Many
investors
know
physical
gold
is
in
demand
for
jewellry
and
acts
a
store
of
value
during
market
uncertainties
and
currency
devaluations.
It
also
offers
low
correlation
with
other
asset
classes
and
provides
a
hedge
during
periods
of
high
inflation.
The
Morningstar
Quantitative
Research
Team
has
analysed
this
issue
in
detail
in
a
recent
report.
Here
are
their
conclusions.
Types
of
Mining
Stocks
There
are
four
types
of
companies
involved
in
the
precious
metals
ecosystem
and
four
areas
of
activities:
1)
exploration
and
development;
2)
mining
and
production
(M&P);
3)
extraction,
refining,
investments,
royalty,
and
streaming;
and
4)
equipment
and
services.
Some
47%
of
these
companies
are
actively
involved
in
precious
metals
exploration
and
development,
while
another
41%
are
associated
with
mining
and
production
activities.
Many
investors
may
expect
mines
to
be
located
in
developing
markets.
But
precious
metals
companies
are
mainly
concentrated
in
Canada
and
Australia
because
of
the
availability
of
raw
materials,
as
well
as
their
long
history
of
exploration
and
production.
Mines,
But
No
Moats
Most
of
the
companies
in
this
ecosystem
do
not
possess
economic
moats
due
to
the
uncertainty
around
successful
exploration,
its
geological
challenges,
and
the
significant
environmental
impacts.
And
the
companies
do
not
have
pricing
power
and
face
challenges
around
fuel
costs,
labour
shortages,
and
volatile
commodity
prices.
Mining
is
capital
intensive
and
has
a
low
return
on
capital.
It
is
unlikely
that
companies
will
generate
economic
return
more
than
cost
of
capital
barring
materially
high
gold
prices.
These
challenges
prevent
the
establishment
of
robust
economic
moats.
Exceptional
Returns,
But
Also
Volatility
Still,
as
a
group
the
precious
metals
companies
have
generated
exceptional
returns
in
the
long
run.
During
bull
markets,
these
companies
can
deploy
their
operating
leverage
to
maximise
profits.
However,
their
volatility
during
periods
of
market
turbulence
may
put
off
potential
clients
from
owning
the
stocks
in
their
portfolios.
Correlation,
Inflation
What
about
correlation
with
other
assets?
There
is
a
fair
level
of
correlation
between
precious
metal
stocks
and
commodities,
US
real
estate
investment
trusts,
and
equity
market
returns.
But
the
low
correlation
with
fixed
income
and
negative
correlation
with
the
dollar
index
does
offer
some
respite
here.
The
connection
with
inflation
is
illustrated
in
the
following
graph,
which
shows
the
12-month
rolling
correlation
between
US
core
inflation
and
a
precious-metals
equity
basket
over
the
last
five
years.
The
horizontal
line
indicates
the
historical
correlation
average
from
2000
to
2023.
The
basket
performed
well
during
the
coronavirus
pandemic
as
correlations
started
falling.
But
during
the
bear
market
of
2022,
correlations
started
to
improve
(i.e.
became
less
negative),
resulting
in
an
increase
in
the
precious
metals
basket
returns.
Owning
precious
metals
miners
has
benefits
but
also
brings
risks.
What’s
obvious
is
the
sector
is
overexposed
to
small-cap
and
highly
volatile
companies,
but
liquidity,
quality,
and
yield
remain
areas
of
opportunity.
Given
these
factors,
they
may
have
a
place
in
portfolios.
These
companies
also
have
ESG
issues.
As
can
be
seen
in
the
following
chart,
the
precious
metals
basket
has
higher
risk
scores
relative
to
broad
equity
markets.
Mining
Valuations
Stretched?
There
are
clearly
challenges
with
valuations
with
precious
metals.
Return
of
equity
(ROE)
and
return
on
invested
capital
(ROIC)
being
lower
than
broad
markets
and
price/earnings
ratios
also
seem
too
high.
The
higher
P/E
suggests
that
investors
are
willing
to
pay
more
for
the
future
growth
potential,
capitulating
on
rising
prices
of
precious
metals,
despite
their
current
lower
profitability
compared
with
the
broader
market.
The
low
return
can
be
attributed
to
the
capital-intensive
nature
of
the
mining
industry,
which
is
triggered
by
challenges
in
managing
cost
structures
and
exploration
costs
due
to
the
scarce
availability
of
these
metals.
In
addition,
risks
of
volatile
commodity
prices,
geopolitical
issues,
and
regulatory
ecosystems
further
impact
profit
margins.
Read
more:
why
one
company
is
bullish
on
bullion
and
the
case
for
holding
gold
next
year
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