a significantly different volatility profile to that of the metal. The risk and potential return associated with gold equities is about 2.5x that of gold. When interest rates are low, the opportunity cost of bigger position sizes is also low. When rates are higher, taking a much larger position in physical gold (e.g. 25% NAV) rather than a smaller, but risk-equivalent, position in gold miners (e.g. 10% NAV) sacrifices an extra 15% of portfolio assets that can’t sit in high-yielding bills. Over the long term this adds up. Investing via gold futures or other vehicles does not change the arithmetic, as buying and rolling futures incurs a running cost that exceeds the pick-up from investing the unencumbered cash in bills.

When you correct for these factors and carry out a long-term analysis, the perceived structural outperformance of gold over the miners disappears. 

We have run our analysis (Chart 1) from 1980 onwards using Newmont; the largest listed miner and the gold stock with the longest single history. Our analysis compares the performance of a 10% NAV position in the miner with a risk-equivalent investment of 25% NAV in the metal (this risk ratio is fairly stable over time, and we hold at 2.5x for simplicity). Before accounting for interest rate sacrifice, the miner and the metal have delivered similar returns of 62% and 58%, respectively, since 1980. 

Due to the much larger notional size in gold relative to the miner, the interest rate sacrificed in holding the metal is significant, all but eliminating positive returns accrued over the period (realised return of just 1% since 1980). The return on the miner is also meaningfully reduced to 38% but is far less impacted than the metal, hence running an RV trade long the metal relative to the miner would have resulted in a 28% loss over the period.

Source: Bloomberg & Trium Capital. Data as of 30 Aug 2024. Newmont Corporation used as proxy for Gold Miners.

We also ran an analysis (Chart 2) replacing Newmont with the gold miner index (GDX) from the point at which data became available in 2004. As you can see from the chart, the difference was small, leading us to believe that Newmont was a fair proxy for the 1980 to 2004 period.

Source: Bloomberg & Trium Capital. Data as of 30 Aug 2024.

Contrary to popular belief, it has not been a bad strategy to play the miners instead of the metal. Gold persistently underperformed miners during the [gold] bear market from 1980 to 2001; and after factoring in the high rates prevalent during the period, performance was substantially worse still. It seems that much of the investor frustration stems from the 2003 to 2013 bull market when gold genuinely outperformed the miners (which were supposed to offer a levered play on rising prices), even after all factors were accounted for. Again, actual outperformance was less than commonly thought, but it is still clear outperformance. 

We believe that this historical aberration can be explained by ill capital discipline over the period coupled with a very high starting valuation. 2003 also saw the approval of the first gold ETF, absorbing sizeable flows that might have otherwise been destined for equity plays. Gold miners have learnt their lessons and are much better custodians of capital today, while Newmont’s current P/E is an unchallenging 15x (less than half of what it was at the start of the 2003 to 2013 bull market).

Source: Bloomberg & Trium Capital. Data as of 30 Aug 2024.

Investors have been scarred by the 2003 to 2013 outperformance of gold. What at first looks like a continuation of that outperformance since then has been completely eroded by interest rates. While historical analysis doesn’t tell you how to play the theme today, we believe that correcting the record is important.

Why do we like gold miners today?

As discussed in our previous note, the structural underpinning of the gold market is stronger now that it has found a significant, more resilient, new buyer in non-US-aligned central banks. No longer is gold purely at the whim of US real rates. We still think that if real rates go down, then gold will go up, but buying will get more crowded and the price will go up even quicker. Central bank buying is less cyclical and offers more long-term certainty of price-insensitive gold demand. So long as the US/China relationship remains strained and China maintains its policy of industrial surplus, then the buyer will be there. This reduces the volatility of the outlook for gold and, hence, should make gold reserves in the ground more valuable, leading to a re-rating of the currently undemanding valuation levels.

Our main point remains that investors should own more gold, whether or not they do that via the miners. We see it as a long-term opportunity, but not necessarily a 40-year “buy and hold”. While the miners are currently our preferred way of playing the theme, as macro investors we remain willing to toggle between expressions, and trade around shorter-term market gyrations.