The junior gold miners’ stocks have spent months grinding sideways near lows, sapping confidence and breeding widespread bearishness.  The entire precious-metals sector has been left for dead, eclipsed by the dazzling Trumphoria stock-market rally.  But traders need to keep their eyes on the fundamental ball so herd sentiment doesn’t mislead them.  The juniors recently reported Q2 earnings, and enjoyed strong results.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports.  Companies trading in the States are required to file 10-Qs with the US Securities and Exchange Commission by 45 calendar days after quarter-ends.  Canadian companies have similar requirements.  In other countries with half-year reporting, some companies still partially report quarterly.

The definitive list of elite junior gold stocks to analyze used to come from the world’s most-popular junior-gold-stock investment vehicle.  This week the GDXJ VanEck Vectors Junior Gold Miners ETF reported $4.0b in net assets.  Among all gold-stock ETFs, that was only second to GDX’s $7.5b.  That is GDXJ’s big-brother ETF that includes larger major gold miners.  GDXJ’s popularity testifies to the great allure of juniors.

Unfortunately this fame has recently created major problems severely hobbling the usefulness of GDXJ.  This sector ETF has shifted from being beneficial for junior gold miners to outright harming them.  GDXJ is literally advertised as a “Junior Gold Miners ETF”.  Investors only buy GDXJ shares because they think this ETF gives them direct exposure to junior gold miners’ stocks.  But unfortunately that’s no longer true!

GDXJ is quite literally the victim of its own success.  This ETF grew so large in the first half of 2016 as gold stocks soared in a massive upleg that it risked running afoul of Canadian securities law.  Most of the world’s junior gold miners and explorers trade in Canada.  In that country once any investor including an ETF goes over 20% ownership in any stock, it is deemed a takeover offer that must be extended to all shareholders!

Understanding what happened in GDXJ is exceedingly important for junior-gold-stock investors, and I explained it in depth in my last essay on juniors’ Q1’17 results.  GDXJ’s managers were forced to reduce their stakes in leading Canadian juniors.  So last year capital that GDXJ investors intended to deploy in junior gold miners was instead diverted into much-larger gold miners.  GDXJ’s effective mission stealthily changed.

Not many are more deeply immersed in the gold-stock sector than me, as I’ve spent decades studying, trading, and writing about this contrarian realm.  These huge GDXJ changes weren’t advertised, and it took even me months to put the pieces together to understand what was happening.  GDXJ’s managers may have had little choice, but their major direction change has been devastating to the junior gold miners.

Investors naturally poured capital into GDXJ, the “Junior Gold Miners ETF”, expecting to own junior gold miners.  But instead of buying junior gold miners’ shares and bidding up their prices, GDXJ was instead shunting those critical inflows to the much-larger mid-tier and even major gold miners.  That left the junior gold miners starved of capital, as their share prices they rely heavily upon for financing languished in neglect.

GDXJ’s managers should’ve lobbied Canadian regulators and lawmakers to exempt ETFs from that 20% takeover rule.  Hundreds of thousands of investors buying an ETF obviously have no intention of taking over gold-mining companies!  And higher junior-gold-stock prices boost the Canadian economy, helping these miners create valuable high-paying jobs.  But GDXJ’s managers instead skated perilously close to fraud.

This year they rejiggered their own index underlying GDXJ, greatly demoting most of the junior gold miners!  Investors buying GDXJ today are getting very-low junior-gold-miner exposure, which makes the name of this ETF a deliberate deception.  I’ve championed GDXJ for years, it is a great idea.  But in its current sorry state, I wouldn’t touch it with a ten-foot pole.  It is no longer anything close to a junior-gold-miners ETF.

There’s no formal definition of a junior gold miner, which gives cover to GDXJ’s managers pushing the limits.  Major gold miners are generally those that produce over 1m ounces of gold annually.  For years juniors were considered to be sub-200k-ounce producers.  300k ounces per year is a very generous threshold.  Anything between 300k to 1m ounces annually is in the mid-tier realm, where GDXJ now traffics.

That high 300k-ounce-per-year junior cutoff translates into 75k ounces per quarter.  Following the end of the gold miners’ Q2 earnings season in mid-August, I dug into the top 34 GDXJ components.  That is just an arbitrary number that fits neatly into the tables below.  While GDXJ had a whopping 73 component stocks in mid-August, the top 34 accounted for 81.5% of its total weighting.  That’s a commanding sample.

Out of these top 34 GDXJ companies, only 4 primary gold miners met that sub-75k-ounces-per-quarter qualification to be a junior gold miner!  Their quarterly production is highlighted in blue below, and they collectively accounted for just 7.1% of GDXJ’s total weighting.  And that isn’t righteous, as these include a 126-year-old silver miner, a mid-tier miner with temporary production declines, and a ramping mid-tier producer.

GDXJ is inarguably now a pure mid-tier gold-miner ETF.  That’s great if GDXJ is advertised as such, but terrible if capital investors explicitly intend for junior gold miners is instead being diverted into mid-tiers without their knowledge or consent.  The vast majority of GDXJ shareholders have no idea how radically this ETF has changed since early 2016.  It is all but unrecognizable, straying greatly from its original mission.

I’ve been doing these deep quarterly dives into GDXJ’s top components for years now.  In Q2’17, fully 29 of the top 34 GDXJ components were also GDX components.  These ETFs are separate, a “Gold Miners ETF” and a “Junior Gold Miners ETF”.  So why on earth should they own many of the same companies?  In the tables below I highlighted GDXJ components also in GDX in yellow in the column showing GDXJ weightings.

These 29 GDX components accounted for 74.6% of GDXJ’s total weighting, not just its top 34.  They also represented 30.1% of GDX’s total weighting.  So three-quarters of the junior gold miners’ ETF is made up of nearly a third of the major gold miners’ ETF!  I’ve talked with many GDXJ investors over the years, and have never heard one wish their capital allocated specifically to junior golds would instead go to much-larger miners.

Fully 12 of GDXJ’s top 17 components weren’t even in this ETF a year ago in Q2’16.  They alone now account for 40.6% of its total weighting.  15 of the top 34 are new, or 45.3% of the total.  In the tables below, I highlighted the symbols of companies actually in GDXJ a year ago in light blue.  Today’s GDXJ is a radical departure from a year ago.  Analyzing Q2’17 results largely devoid of real juniors was frustrating.

Nevertheless, GDXJ remains the leading “junior-gold” benchmark.  So every quarter I wade through tons of data from its top components’ 10-Qs, and dump it into a big spreadsheet for analysis.  The highlights made it into these tables.  A blank field means a company didn’t report that data for Q2’17 as of that mid-August 10-Q deadline.  Companies have wide variations in reporting styles, data presented, and report timing.

In these tables the first couple columns show each GDXJ component’s symbol and weighting within this ETF as of mid-August.  While most of these gold stocks trade in the States, not all of them do.  So if you can’t find one of these symbols, it’s a listing from a company’s primary foreign stock exchange.  That’s followed by each company’s Q2’17 gold production in ounces, which is mostly reported in pure-gold terms.

Many gold miners also produce byproduct metals like silver and copper.  These are valuable, as they are sold to offset some of the considerable costs of gold mining.  Some companies report their quarterly gold production including silver, a construct called gold-equivalent ounces.  I only included GEOs if no pure-gold numbers were reported.  That’s followed by production’s absolute year-over-year change from Q2’16.

Next comes the most-important fundamental data for gold miners, cash costs and all-in sustaining costs per ounce mined.  The latter determines their profitability and hence ultimately stock prices.  Those are also followed by YoY changes.  Finally the YoY changes in cash flows generated from operations, GAAP profits, revenues, and cash on balance sheets are listed.  There’s one key exception to these YoY changes.

Percentage changes aren’t relevant or meaningful if data shifted from negative to positive or vice versa.  Plenty of major gold miners earning profits in Q2’17 suffered net losses in Q2’16.  So in cases where data crossed that zero line, I included the raw numbers instead.  This whole dataset offers a fantastic high-level fundamental read on how the mid-tier gold miners are faring today.  They’re looking quite impressive.

After spending days digesting these GDXJ gold miners’ latest quarterly reports, it’s fully apparent their vexing consolidation this year isn’t fundamentally righteous at all!  Traders have abandoned this sector since the election because the allure of the levitating general stock markets has eclipsed gold.  That has left gold stocks exceedingly undervalued, truly the best fundamental bargains out there in all the stock markets!

Once again the light-blue-highlighted symbols are GDXJ components that were there a year ago.  The white-backgrounded ones are new additions.  And the yellow-highlighted GDXJ weightings are stocks that were also GDX components in mid-August.  GDXJ is increasingly a GDX clone that offers little if any real exposure to true gold juniors’ epic upside potential during gold bulls.  GDXJ is but a shadow of its former self.

VanEck owns and manages GDX, GDXJ, and the MVIS indexing company that decides exactly which gold stocks are included in each.  With one company in total control, GDX and GDXJ should have zero overlap in underlying companies! GDX or GDXJ inclusion should be mutually-exclusive based on the size of individual miners.  That would make both GDX and GDXJ much more targeted and useful for investors.

GDXJ’s highest-ranked component choices made by its managers are mystifying.  This “Junior Gold Miners ETF” has a major primary silver miner as its largest component.  Over half of PAAS’s sales in Q2 came from silver.  And the next two biggest are large South African gold miners.  That country has one of the most anti-shareholder governments in the world now, forcing unconscionable racial quotas on owners.

Since gold miners are in the business of wresting gold from the bowels of the Earth, production is the best place to start.  These top 34 GDXJ gold miners collectively produced 3,583k ounces in Q2’17.  That rocketed 74% higher YoY, but that comparison is meaningless given the extreme changes in this ETF’s composition since mid-2016.  On the bright side, GDXJ’s miners do remain significantly smaller than GDX’s.

GDX’s top 34 components, fully 20 of which are also top-34 GDXJ components, collectively produced 9854k ounces of gold in Q2.  So GDXJ components’ average quarterly gold production of 119k ounces excluding explorers was 61% lower than GDX components’ 308k average.  So even if GDXJ’s “Junior” name is very misleading, it definitely has smaller gold miners even if they’re well above that 75k junior threshold.

Despite GDXJ’s top 34 components looking way different from a year ago, these current gold miners are faring well on the crucial production front.  Fully 19 of these mid-tier gold miners enjoyed big average YoY production growth of 26%! Overall average growth excluding explorers was 12% YoY, which is nothing to sneeze at given gold’s rough year since mid-2016.  These elite GDXJ gold “juniors” are really thriving.

Gold production varies seasonally within calendar years partially due to mining-plan timing.  Gold-bearing ore was certainly not created equal, with even individual deposits seeing big internal variations in their metal-to-waste-rock ratios. Miners often have to dig through lower-grade ore to get to the higher-grade zones underneath.  This still has economically-valuable amounts of gold, so it is run through the mills.

These mills are essentially giant rock grinders that break ore into smaller pieces, vastly increasing its surface area for chemicals to later leach out the gold.  Mill capacity is fixed, with limits on ore tonnage throughput.  So when miners are blasting and hauling lower-grade ore, fewer ounces are produced.  As they transition into higher-grade zones, the same amount of rock naturally yields more payable ounces.

Regardless of the ore grades being blasted and milled, the overall quarterly costs of mining don’t change much.  Operations require the same levels of employees, fuel, maintenance, and electricity no matter how rich the rock being processed. So higher gold production directly leads to lower per-ounce mining costs.  The big fixed costs of gold mining are spread across more ounces, making this business more profitable.

There are two major ways to measure gold-mining costs, classic cash costs per ounce and the superior all-in sustaining costs per ounce.  Both are useful metrics.  Cash costs are the acid test of gold-miner survivability in lower-gold-price environments, revealing the worst-case gold levels necessary to keep the mines running.  All-in sustaining costs show where gold needs to trade to maintain current mining tempos indefinitely.

Cash costs naturally encompass all cash expenses necessary to produce each ounce of gold, including all direct production costs, mine-level administration, smelting, refining, transport, regulatory, royalty, and tax expenses.  In Q2’17, these top 34 GDXJ-component gold miners that reported cash costs averaged just $628 per ounce.  That was indeed down a sizable 1.3% YoY from Q2’16, and 3.0% QoQ from Q1’17.

This was really quite impressive, as the mid-tier gold miners’ cash costs were only a little higher than the GDX majors’ $605.  That’s despite the mid-tiers each operating fewer gold mines and thus having fewer opportunities to realize cost efficiencies.  Traders must recognize these smaller gold miners are in zero fundamental peril as long as prevailing gold prices remain well above cash costs.  And $628 gold ain’t happening!

Way more important than cash costs are the far-superior all-in sustaining costs.  They were introduced by the World Gold Council in June 2013 to give investors a much-better understanding of what it really costs to maintain a gold mine as an ongoing concern.  AISC include all direct cash costs, but then add on everything else that is necessary to maintain and replenish operations at current gold-production levels.

These additional expenses include exploration for new gold to mine to replace depleting deposits, mine-development and construction expenses, remediation, and mine reclamation.  They also include the corporate-level administration expenses necessary to oversee gold mines.  All-in sustaining costs are the most-important gold-mining cost metric by far for investors, revealing gold miners’ true operating profitability.

In Q2’17, these top 34 GDXJ components reporting AISC averaged just $879 per ounce.  That’s down 0.9% YoY and 4.9% QoQ.  That also compares very favorably with the GDX majors, which saw average AISC nearly identical at $867 in Q2.  The mid-tier gold miners’ low costs show they are faring far better fundamentally today than everyone thinks based on this year’s largely-disappointing technical stock-price action.

All-in sustaining costs are effectively this industry’s breakeven level.  As long as gold stays above $879 per ounce, it remains profitable to mine.  At Q2’s average gold price of $1258, these top GDXJ gold miners were earning big average profits of $379 per ounce last quarter!  That equates to hefty profit margins of 30%, levels most industries would kill for.  The mid-tier gold miners aren’t getting credit for that today.

Unfortunately given its largely-junior-less composition, GDXJ remains the leading benchmark for junior gold miners.  In Q2’17, GDXJ averaged $33.30 per share.  That was down a sharp 11% from Q1’s average of $37.46.  Investors have largely abandoned gold miners because they are captivated by the extreme Trumphoria stock-market rally since the election.  Yet gold-mining profits surged in that span.

At Q1’s average gold price of $1220 and Q1’s average top GDXJ components’ AISC of $924, these elite mid-tier miners were earning $296 per ounce on average.  That’s already quite healthy.  But quarter-on-quarter from Q1 to Q2, these top 34 GDXJ components’ operating profits rocketed 28% higher to $379 per ounce.  There’s absolutely no doubt the sharp decline in gold-stock prices in Q2 had nothing to do with fundamentals!

Gold stocks are in the dumps technically because these lofty stock markets keep powering higher.  Even though they are in dangerous bubble territory and the Fed is on the verge of starting to suck capital out of the markets via super-bearish quantitative tightening.  These record stock markets have really retarded investment demand for gold, which tends to move counter to stock markets.  So gold stocks are deeply out of favor.

Gold-stock price levels and psychology are totally dependent on gold, the dominant driver of miners’ profits.  Gold stocks enjoy major profits leverage to gold, which gives their stocks big upside potential when gold rallies.  Gold-mining costs are essentially fixed during mine-planning stages.  Generally the same numbers of employees and equipment are used quarter after quarter regardless of the gold price.

So higher gold prices flow right through to the bottom line, costs don’t rise with them.  If gold rallies just another 3.4% from Q2’s average prices to average $1300 in a coming quarter, profits will surge another 11.1% at Q2’s all-in sustaining costs.  In a $1400-average-gold quarter, merely 11.3% higher from Q2’s levels, gold-mining profits would soar 37.5% higher.  At $1500, those gains surge to 19.3% and 63.9%!

And a 20% gold rally from Q2’s levels is nothing special.  Back in roughly the first half of last year after a sharp stock-market correction, gold powered 29.9% higher in just 6.7 months!  So if you believe gold is heading higher in coming quarters as these crazy stock markets falter, the gold stocks are screaming buys today fundamentally.  Their already-strong profitability will soar, amplifying gold’s mean-reversion upleg.

Since today’s bastardized GDXJ largely devoid of juniors changed so radically since last year, the normal year-over-year comparisons in key financial results aren’t comparable.  But here they are for reference.  These top-34 GDXJ companies’ cashflows generated from operations soared 57% YoY to $1458m.  That was driven by sales up 59% YoY to $3840m.  That left their collective cash balances $34% higher YoY at $6140m.

And top-34-GDXJ-component profits skyrocketed 385% YoY to $751m.  Again don’t read too much into this since it’s an apples-to-oranges comparison.  If GDXJ’s component list and weightings finally stabilize after such extreme tumult, we’ll have clean comps again next year.  We can still look at operating cash flows and GAAP profits among this year’s list of top-34 components, which offers some additional insights.

On the OCF front, 10 of these 34 miners reported average YoY gains of 54%, while 13 of them reported average declines of 33%.  Together all 23 averaged operating-cash-flows growth of 5%.  That isn’t much, but it’s positive.  And it’s not bad considering Q2’17’s average gold price was dead flat from Q2’16’s.  These mid-tier gold miners are doing far better operationally than their neglected super-low stock prices imply.

On the GAAP-earnings front, the 10 miners that earned profits in both Q2s averaged huge growth of 110% YoY!  And out of 14 more miners that saw profits cross zero in the past year, 8 swung from losses to gains.  Total annual earnings growth among those zero-crossing swingers exceeded $536m.  Make no mistake, these “junior” gold miners are thriving fundamentally even at Q2’s relatively-low $1258 average gold.

So overall the mid-tier gold miners’ fundamentals looked quite impressive in Q2’17, a stark contrast to the miserable sentiment plaguing this sector.  Gold stocks’ vexing consolidation this year wasn’t the result of operational struggles, but purely bearish psychology.  That will soon shift as stock markets roll over and gold surges, making the beaten-down gold stocks a coiled spring today.  They are overdue to soar again!

Though this contrarian sector is despised, it was the best-performing in all the stock markets last year despite a sharp Q4 post-election selloff.  The leading HUI gold-stock index blasted 64.0% higher in 2016, trouncing the S&P 500’s 9.5% gain!  Similar huge 50%+ gold-stock gains are possible again this year, as gold mean reverts higher as stock markets sell off.  The gold miners’ strong Q2 fundamentals prove this.

Given GDXJ’s serious problems, leading to diverting most of its capital inflows into larger gold miners that definitely aren’t juniors, you won’t find sufficient junior-gold exposure in this troubled ETF.  Instead traders should prudently deploy capital in the better individual junior gold miners’ stocks with superior fundamentals.  Their upside is vast, and would trounce GDXJ’s even if it was still working as advertised.

At Zeal we’ve literally spent tens of thousands of hours researching individual gold stocks and markets, so we can better decide what to trade and when.  As of the end of Q2, this has resulted in 951 stock trades recommended in real-time to our newsletter subscribers since 2001.  Fighting the crowd to buy low and sell high is very profitable, as all these trades averaged stellar annualized realized gains of +21.2%!

The key to this success is staying informed and being contrarian.  That means buying low when others are scared, like late in this year’s vexing consolidation.  An easy way to keep abreast is through our acclaimed weekly and monthly newsletters.  They draw on our vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  For only $10 per issue, you can learn to think, trade, and thrive like contrarians.  Subscribe today, and get deployed in the great gold stocks on our trading books before they surge far higher!

The bottom line is the mid-tier gold miners that now dominate GDXJ enjoyed strong fundamentals in their recently-reported Q2 results.  Despite a flat comp-quarter gold price, they collectively mined more gold at lower costs.  That naturally fueled better operating cash flows and profits.  Today’s low gold-stock prices and popular bearishness are wildly unjustified fundamentally, an anomaly that doesn’t reflect operations.

As gold itself continues mean reverting higher, these mid-tier gold miners will see their profits soar due to their big inherent leverage to gold.  GDXJ now offers excellent exposure to mid-tier gold miners, which will see gains well outpacing the majors.  But if you are looking for the extreme upside likely in true junior gold miners, avoid today’s GDXJ and buy individual stocks.  GDXJ is no longer a “Junior Gold Miners ETF”!

Adam Hamilton, CPA

August 25, 2017

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