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Gold Explorer Stocks GLDX ETF Analysis

Commodities / Gold and Silver 2011 Apr 29, 2011 - 02:29 PM GMT

By: Zeal_LLC


Best Financial Markets Analysis ArticleJunior gold explorers represent a vital component of the global gold supply chain.  These small companies take on the arduous task of discovering and developing many of the next-generation gold deposits.  Without them, the gold markets would be in complete disarray and the large miners would be scrambling to backfill their project pipelines.

But regardless of their significance, junior golds have long operated under the radar for most investors.  While exploring for gold seems exotic and adventurous, the reality is it is an unglamorous and highly-risky business that only attracts the most hardcore entrepreneurs and rock-jocks.

From an investment perspective these “start-up” companies are unproven, with more of them likely to fail than succeed.  These companies don’t generate any revenues, and they burn capital at an incredibly fast rate.  Those who’ve invested and/or speculated in these junior golds until recent were a rare breed, risk junkies.

But with gold in the midst of a powerful secular bull market, investors have developed more of an appetite for juniors in recent years.  The risks haven’t gone away, but at $1500 gold the rewards of being part of a big discovery are more enticing than ever.  And with gold’s future still wildly bullish, more and more investors are willing to finance gold exploration in hopes of striking it rich.

Unfortunately many investors have been constrained in their ability to own shares of these companies, running into quantity and quality issues.  Towards the beginning of the bull, there just weren’t that many good juniors to choose from considering the damage done by the previous bear market.  Now there are so many to choose from investors feel overwhelmed, inundated with hundreds of juniors touting their projects as the bee’s knees.

It has become quite the challenge wading through the masses to find those quality companies that actually have a shot at succeeding.  It’s even more intimidating since the average investor just doesn’t understand metallurgy or geological nomenclature.  It takes a lot of work for non-professionals to understand the machinations of this sector, and even more work to undertake the research required to make intelligent trading decisions.

There are also tradability issues, an area that US investors in particular have had some big challenges.  For a variety of reasons, the vast majority of junior golds have their primary listings on the Canadian stock exchanges.  US investors can access these stocks by opening cross-borders trading accounts or buying their generally-illiquid Pink Sheet listings.  But for most these hassles are enough of a barrier to entry that they just don’t bother.  And this is unfortunate since some of the world’s best junior gold stocks only trade in Toronto.

Thankfully in this new era of exchange-traded funds investors can overcome many of these challenges.  ETFs have given the average investor access to a myriad of different markets all over the world that they wouldn’t have been able to access otherwise.  They also alleviate individual-stock research so long as the custodian is a trusted research house.  And thanks to the new GLDX ETF, the average investor has easy access to the world of junior gold-exploration stocks.

I applauded the inception of the GDX Gold Miners ETF in 2006, an excellent vehicle for investors to get diversified exposure to the elite gold-producer stocks.  I also welcomed the birth of the GDXJ Junior Gold Miners ETF in 2009, an excellent gateway for investors to gain diversified exposure to smaller precious-metals stocks.  And I now salute the GLDX Gold Explorers ETF, the first ETF that gives investors diversified exposure to pure junior gold-exploration stocks.

While I personally prefer individual stock picking for a variety of reasons, I understand that this isn’t for all investors.  And whether or not gold-stock ETFs are your thing, you have to admit they are ultimately bullish for this sector.  Among the many benefits is that the ETFs are buying actual shares.  And the juniors in particular welcome the exposure and capital chasing their shares.  Thanks to these ETFs, investors who would not have bothered to try to pick individual gold stocks are now owners of gold stocks.

When I first heard about GLDX around the time of its inception nearly six months ago, I admit I was a bit skeptical.  At Zeal we’ve been doing exhaustive junior gold-stock research for years, and it is no secret that this sector is super-complex.  And believe me, we’ve seen a number of commodities ETFs really drop the ball when it comes to the quality of their holdings and/or the indices they mirror.  Was GLDX’s structure going to give investors exposure to a good mix of quality junior golds?  Well after keeping my eye on this ETF for a while, overall I’d say yes.

The GLDX Gold Explorers ETF is managed by respected ETF powerhouse Global X Funds.  This ETF seeks to generally mirror the performance of the Solactive Global Gold Explorers Index, with its stated goal to track the performance of the largest and most-liquid listed companies that are active in the exploration for gold.

The stocks that comprise this index are pulled from a “Selection Pool” provided by the index advisor.  These stocks are ranked by the capital value of their average daily trading volume (last three months), of which the highest-ranked stocks are chosen to comprise the index.  GLDX is rebalanced semi-annually based on an updated selection pool.

The GLDX ETF is currently comprised of 27 stocks.  In the table below these stocks (by symbol) are listed in descending order, ranked by percentage weighting as of this week.  In the other columns are their current market capitalizations and the countries in which these companies operate.

The first thing of note is only a quarter of these stocks have big-board listings in the US.  And since each of these US listings is dual-listed in Canada, a whopping 85% of GLDX’s components hold a Canadian listing.  Accessing these Toronto stocks is exactly what investors should desire if they want a quality sampling of junior gold stocks.

There are two other key features that attract me to this ETF.  First, each and every one of its component companies is gold-centric.  Second is GLDX’s commitment to true exploration companies.  Interestingly, these features are a stark contrast from those of the more popular GDXJ Junior Gold Miners ETF.

Though GDXJ is a great ETF, its broader definition of “junior” allows it to include both explorers and producers.  In fact, as of this week the producer stocks comprise 73% of GDXJ’s weighting.  Only a quarter of this ETF’s holdings are true exploration stocks.  Also distinguishing is even though GDXJ is touted as gold-centric, a handful of silver stocks make up a lofty 15% of this ETF’s weighting.

GLDX on the other hand explicitly targets companies involved in gold projects where the formal development decision has yet to be made.  It specifically states that the companies in its pool should not yet know the production profiles of their prospective mines, and that development financing has yet to be achieved.  With the exception of a single stock that just commenced production (I would expect this stock to be dropped at the next rebalancing) all of the stocks that comprise the GLDX ETF are gold-centric explorers that have yet to achieve commercial production.

As for the market capitalizations, you’ll notice that the heavier weightings are on the larger market-cap stocks.  This is of course a result of GLDX’s market-capitalization-weighted structure.  And since the rebalance is only semi-annually, over time they won’t line up in perfect order as these stocks’ individual performances vary.

Regis (RRL), Sabina (SBB), and US Gold (UXG) for example have been outperformers so far this year, hence their current heavier weightings.  Whereas Gabriel (GBU), NovaGold (NG), and European Goldfields (EGU) have been underperformers so far, hence their lower weightings relative to their larger market caps.

This table also includes the locations of these juniors’ primary projects.  Geography is very important when it comes to where juniors decide to spin their drills.  Some countries just happen to be more geologically-blessed than others when it comes to the quantity and quality of their gold mineralization.  The locations are also important from a geopolitical perspective.  Regardless of the appeal of a gold deposit, the geopolitical environment must be mining-friendly if a profitable operation is ever to be born.

Some countries definitely hold higher geopolitical risk than others.  Romania for example holds much more geopolitical risk than say Canada.  Overall GLDX has a good mix of projects spread across the globe.  North America houses the most with 41%, next is Africa at 22%, followed by South America at 15%, Asia at 11%, and Europe and Australia at 7% each.

Now that we have a high-level view of GLDX’s components, the first question I ask myself is would these be my exact picks if I were this ETF’s index advisor?  At Zeal our comprehensive junior-gold research whittles down the entire pool of stocks that are listed in the US and Canada, and the results are an elite group that we consider our favorites.  We believe these stocks to hold the highest probability for success over the course of gold’s bull, and thus profile them in our popular research reports.  Do our favorites line up exactly with GLDX’s?  Definitely not.  But there are several that overlap.

In 2010 we published three favorite junior gold-stock reports, of which two were focused on non-producing explorers.  And just last month we published a brand-new favorite junior gold-stocks report profiling a new batch of non-producing explorers.  Of the 36 stocks we profiled in these recent qualifying reports, 10 matched up with GLDX’s components (37% commonality).

I was also pleased to find that an additional 7 of GLDX’s holdings were juniors that we profiled in some of our reports from years past.  Interestingly the average gains of these 7 stocks, from Zeal’s profile date to current, is 125%.  In all, 17 of GLDX’s 27 components (63%) are stocks that we are currently bullish on or have been bullish on in the past.  And if we take out the 4 GLDX stocks that we don’t cover since they are only listed in Australia and Hong Kong, the total overlap percentage is 74%.  This ETF’s index advisors have pretty good taste!

A big factor that disassociates GLDX’s picks with Zeal’s is this ETF’s rules basing, as it has average-daily-trading-volume ($125k minimum) and market-capitalization ($100m minimum) constraints.  Its subjectivity is also a factor since the index advisors that compile GLDX’s selection pool have certain criteria and discretion to determine which junior gold explorers they favor.  At Zeal we of course have our own customized selection process, and we don’t limit ourselves to GLDX’s volume and market-cap rules.

So as an investor, if individual stock picking in this sector is something that interests you, having a look at GLDX’s components is a good starting place since many of these juniors are quality picks by our standards.  If you want to bypass the research and get more comprehensive profiles of elite junior golds, consider purchasing a Zeal report.  Our extensive knowledge and research in this realm is second to none.

But if you are an American investor who doesn’t want to bother with foreign-listed stocks, you are not into individual stock picking, and you are looking for good diversified exposure to the exciting junior gold-explorer sector, GLDX can be a great vehicle for you.  The way it is designed, this ETF should serve its purpose as a leveraged play in the gold-stock sector.

Considering the inherent high risk that comes with these tiny companies, this leverage works both to the upside and the downside.  If the markets aren’t cooperating and/or your junior is a dud, your capital will be decimated.  But if you pick a winner, and/or the markets are moving in your direction, the gains can be legendary.

To test this leverage I compiled a 12-month chart showing the performances of the benchmark HUI gold-stock index, plotted in red to the left axis, along with the GDX (light blue), GDXJ (yellow), and GLDX (blue) ETFs to the right axis.  And since GLDX is still so young, I focus in on the raw performances of these four vehicles from this ETF’s inception date (November 4, 2010) to this week, with no optimizations for uplegs or selloffs.

Using the HUI as a baseline, the performances of these ETFs are scrubbed up against its 6.9% gain over this span.  Starting with GDX, since this ETF has a similar composition of larger producer stocks along with a correlation r-square of 95% to the HUI, their performances should be very similar.

But provocatively with a gain of only 3.4%, GDX actually underperformed the HUI over this span.  The expense ratio would account for some of the difference, but not all of it.  The larger component list and slight weighting differences of the major holdings obviously had a negative impact on GDX over the last six months.

Moving on to GDXJ, this ETF’s junior explorer/producer composition did in fact deliver positive leverage to the HUI over this span.  GDXJ’s 12.3% gain gave investors 1.78x leverage to the world’s top gold-stock index.  Considering historical precedent from past uplegs this leverage is a bit on the low side, but good nonetheless.

Since its inception GLDX has also gained 12.3% to this week, delivering 1.78x leverage itself.  Honestly before I ran these numbers I had expected GDXJ to outperform GLDX considering the outsized gains in silver stocks over the last six months.  But not only was GLDX able to keep pace, up until the middle of this week when silver again went ballistic prompting huge gains in silver stocks, GLDX had indeed outperformed GDXJ.

Over a longer horizon, when silver comes back down to earth, I fully expect GLDX to outperform GDXJ when the going is good for gold stocks.  Pure exploration stocks ought to outperform producer stocks.  If they don’t, the risk/reward tradeoff is broken and owning this ETF wouldn’t be worth it.

Also of note are the correlation r-squares of GDXJ and GLDX to the HUI.  Interestingly GDXJ has an r-square of 88%.  And this tight correlation makes sense because of this ETF’s producer bias.  GLDX on the other hand has an r-square of only 49% over this span.  The pre-production explorers do follow the greater movements of gold and gold stocks in general, but this low correlation tells me that GLDX can have the tendency to be more news-driven than sector-driven.  This is why it is important to be comprised of high-quality juniors, those companies that are likely to generate positive newsflow from superior drill results and big discoveries.

Overall so far I am very impressed with the new GLDX ETF, and I believe it offers investors an excellent way to get diversified exposure to the junior gold exploration-stock sector.  It should be noted that GLDX doesn’t yet have a following like some of the other gold-stock ETFs.  GLDX’s market cap is only about 1% that of GDXJ, and it trades on very-thin volume.  But I suspect this will change over time as more investors become aware of it.

While GLDX can indeed be a good junior-gold option for investors, it’s not likely to perform as well as a hand-crafted portfolio of elite junior gold stocks.  ETFs serve their purpose in bringing new investors to the ballgame.  But if they want to be star performers on the field, they need to customize their holdings so as not to over-diversify and to ensure they hold only the highest-potential stocks.

Zeal’s expert research distills hundreds of hours of hard work into an easy-to-read compact report with detailed fundamental profiles of high-potential gold exploration stocks.  Our newest report, published just last month, profiles our favorite dozen.  These stocks are gold-centric pre-production explorers that own high-quality projects spanning the globe.  Buy your report today!  You’ll really enjoy this fascinating 26-page read.

These reports not only serve as a gateway to learning about some of the highest-quality junior golds, they feed potential trades in Zeal’s bread-and-butter newsletter products.  Our weekly and monthly newsletters skillfully analyze the markets, while applying our knowledge to execute real-world trades.  Since 2001 all 500+ of our newsletter stock trades have averaged annualized realized gains of +52%.  Subscribe today, join us in navigating these markets and profiting.

The bottom line is the new GLDX Gold Explorers ETF is a fantastic vehicle for investors who are looking for diversified exposure into one of the most exciting sub-sectors of the gold-stock world.  Junior gold-exploration stocks have a dirty job, but can score big for investors if they hit the mother lode.

By owning GLDX investors can indeed strike gold with these juniors, positively leveraging the underlying metal and the larger mining companies that are bringing it to market.  This ETF is comprised of some of the world’s elite gold explorers, and if you aren’t a stock picker it may be your best bet to ride the gold-discovery wave.

By Scott Wright

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