Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 31st January, 2010.

It is widely believed that gold stocks offer leveraged exposure to changes in the gold price, but this belief is false. At least, the historical record suggests that it is false on a long-term basis. As evidence we include, below, a chart of the BGMI/gold ratio covering the past 50 years (BGMI is short for Barrons Gold Mining Index).

The long-term BGMI/gold chart shows that there was a huge rally in gold stocks relative to gold bullion during the 1960s. This massive out-performance on the part of the stocks occurred for two main reasons. First, the gold price was fixed at $35/ounce at the time, but it was becoming increasingly clear that relentless monetary inflation was going to make it impossible to maintain 'the fix'. Consequently, the stock market began to discount the large rise in the gold price that would likely occur once the last remnants of the Gold Standard were abandoned. Second, US citizens were not permitted to own gold bullion at the time, so the only way that people in the US could speculate on a future rise in the gold price was to buy the shares of gold-mining companies.

The huge BGMI/gold rally of the 1960s was followed by a 12-year bear market that bottomed in 1980. In other words, the gold bull market of the 1970s was accompanied by a BEAR market in gold stocks relative to gold bullion. One of the most important drivers of this bear market was the fact that gold stocks had previously been bid up to extremely high levels relative to gold in anticipation of a large rise in the gold price.

Since 1980 the BGMI/gold ratio has oscillated within a horizontal range. Note, though, that it briefly moved below the bottom of this range towards the end of the 2008 market crash. In fact, in October of 2008 the BGMI/gold ratio hit a 50-year low!

The BGMI/gold ratio reflects the performance of a basket of larger-sized gold producers relative to gold bullion, so the above chart makes it clear that larger-sized gold stocks, as a group, have not provided their owners with leveraged exposure to gold over long time periods. A well-selected basket of junior gold stocks could have outperformed the BGMI by a wide margin and could potentially have provided the leveraged exposure that gold-stock investors typically seek, but the juniors tend to be a lot more risky and are therefore not appropriate for many investors.

This prompts the question: why aren't gold mining companies able to leverage gains in the gold price over the long-term? After all, shouldn't an X% gain in the gold price lead to a gain of more than X% in a gold miner's cash flow?

A number of factors have contributed to the lacklustre long-term performance of the BGMI/gold ratio, one being that the costs of gold mining tend to rise. Due to rising costs, only part of any increase in the gold price flows to miners' bottom lines. Other factors include political issues, environmental issues, and management errors, but in our opinion the single most important factor is simply that gold mines deplete. Due to the fact that gold mines experience depletion, gold mining companies must devote a lot of cash each year to exploration to prevent their total quantity of in-ground reserves from declining. Alternatively, a mining company can maintain or grow its reserves through acquisition, but this will also be costly in terms of cash or new shares; and it won't prevent reserves from declining on an industry-wide basis.

As we've mentioned in previous TSI commentaries over the past six years, the proven inability of large gold-mining stocks to leverage long-term gains in the gold price means that people who plan to hold a gold investment for many years, and who do not want to take-on the risk inherent in junior mining stocks, should accumulate gold bullion as opposed to gold stocks. From time to time, however, the major gold stocks become very under-valued relative to the bullion and therefore become good candidates for intermediate-term TRADES. October of 2008 was a classic example.

It's all a question of relative valuation. In general, for an investment in a gold stock to be justified the stock must be under-valued relative to gold bullion by enough to warrant taking on the additional risk inherent in the stock. To put it another way: a lot more things can go wrong with a gold mining company than with gold bullion, so investors should only favour the stock over the bullion if the stock's valuation implies that its additional upside potential is more than enough to compensate for the additional risk.

The major gold stocks are not as cheap relative to gold bullion today as they were in October of 2008, but in gold terms they are still close to their lows of the past 50 years. Also, in nominal currency terms they are becoming sufficiently oversold to be of interest as short- or intermediate-term trades. Having said that, we much prefer the juniors.

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