Miner Mania!

In the mid-nineteenth century the allure of finding gold out west and striking it rich appealed to a certain adventurous type. Thousands of optimists ended up making the exodus to California. A few got lucky, but most were sorely disappointed. The allure continues to this day, although we don’t necessarily have to travel across the country and work the mines as our forefathers did. With the click of a button we can easily purchase the stock of companies involved in the exploration, mining and processing of precious metals like gold and silver. They’re the modern day equivalent of hitching a covered wagon out west, and their 2016 first quarter performance surely didn’t disappoint. A collection of these companies, as measured by the return of the Market Vectors Gold Miners ETF (GDX), was up an incredible 45.6%.

GDX vs. Global Indexes-Q1 2016

But hold on, let’s not get too excited. It’s probably best to take a lesson from the forty-niners and exercise some prudence. The past few years have been downright abysmal for this cohort. Total returns from 2011 through 2015 compounded at a loss of almost 77%. That 45.6% gain in the first quarter turned out to be nothing more than a speed bump. Since 2011 this asset was still down an astounding 66.3% through March of 2016.

GDX Total Return 2011-2015

The reality of the gold miners is that they are an incredibly volatile asset class and experience large swings both up and down. This should come as no surprise. Gold mining is an incredibly risky endeavor just as it was in the 1840s.

At first practically everybody came to California under the excitement of the gold rush and with the intention of having at least one try at the mines. But though gold was to be found in unprecedented abundance, the getting of it was at best extremely hard work. Men fell sick both in body and spirit. They became discouraged. Extravagance of hope often resulted, by reaction, in an equal exaggeration of despair. The prices of everything were very high. The cost of medical attendance was almost prohibitory. [1]

Times have changed dramatically. Fever is no longer a life threatening ailment to miners. Volatile commodity markets, unstable emerging economies and demanding labor unions have taken over as the new risks in this industry (to name a few). As a consequence gold mining remains an extremely challenging and volatile business to this day. Take a look at these headlines from around the web over the past few years

Gold Prices Surge, But Barrick’s CEO Axed On Weak Stock Performance (Forbes, June 6, 2012)
Kinross CEO’s ouster may be a sign of more bad news to come (Financial Post, August 8, 2012)
Anglo American Hires Cutifani as CEO After Losing $14 Billion (Bloomberg, January 8, 2013)
Miner Rio Tinto Ousts CEO as Bad Bets Cost Billions (WSJ, January 17, 2013)
Trouble brewing in South Africa’s gold mining sector (Mining.com, June 8, 2015)

Thinking that these types of events are rare for this industry is pure fantasy. The manic business environment and crazy fluctuations in returns have always been the norm rather than the exception. Using a larger data set from Ken French’s data library helps give a broader perspective on how this asset behaves over the long run. His gold miners series dates back to July 1963 and runs through December 2012. I completed the time series up to the present day by supplementing French’s data with total returns of GDX. The volatility of this Precious Metal Equities (PME) series is about the same as emerging market stocks and roughly double that of the S&P 500. This is the stuff financial nightmares are made of.

Asset Volatility
US Large Cap (S&P 500)
(Jan 1964 – Dec 2014)
US Small Cap
(Jan 1964 – Dec 2014)
(Jan 1970 – Dec 2014)
MSCI Emerging Markets (Gross)
(Jan 1988 – Dec 2014)
Precious Metal Equity
(Jan 1964 – Dec 2014)

Single year returns were indeed all over the place. PME returned 128% in 1979 but -54% in 2013–just what you would expect from a highly volatile asset. However, the volatility extends to long-term returns as well. The chart below shows that the rolling 30 year return of PME has declined substantially since the early 1990s and even went negative for periods ending in 2013 and 2015. The point here is that this asset can go for decades without producing any meaningful return. One or two bad years can completely wipe out what has accumulated over decades.

Rolling 30 Year Returns of Precious Metal Equity

For all of the stress that PME is likely to cause for owners it does have some redeeming qualities. The correlation between PME and many other equity asset classes is fairly low. A remarkable characteristic that is near impossible to find in this age of globally integrated markets. Additionally William Bernstein demonstrated that PME has performed very well during periods of high inflation (>5%). During such years PME provided an annualized real return of 3.25% versus -6.19% for the broader US market as represented by the CRSP 1-10 . [2]

Precious Metal Equity Correlations

In his follow up book Rational Expectations Bernstein performed a more rigorous analysis of PME. Historically adding some PME to a regularly rebalanced portfolio helped to reduce volatility and increase return, but these benefits were small and limited.

Efficient Frontier-US Stocks & Precious Metal Equities

The poor long-term return potential of PME presents a very serious problem. When the long-term returns of asset classes are different by a substantial amount (as the above rolling 30 year return chart demonstrates), adding even a small amount to a regularly rebalanced portfolio can, over the long-run, actually reduce portfolio returns. Even the most disciplined and unemotional investor could lose out. Brutal. Bottom line: don’t count on this asset to deliver reasonable returns over long periods of time like broad market indexes have done. [3]

That being said, this is definitely not a buy and hold asset class. I currently have a small percentage of my portfolio allocated to miners. I use both the Vanguard Precious Metals and Mining Fund along with GDX. Both are held in tax advantaged accounts to eliminate any tax burden that comes from selling. I monitor the internal rate of return like a helicopter parent and I don’t hesitate to sell when a position turns profitable. I target an 8% rate of return before selling any share (roughly on par with the long-term return of broader developed markets). Remember, the goal is to make money. Owning an asset that reduces portfolio volatility at a loss isn’t a very bright idea.

The real challenge with this asset class is more emotional and psychological than it is technical. You’ll have to endure some manic months and years while exercising an incredible amount of patience. Not for the faint of heart.

1. White, Stewart Edward. The Forty-Niners: A Chronicle of the California Trail and El Dorado. Yale University Press. New Haven, CT. 1920. p. 119. http://nrs.harvard.edu/urn-3:FHCL:892922
2. Bernstein, William J. Deep Risk: How History Informs Portfolio Design. 2013. p. 40.
3. Bernstein, William J. Rational Expectations. 2014. pp. 58-63.

What I’m Reading
How to Avoid the Problem of Short-Termism (Cullen Roche)
Simple vs Complex (Josh Brown)
Final U.S. retirement advice rule addresses industry, political concerns (Reuters)