Contrarian Case For Precious Metals Equity

It's been a bloodbath for precious metals equities (PMEs). PMEs are companies that mine gold, platinum and other precious metals.

While gold is down 8.4 percent over the past five years ending July 24, 2015, PMEs are down far more. The Market Vectors Gold Miner's ETF (GDX | C-78) has lost 70.2 percent over the same period, while the Vanguard Precious Metals and Mining Fund (VGPMX) is down 56.8 percent. Both are with total returns, including dividend reinvestment.

Source: Yahoo Finance including dividend reinvestment

And it's just not recent performance that's been so abysmal.

Financial author and theorist William Bernstein says that Ken French’s Precious Metals Equities series (spliced with GDX return YTD) returned a dismal minus 0.13 percent real return from 6/30/63 through 7/27/15. Thus, unlike gold itself, precious metals equities haven’t kept up with inflation.

What's Gone Wrong?

Why have PMEs done so much worse than gold itself? There are perhaps several reasons.

First, their profitability is much more sensitive than the price of the metals themselves. Since there are costs to mine, a 10 percent decline in the price of gold could have a 20-30 percent hit to their profitability.

Next, these stocks are typically levered, so their debt service adds more stress to the bottom line. Further, many of these mining companies are located in South Africa and have gone through violent strikes. Finally, many of these companies have been called poorly managed. When gold prices surged, many built a cost structure that assumed they would stay high or continue to surge.

Why I Still Believe

I've painted a pretty bleak picture of precious metals equities, so why do I still believe in them?

Bernstein notes that if you had looked at the return of PMEs though 2004, you'd have seen a real return of about 4.5 percent annually. Today that's a negative real return. Bernstein thinks the prospective long-run return will be somewhere in the middle, or about a 1 percent annual real return.

While that prospective real return may be below expectations for stocks, the value comes in two ways: low correlation and high volatility. Bernstein states that the near-zero correlation can often smooth out the return of the total portfolio. And the extreme volatility allows buying after plunges and selling after surges.

But Bernstein says two things are required for successful PME investing. Those two requirements would be a 40-year time horizon, and a stomach that can handle the pain during the long ride. Bernstein definitely has a way with words, and concludes:

"You always have to be careful making such a statement, but I’m pretty sure that gold mining will not go the way of encyclopedias or road maps."

While I admit I never envisioned precious metals equities performing as badly as they have, I'm sticking to the strategy of rebalancing. How much can I lose? … All of it!

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for AARP publications. At the time of this writing, he owned VGPMX.