The Datastream World Gold Mining index is up 18% over the past three months as investors returned to gold equities. Despite this, gold equities remain nearly 10% down year on year.

Valuations in the gold equities sector remain depressed despite recent outperformance and the rally in the gold price

Gold equities have lagged the performance of gold since the global financial crisis in 2008. Cash cost inflation, capex inflation and major overspends, difficult labour relations and testing operating environments have all contributed to underperformance.

However, according to investment bank Nomura, “increasingly compelling gold demand dynamics and a general lowering of expectations for other more industrial-exposed mining companies” provide the potential for a continuation of the outperformance we have seen over the past three months.

Nomura note that should the gold price improve from these higher levels (and they think it will), “with margins increasing from record levels, we can see rationale for further outperformance in the gold equities, especially when factoring the demand challenges of more industrial-exposed metals.”

Valuations in the sector remain depressed despite the rally in the gold price. The bank points to companies such as Centamin, Petropavlovsk and Avocet Mining, which all trade on less than 0.5x price to net present value using spot gold.

In addition to valuations, the bank has also looked at how correlations between gold equities and gold prices have cyclically broken down and caught up numerous times over the past 15 years. Their analysis suggests that, when the correlations are increasing, gold equities have outperformed the gold price.

Nomura reckons we are in the middle of one of these phases at the moment. “Between mid 2011 and April 2012 the correlation was very low for an unusually long period of time (and reminiscent of the gold price lows seen in 1999-2000). The Datastream World Gold Mining index continues to underperform gold but the index is just beginning to move off of a 20-year low relative to the gold price.”

Although recent months have seen the correlation begin to increase, this has not yet reached the 0.9x peaks achieved in past mini-cycles. Nomura expects a further strengthening of the correlation between the two over the next six months.

In the past, their analysis suggests that periods of increasing correlation between the gold equities and the gold price have seen equities outperform on a relative basis. The average performance of gold equities since 1999 has been 49% when the correlation has been rising and -8% when the correlation has been falling.

Overall, Nomura makes a fairly bullish and compelling case for gold equities. On individual company names, they have ‘Buy’ ratings on Polymetal and Randgold, which have both performed well, especially since the gold price passed the lows below, and Petropavlovsk, Centamin and African Barrick Gold, which all have the potential to move back into year-to-date positive territory over the next three months.

For investors looking to access gold equities, exchange-traded funds (ETFs) provide a quick, cheap and efficient method to gain exposure to the sector. The following are all available to UK and European investors:

iShares S&P Commodity Producers Gold ETF (SPGP)
The iShares S&P Commodity Producers Gold ETF tracks the performance of the S&P Commodity Producers Gold Index. This index provides exposure to the largest publicly-traded companies involved in the exploration and production of gold and related products from around the world. Apart from Polymetal, which went public less than 12 month ago, all of Nomura’s ‘Buy’ picks listed above are held in the fund. Physically replicated. London listed. TER 0.55%.

ETFX DAXglobal Gold Mining ETF (AUCP)
The DAXglobal Gold Mining Fund tracks the performance of the DAXglobal Gold Miners Index. This index gives investors the opportunity to participate in the performance of companies operating around the world primarily in the areas of gold mining. The constituents are exclusively companies that generate at least 50% of their income from this sector. Swap-based. London listed. TER 0.65%.

RBS Market Access NYSE Arca Gold BUGS Index ETF (GOLB)
The RBS Market Access NYSE Arca Gold BUGS Index ETF tracks the performance of the NYSE Arca Gold BUGS Index. The Gold BUGS (Basket of Un-hedged Gold Stocks) Index is a modified equal weighted index of companies involved in gold mining. The index provides significant exposure to near-term movements in gold prices by including companies that do not hedge their gold production beyond 1.5 years. Swap-based. London listed. Cross-listed on a number of European exchange including Deutsche Börse, Euronext Amsterdam, SIX Swiss Exchange and Borsa Italiana. TER 0.70%.

Market Vectors Junior Gold Miners ETF (GDXJ)
The Market Vectors Junior Gold Miners ETF seeks to track the performance of the Market Vectors Junior Gold Miners Index, a rules-based, modified market capitalization-weighted, float-adjusted index intended to investors exposure to small- and medium-capitalisation companies in the gold and silver mining industry. Physically replicated. NYSE Arca-listed. Certified as a ‘UK Reporting Fund’ by HMRC. TER 0.54%.