Gold Juniors’ Q1’17 Fundamentals

The junior gold miners’ stocks suffered a serious thrashing between mid-April and early May. Relentless heavy selling blasted many back down near deep mid-December lows, leaving sentiment in tatters. But traders distracted by weak technicals need to keep their eyes on the fundamental ball. The gold juniors just finished their Q1 earnings season, which was solid. Their low stock prices are disconnected from reality.

Four times a year publicly-traded companies release treasure troves of valuable information in the form of quarterly reports. These are generally due by 45 days after quarter-ends in the US and Canada. They offer true and clear snapshots of what’s really going on operationally, shattering the misconceptions bred by the ever-shifting winds of sentiment. There’s no junior-gold-miner data that is more highly anticipated.

Until later last year, the definitive list of elite junior gold stocks to analyze came from the world’s most-popular junior-gold-stock investment vehicle. The GDXJ VanEck Vectors Junior Gold Miners ETF was born in November 2009, and is the second-largest gold-stock ETF after its big brother GDX which tracks the larger major gold miners. Investors love junior gold miners’ stellar potential, so GDXJ has been very popular.

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 that’s increasingly becoming less true.

When capital flows into GDXJ as a proxy for owning junior gold miners, this ETF should be shunting that buying directly into junior gold miners’ stocks. But GDXJ is no longer fully doing that. Instead some of these capital inflows are now stealthily diverted into larger gold miners’ stocks, which is troubling. Investors who actually wanted to own majors would buy GDX rather than GDXJ. This junior ETF is failing its mission.

With capital explicitly intended by investors to buy juniors instead redirected into majors, the junior gold miners’ stocks are being starved of capital inflows. Strong investment buying that should be propelling the juniors much higher isn’t reaching them, which is quite frankly an outrage. That’s not only hurting their present prices, but future potential too since buying begets buying. GDXJ is sabotaging the junior sector.

How did GDXJ go so wrong since the middle of last year? Ironically it’s the victim of its own success. This leading junior-gold-miners ETF tracks an index called the MVIS Global Junior Gold Miners Index. MV Index Solutions is the indexing arm of VanEck, and its analysts have done a good job constructing their junior index for GDXJ to replicate. It contains most of the world’s best junior gold miners and explorers.

The inclusion criteria are pretty simple. Companies need to have market caps over $150m, which is tiny. They must have average daily trading volume of $1m, also small. And they have to generate at least 50% of their revenues from gold or silver mining. As of this week, this index underlying GDXJ has 48 component companies. Many are great choices, though some are operating at mid-tier instead of junior scales.

Before mid-2016, GDXJ’s composition was able to track this index as claimed. But in the first half of last year as gold surged 30% higher in its first new bull market in years, investors flooded into GDXJ to chase the soaring junior gold miners’ stocks. This small ETF mirroring a small sector enjoyed massive capital inflows. GDXJ’s net assets exploded from $1b to over $5b in that span, exceedingly large relative to its sector!

GDXJ attempted to shunt that capital into its underlying junior gold stocks as normal, which is the way ETFs are supposed to work. That’s why ETF-share buying directly bids up underlying stocks. But GDXJ ran into multiple problems. This ETF’s footprint in some component junior gold miners was so large that its ownership stakes approached 20%, a threshold that must not be crossed under Canadian securities law.

GDXJ is dominated by Canadian companies because that’s where the great majority of the world’s junior gold miners list and trade. This week Canadian companies accounted for nearly 2/3rds of GDXJ’s net assets. In Canada once any investor including an ETF goes over 20% ownership, it is deemed to be a takeover offer which must then be automatically extended to all remaining shareholders on the same terms!

As a passive investor on behalf of its shareholders, GDXJ can’t be acquiring and running gold miners.  So this leading junior-gold-miners ETF had to simply stop investing in Canadian juniors nearing that 20% threshold!  Instead GDXJ’s managers started diverting the torrents of capital inflows into investments in larger gold miners that weren’t a part of its mission or underlying index. That even included adding GDX.

Every quarter I analyze the latest results from major gold miners, junior gold miners, and silver miners using their respective leading ETFs’ component lists. Sometime between Q2’16 and Q3’16, GDXJ’s managers started buying GDX shares. GDX showed up as the third-largest component of GDXJ in both Q3’16 and Q4’16, so I railed about it in both analyses. It was false advertising, GDXJ investors wanted juniors.

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