Tomorrow's Monster Outperformers: Miners of Gold and Silver

Hotshot hedge fund manager David Einhorn is bullish on gold, but physical gold is no longer his default vehicle for profitable gold exposure.

During the third quarter, Einhorn's Greenlight Capital Re (NYS: GLRE) sold physical gold holdings in order to purchase a "significant position" in the Market Vectors Gold Miners ETF (NYS: GDX) . With that deliberate shift in the structure of his gold allocation, Einhorn becomes the latest institutional investor to recognize that "a substantial disconnect has developed between the price of gold and the mining companies."

That may just be the greatest understatement of 2011! That disconnect sailed straight past the "substantial" stage earlier this year, such that in recent months the opportunity to gain coveted gold exposure at truly ludicrous valuations began to stare investors squarely in the face. I have labored to draw attention to the resulting investment opportunity, beginning with this valuation alert back in July. When Goldcorp (NYS: GG) slipped beneath $50 per share, I told my readers I thought the market was handing them a gift-wrapped treasure.

The deepest valuation disconnect in the markets today
For those suffering from a persistent case of sticker shock in response to elevated gold prices, I highlighted the miners last August as a lustrous panacea with their built-in margin of safety. As I stated then: "Because the precious-metal equities have remained remarkably disjointed from the upward momentum of metal prices for quite some time now, I believe these equities offer entry points to investors that are akin to buying gold or silver bullion at a 25% to 50% discount to prevailing spot prices." Now let's take a glance at the disconnect in visual form:

Over the past five years, a 63% gain for the Market Vectors Gold Miners ETF has comfortably outperformed the 10% decline in the S&P 500 (INDEX: ^GSPC) . But note the dramatic contrast since late-2010 between the performance of physical gold and silver -- depicted above via the SPDR Gold Trust (NYS: GLD) and the iShares Silver Trust (NYS: SLV) -- and the flat performance by the miners at large.

Keep in mind, the Gold Miners ETF offers a reasonable proxy for the gold mining industry at large, with only the rather odd inclusion of Silver Wheaton (NYS: SLW) within a set of top holdings that are otherwise dominated by the majors such as Barrick Gold (NYS: ABX) , Goldcorp, and Newmont Mining (NYS: NEM) . Now it's time to weigh the flat trajectory for the ETF over the past year (as depicted in the above chart), against Einhorn's resolutely bullish outlook for the group. Einhorn states: "With gold at today's price, the mining companies have the potential to generate double-digit free cash flow returns and offer attractive risk-adjusted returns even if gold does not advance further. Since we believe gold will continue to rise, we expect gold stocks to do even better."

These stocks are down but certainly not out
Understanding the degree of valuation disconnect between gold prices and gold mining stocks is key to appreciating the importance of acquiring some timely exposure to this well-positioned group, but I believe it's just as critical to grasp that their generally elusive leverage to gold price gains remains a promise that quality miners are ultimately bound to keep. I could write a tome on the array of factors that has contributed to the trailing underperformance by miners vis-a-vis the price of gold, but I consider it a better use of my time to focus on the reasons why that condition is bound to reverse over the months and years to come. On the operational side, I see margin expansion comfortably outpacing further cost escalation. Perhaps more importantly, from a strategic perspective, I forecast an overdue groundswell in demand for mining equities as ill-informed notions of a gold bubble are replaced with growing awareness of the scale and longevity of the price gains yet to come. The onset and expansion of gold mining dividends forms another core precursor of that looming influx of investment capital.

It is worth noting, furthermore, that select gold stocks have easily surpassed the price performance of gold over the past five years. The following chart illustrates four prime examples, including a noteworthy 584% five-year advance for shares of Allied Nevada Gold (ASE: ANV) . Incredibly, even after a growth spurt of that magnitude, I recently encountered a compelling report by GARP Research & Securities outlining a favorable valuation disconnect in those shares as well. Allied Nevada's enterprise value per ounce of gold in reserves remains well below the industry average, and that excludes the miner's outlandish stash of silver reserves in excess of 380 million ounces!

As we turn our gaze from the trailing five-year period to the five years that lie ahead, I expect we'll find a vast array of gold mining equities surpassing the price performance of gold bullion by similar margins to those depicted in the chart above. Like a tightly coiled spring, the industry's trailing underperformance belies the remarkable and expanding profitability of quality gold miners even within the present price environment. The incremental impact of gold's inevitable long-term advance through $2,000 and beyond has, it would seem, not yet garnered the attention of the world's financial markets. In this respect, I believe Einhorn's deliberate tweaking of his gold allocation from bullion into mining equities will prove both timely and insightful. For those who agree with fund manager Eric Sprott that "silver is the investment of this decade as gold was the investment of the last decade," I hasten to suggest that forthcoming returns from well-selected silver producers are quite likely to stagger the imagination. Simply stated, precious metals remain the world's greatest bull market within an era when few reliable opportunities exist, and I strongly encourage each and every Fool to consider making some room for at least a presence of precious metals exposure.