What Will Happen To Gold Stocks In 2013

By Will Ashworth | December 10, 2012 AAA

The year 2012 is almost in the books; it was a brutal time for gold miners like Iamgold (NYSE:IAG) who've seen their share prices crater while gold actually increased in value. There's a serious disconnect between the two and it's questionable whether this will change anytime soon. As we head into 2013, I'll have a look at what I expect will happen to gold stocks in 2013.

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Rising Costs
The big problem for gold miners is that they have to get the gold out of the ground; the cost to do so keeps rising. Barrick's (NYSE:ABX) Pascua-Lama project on the border of Chile and Argentina is full of hope and promise, yet it has been hit by rising labor costs and much uncertainty. According to Pav Jordan of the The Globe And Mail, the cost to develop Barrick's mine was estimated at $8.5 billion in November. Only four months earlier it was $500 million less. That's a 6.3% increase. With the opening not expected until the summer of 2014, development costs could easily rise to $10 billion by then. That's one of the reasons why Barrick fired its CEO Aaron Regent in June. Costs were getting out of hand. Unfortunately, for gold miners in general, it's a pretty standard occurrence industry-wide. According to a Canadian bank, the all-in cost to produce an ounce of gold is $1,500. Even worse, gold miners need the price of gold to remain at or above $1,700 for a sustainable amount of time in order to profit from their mining. Given the price of gold is currently around that number, it doesn't leave a lot of wiggle room for investors. In the past five years, Barrick's stock has lost ground while the price of gold has increased by approximately 120%. While it might have 17.9 million ounces of gold reserves at the one mine alone, if the cost to get it out of the ground keeps rising, only a sustained run in gold prices will allow it to sufficiently profit from those reserves. Therefore, the economic argument for investing in gold miners doesn't appear sound.

SEE: The 5 Best Performing Gold ETFs

Exchange Traded Funds
One of the big reasons for the price of gold rising in recent years is the introduction of exchange traded funds (ETFs) like the SPDR Gold Shares (ARCA:GLD) and the iShares Gold Trust (ARCA:IAU), which allow investors to own gold bullion more easily. Prior to ETFs, most people would buy the stocks of big producers like Barrick and Iamgold benefiting indirectly from the rising price of gold. When gold prices increased the share price of gold producers tended to follow suit. Now, because investors are creating increased demand for these commodity ETFs, it's putting upward pressure on the price of gold. The big problem with what's happening is that investors are no longer buying an asset that's uncorrelated with equities. It used to be if you were worried about the performance of stocks, you'd invest in gold as the ultimate hedge. Since 2009, the price of gold and the S&P 500 have moved almost in lock-step with each other. Therefore, an argument can be made to own the S&P 500 exclusively, eliminating any need for a discussion about gold.

SEE: 5 Best Bets For Buying Gold

Poor Capital Allocation
At a recent conference in London, BlackRock's (NYSE:BLK) chief investment officer for natural resources, Evy Hambro, was highly critical of the big gold mining companies. Hambro feels they've done a very poor job investing shareholder capital. Since 2006, gold miners have increased their share count by 40% without increasing volume or margins. That means they've been spending billions on exploration with no additional returns to speak of. In addition, Hambro wonders why gold firms payout just 25% of profits as dividends when oil companies are up around 45%. At one time the average gold miner's stock traded at a forward P/E of 30 to 35 compared to 15 for global equities. Today, gold miners trade for less than global equities. Exhibiting very little financial discipline, it makes it hard for investors to justify an investment in the producers themselves.

The Bottom Line
While it's clear the valuation of gold stocks like Barrick are incredibly low on a historical basis, I still have to wonder if it's worth placing a bet. Many analysts feel it's only a matter of time before gold stocks participate in the growing popularity of the commodity itself. I'm not so sure. I subscribe to the Warren Buffett theory about gold that says it serves no useful purpose besides looking pretty. Eventually, people will get bored of looking at it. And even if the price keeps rising, there's no guarantee producers will be able to profit from the increase.

Therefore, I don't hold out much hope for a rally in gold stocks in 2013. However, if you must place a bet, I'd do so with an ETF like the iShares MSCI Global Gold Miners Fund (NYSE:RING), which is reasonably diversified with 47 holdings including Barrick and is the least expensive of its ETF peers at an annual expense ratio at 0.39%.

At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.

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