From gold to Bitcoin, why "mining" always fails to outpace the "mine" itself.

Whenever gold prices soar, many people tend to believe that this will benefit gold mining stocks, but in reality, this may be an illusion. Over the past 15 years, gold mining stocks have significantly underperformed physical gold.

Gold may rise, but gold mining stocks may not necessarily follow suit.

According to data from Koyfin, since November 2009, the ETF tracking physical gold - SPDR Gold Shares (GLD), has seen a cumulative increase of 99%. In contrast, the ETF tracking the three major gold mining giants (Newmont, Agnico Eagle, and Barrick Gold) - VanEck Gold Miners (GDX), has recorded a cumulative decline of 17.9% during the same period. Another ETF tracking smaller gold mining stocks - VanEck Junior Gold Miners (GDXJ), has seen a cumulative decline of 40%.

This means that the performance of gold mining stocks has lagged far behind that of gold, serving as a warning to investors that while gold may have a certain "value reserve" function, it does not guarantee returns for gold mining stocks.

Moreover, in reality, gold's overall performance is not particularly impressive. Data from Macrotends shows that, adjusted for inflation, the price of gold has seen a cumulative increase of less than 300% over the past 100 years, with an annualized real return rate of only about 1.34%.

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It is quite surprising that gold mining stocks cannot even outperform an annualized return of around 1%, considering that gold mining companies typically operate with inherent leverage.

The operating leverage effect of gold mining producers

In theory, the stock prices of gold mining companies exhibit a leverage effect when faced with fluctuations in gold prices. This means that the stock price volatility of gold mining companies often exceeds that of gold prices. This leverage primarily stems from the business model of gold mining companies.Generally speaking, the operating costs of gold mining companies are divided into fixed costs and variable costs. Fixed costs (such as equipment, management expenses, etc.) do not change with the production of gold, while variable costs (such as labor, fuel, etc.) are proportional to the production of gold. When the price of gold rises, the fixed costs of gold mining companies are diluted, and the profit margin will increase significantly, thereby amplifying the impact of gold price fluctuations on the company's profitability. Conversely, when the gold price falls, the profits of gold mining companies will also decline sharply. Here is a simplified example to illustrate this point.

Suppose there is a gold mining producer that can produce 100,000 ounces of gold annually, with a cost of $1,500 per ounce, and its overall corporate operating costs are $30 million per year. If the current spot gold price is $2,300, this miner can generate $230 million in revenue from selling gold annually, and the total cost is $150 million, resulting in a gross profit of $80 million. After deducting the $30 million in operating costs, the miner has a pre-tax profit of $50 million.

If the gold price falls by 20% to $1,840 per ounce, you will find that the miner's profit has almost disappeared: his gross profit would drop to $34 million, but the pre-tax profit would be only $4 million. That is to say, with a 20% drop in the base gold price, his profit has decreased by 92%.

Conversely, if the gold price rises by 20% to $2,760 per ounce, the gold mining company's pre-tax profit almost doubles, reaching $96 million.

In both cases, the gold price only rose/fell by 20%, but the profit fluctuation of the gold mining company exceeded 90%. This nonlinear increase in profits is a manifestation of the leverage effect of mining companies. Ironically, this leverage effect does not linearly transmit to the stocks of gold mining companies, meaning that even if the company's profits fluctuate by 90% due to the rise and fall of gold prices, the stock price may not fluctuate by 90%.

Why has the operating leverage of gold mining companies failed?

Even the stock performance of gold mining giants like Newmont and Barrick Gold has been negative over the past 20 years, while the gold price has increased nearly fivefold during the same period.

It is clear that the operating leverage of these gold mining companies has failed. What are the reasons? Some analysts point out:

Firstly, poor management within gold mining companies is one of the influencing factors, such as excessively high executive compensation and inappropriate capital allocation. For many years, John Thornton, the chairman of Barrick Gold, has been criticized for his high compensation.

Secondly, geopolitical turmoil and excessive taxes and fees in mining areas are also key factors. For example, in 2019, the government of Tanzania demanded $19 billion in taxes from Barrick's subsidiary, Acacia Mining, which was later settled for $300 million.Over the past few decades, countless examples have demonstrated that, in addition to understanding reserves and production, gold mining companies also need to face more scrutiny. Both operational management and geopolitical risks are significant factors, and internal and external factors often prevent miners from leveraging their operations as they should. This has led to the underperformance of mining stocks relative to the price of gold.

Interestingly, this phenomenon of "miners not outperforming the mined" is also observed in the Bitcoin sector, apart from gold mining stocks.

The Bitcoin miners ETF - Valkyrie Bitcoin Miners (WGMI), since its launch in February 2022, has declined by 12%, while Bitcoin itself has risen by 29% during the same period.

This once again proves that the leverage that should theoretically be present is, in practice, very difficult to achieve.