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Gold vs. Gold Shares: A divergence?

Why were not so sure that the values of gold equities are lagging the price of gold
There has been much hand-wringing among gold equity investors
of late. The average gold share seems to have forgotten that it is,
indeed, a gold share, and that it should be scooting on higher
hand-in-hand with its big brother, the metal. In fact, one would
expect that the operating leverage that mining companies have to
the gold price would juice their performance such that an x%
increase in gold would equate to an x+n% increase in share
prices. But the shares seem to have lost their way. While observers are right that the average price of a gold share has been lagging
gold, our view is that the overall market capitalization of the gold
industry has been increasing much faster than the price of the
average share. This is because even though share prices have been
dilly-dallying, exuberant growth in share issuance has more than
compensated. As such, the mysterious gold-share divergence is
not really a divergence, since the gold companies collective market capitalization, and not their price, has much better approximated the rising gold price.
First, we present the evidence for weak prices. The most popular way to measure the relative strength of gold shares vs. physical gold is to take the ratio of the Philadelphia Gold & Silver
Index (XAU) to the gold price. We submit figure 1.
The XAU gold index managed to maintain a fixed, even slightly
rising, ratio to the gold price through the first few years of the
gold bull market. Everything was as it should be. But starting in
2006 the XAU began to fall relative to gold, with the fall accelerating during the credit crisis of late 2008. Shares managed to
rally briefly versus the metal in 2009, but this rally stalled and
the XAUs relative weakness continues in 2011.
Next well focus in on the last three or so years. From the end of
2007 to May 31, 2011, the spot price of gold rose 84%. Over

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that same period the XAU underperformed, rising a measly

21%. We have constructed our own capitalization-weighted
grouping of 10 international gold companies, removing the
silver and base metals bias that characterizes the XAU. That
group is up 28%. Lastly, we have crunched the return for the
11 Canadian gold miners spotlighted in our 2011 Gold Survey.
These are up 73%. See figure 2 for the respective changes,
weightings, and constituents.
While the mid-caps in the Canadian-11 group have outperformed the stocks in our International-10 group, in general
stocks have underperformed gold. In the table on the opposite
page we show the market capitalizations for our Canadian-11
and International-10 groupings. Starting from a market cap of
$3.0 billion at the end of 2007, the value of the Canadian-11
has jumped to $6.7 billion. The market cap of the International11 has run up from $137 to $202 billion. The total values of
our two indexes have risen by 124% and 48% respectively.
Figure 3, opposite page, puts everything in perspective. While
the price of the average share in the Canadian-11 has underperformed gold, the increase in their combined market cap has
almost doubled that of the metal. While the average international miners market capitalization is still underperforming
gold, this market cap is still increasing twice as fast as the average international miners share price.
The rise in gold company valuations since the end of 2007 is
due in no small part to the flood of new capital entering the
market. Over the last three years about $1.7 billion in new

Table 1. The values of Pollitts two gold indexes

Changes from Dec 31, 2007 to May 31, 2011

Billion $
Canadian-11 International-10
Initial Market Cap
End Market Cap
$ Change
% Change
Equity raised





shares has been issued by the Canadian-11, and $26 billion by the
international players.
This underlines the main difference between the physical gold
market and the gold share market. When demand for gold rises,
the sole way that demand can be satisfied is through existing
ounces of the metal coming to the market, or new ounces mined
through sweat and tears. Only a higher gold price can coax these
ounces out. But when the demand for gold shares rises, this demand can be met by either existing shares coming to market, or
newly-printed shares coming to the market. Thus, unlike gold,
higher equity prices are not needed to coax shares onto the market to meet demand, since eager mine promoters are more than
willing to meet that demand at existing share prices by creating
shares out of thin air. That is why we see the phenomenon of a
rising gold price, lagging gold share prices, and outperforming
gold market capitalization.
The massive dilution that gold companies have perpetrated on
existing shareholders has only compounded gold shares underperformance relative to the metal. With many miners issuing
new shares, and the gambling public more than willing to snap
these issues up, there has been an artificially large amount of new
funds entering the mining camps, driving up the price of everything from washed-up gold mines, machinery, mining wages,
drilling contractors, and mine engineering costs. The result is
that any rise in the gold price has been eroded by these higher
costs. Had gold companies not issued so many shares, and the
gold investing community been less tolerant of dilution, less
money would be chasing the limited number of miners, contractors, etc., and the operating position of gold companies would be
less precarious.

John Paul Koning

Gold mining is a tough business that typically yields low returns

on capital. But it has always attracted its fair share of dreamers
and, as a result, gold shares tend to be issued in such tremendous amounts, and at such high valuations, that they never outperform the metal for any extended period of time. The
divergence between shares and the metal is not so much a
divergence, as a convergence to the mean.

Toronto, Ontario
June 17, 2011

The information contained in this report is believed to be reliable, but its accuracy and/or completeness is not guaranteed. All opinions, estimates and other information included in this report constitute our
judgement as of the date thereof and are subject to change without notice. Pollitt & Co. Inc. does not issue ratings or price targets on any securities mentioned within this letter, nor does Pollitt & Co. Inc.
maintain and publish current financial estimates and recommendations on securities mentioned in this publication. Pollitt & Co. Inc. discontinues coverage of the stocks highlighted in this letter. For information on our policies on research dissemination, please see our website, Stock Recommendation System and Terminology: Pollitt does not issue price targets for companies. Pollitt intends to
maintain a Buy List of 10-15 stocks. The listing of a stock on the Buy List should be considered as advice to carry a position in that stock. The removal of a stock from the list should be considered as advice to
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