Source: Flickr user Bullion Vault.
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The stock market may be in full rally mode, but you'd never be able to tell by examining gold stocks, which have vastly underperformed the broad market for the past four years. Since gold peaked at more than $1,900/oz. in 2011, the Market Vectors Gold Miners ETFhas lost more than 60% of its value when adjusted for dividend payments. Comparatively, the broad-based S&P 500 is up 57%, for an underperformance equal to 117%! I believe "yuck!" sums that comparison up well.
Despite this underperformance, there are both short- and long-term investors who continue to find value in gold stocks (including yours truly, who owns a couple in his personal portfolio). But, as you can tell by gold stocks' performance, this industry clearly isn't without risks, and even following a substantial drop, the industry and its components could still have further downside.
Three types of risk facing gold stocks
With that in mind, let's take a closer look at three types of risks gold stocks are facing so you as the investor will have a better bead of what to closely monitor.
1. The risk of a rising dollar
Arguably, there is no greater risk for gold stocks than a precipitously strong U.S. dollar. A strong dollar is great news for the U.S. consumer who can comparatively afford more in overseas markets, but it also means overseas consumers can't afford as much as they previously could with the same amount of currency.
The same line of thinking holds true for overseas countries that are purchasing gold, since gold is often priced in dollars. Purchasers of gold in a strong U.S. dollar environment can't comparatively buy as much as before with the same amount of their own currency, thus the amount of gold sold globally falls, hurting the underlying price of the commodity. If it's any consolation, when the U.S. dollar rises, it isn't just gold that feels the pangs, but all commodities, including oil.
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Source: Royal Gold.
But, a rising dollar is doubly bad for emerging market countries that rely on exports and/or rising commodity prices to drive growth. China, for instance, is a very export-driven economy, but it's witnessed its currency, the yuan, shrink to 6.2 to $1 compared to 6.8 to $1 just five years ago. If China, the most important metals importer in the world, sees its growth slow because of weaker exports, it could further dampen gold consumption.
One company clearly at risk from a rising dollar is gold royalty interest stock Royal Gold .
Unlike traditional miners, Royal Gold provides up-front cash to mining companies in exchange for a percentage interest of their mineable gold reserves at a very low fixed cost. Although its fixed cost for gold is extremely low and not in danger of losing money anytime soon, it is easily affected by fluctuations in the underlying price of gold. It also doesn't help that roughly 60% of its revenue in 2014 was derived outside the U.S., meaning it's getting hit by the negative effects of currency translation.
2. Financing risk
The second big risk for gold stocks is simply financing their build-out, especially if a company like Royal Gold isn't there to help.
Source: Thompson Creek Metals.
Just because gold prices have fallen $700/oz. since peaking in 2011 doesn't in any way mean that the costs associated with paying for labor, maintaining a mine, expanding a mine, or completely building a mine from scratch have abated in any way. With gold well off its highs, it's left gold companies with an interesting dilemma of either scrapping projects until the development is feasible, selling projects to asset-hungry miners, or going forward with a potentially costly project. The results aren't always favorable -- and I can speak to this firsthand.
As an owner of Thompson Creek Metals I can attest that I've had far more frowns on my face than smiles over the last three years. The thesis to owning Thompson Creek -- which I do still believe to be true -- was that its Mount Milligan mine, acquired in 2010 with its Terrane Metals purchase, was expected to be a game-changer. With proved and probable reserves totaling 2.1 billion pounds of copper and 6 million ounces of gold, I foresaw $1-plus in EPS for the company four to six quarters after its ramp-up.
Unfortunately, Thompson Creek Metals' budget went up in smoke. Originally slated to cost $750 million, the Mt. Milligan development ultimately cost closer to $1.5 billion. These extra costs, compounded with weakness in the molybdenum market, which provided positive free cash flow to Thompson Creek, caused the company to seek financing for its project, as well as sell off 52.25% of its royalty interest in its Mt. Milligan mine to none other than the aforementioned Royal Gold.
Source: Royal Gold.
What's left is a company that's more than 95% off of its all-time high and is lugging around $700 million in net debt for a debt-to-equity of 133%.
I personally continue to view this as a bullish turnaround candidate, but there are clear liquidity and financing risks, here. My only consolation is that Thompson Creek isn't the only miner facing financing issues.
3. Political risk
The final concern for gold stocks is the political risk of operating in countries or regions that are highly unstable. A strong dollar might be hurting gold miners in Australia or Canada, but there's veritably no risk of political instability harming mining operations in these countries. However, this isn't the case for gold miners operating in Africa, where political instability is practically a way of life.
Source: AngloGold Ashanti.
In 2012, multinational gold miner AngloGold Ashanti saw all of its operations in South Africa come to a grinding halt as mining laborers across the country went on strike, demanding higher wages. Not only did this represent a potential increase in the underlying expenses to run AngloGold Ashanti's South African mines, but it also cut off a third of the gold production AngloGold was producing as a whole.
AngloGold eventually conceded to wage increases and reopened its mines, but the company has noted as recently as this past week that there can't be open wage discussions each year with laborers without there being any consequences. Additionally, South Africa's power utility Eskom is requesting a whopping 25.3% increase in 2015-2016 electricity tariffs, which includes a previous 12.69% increase in March.
You be the judge
There are obviously some well-defined risks associated with gold miners, but it's not as if opportunity doesn't exist. Miners have done a good job of trimming their costs and raising cash to buffer against any additional downside in gold prices. Some gold stocks relative to their profits or book value certainly appear cheap, but inclusive of the risks mentioned above, that's going to be up to you to decide.
The article 3 Types of Risk Facing Gold Stocks originally appeared on Fool.com.
Sean Williamsowns shares of Thompson Creek Metals, but has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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