It's suddenly hard to extract value from mining companies

Precious metals mining companies broke out of a yearlong stock slump in August, but questions persist about whether investors are better off avoiding these middlemen and buying the commodities themselves. Mining operations have historically been a backdoor way for investors to benefit from the rising price of precious metals such as gold and silver. In theory, rising commodities prices should translate into greater earnings and free cash flow for miners — often faster than the rise in the price of the metals themselves. The reality has been different for the better part of this year, though. The $8.66 billion Market Vectors Gold Miners ETF Ticker:(GDX) was down 7% through August, while the $2.6 billion Market Vectors Junior Gold Miners ETF Tcker:(GDXJ), which focuses on small and midsize companies involved in the early stages of gold exploration and production, was down 12%. Meanwhile, the price of gold, as measured by the $68 billion SPDR Gold Shares ETF ticker:(GLD), was up 8% over the same period. The same disconnect can be seen in silver. The performance of the physical shares, via the $9.4 billion iShares Silver Trust ETF ticker:(SLV), was up almost 15%, while the $300 million Global X Silver Miners ETF ticker:(SIL) was up just 1.54% “It's not what you expect to see,” said Dan Denbow, portfolio manager of the $2 billion USAA Precious Metals and Minerals Fund ticker:(USAGX). The underperformance results from the rising costs of production and political issues in some of the bigger mining countries, he said. “It all added extra risk for investors. For most, it was easier to just invest directly in the metals.” Will Rhind, managing director of ETF Securities LLC, said that the easy access investors have to the physical metals has led to lower demand for mining companies. What's more, demand may never come back. “There's been a secular shift,” he said. “Before 2003 [when the first physical gold exchange-traded fund was launched], you had to buy a mining company to get exposure to gold. Now there's a way to get exposure to the gold price without taking on any company risks. We've seen $125 billion go into physical gold ETFs since 2003. The demand has come at the expense of the mining companies.” The lack of interest in miners finally turned into opportunity last month for Lew Altfest, chief investment officer at Altfest Personal Wealth Management. “The disparity between gold prices and the mining companies is fairly wide now,” he said. “That makes the gold stocks reasonable.” The market certainly seems to agree with Mr. Altfest — at least for the moment. In August, gold mining stocks rallied to a 12% gain, twice that of gold. Likewise, the share price for silver miners rose 17%, vs.14% for the metal itself. Mr. Denbow expects the mining stocks to continue to increasingly move in line with the underlying metals as the industry focuses more on the most lucrative projects and cuts back on less-profitable ventures. This is not the only selling point for mining companies. With gold near $1,700 an ounce, some outfits have started returning capital to investors through dividends — a first, according to Mr. Denbow. Then again, it's equally important to remember that mining companies' operating leverage works both ways. If the price of gold or silver starts to crumble, earnings and free cash flow are likely to fall much more quickly than the price of the metals. Moreover, mining stocks don't have some of the diversification benefits of the physical shares. "They're stocks," Mr. Rhind said. "By definition, they're going to be more correlated to the equity market than the metals."