Join our community of smart investors

Solid gold

Why investing in gold still makes sense.
June 17, 2016

Don’t worry, dear reader. The Investors Chronicle isn’t about to start a conspiracy theory rant. We’re not going to speculate on the contents of the Federal Reserve’s vaults beneath Fort Knox, or how frequently they’ve been audited. Nor are we about to predict the collapse of the fiat money system by 2018. No one in our office – with the possible exception of the deputy production editor – has been stockpiling gold bars along with canned food and flares in preparation for a post-apocalyptic, post-cash economy.

Still, it’s hard to escape the fact that advising people to buy gold can feel a little paranoiac. Investing in gold sounds like getting ready for disaster.

But it has long been our position that investors should reserve some of their portfolio for what the economist John Maynard Keynes did not actually call a “barbarous relic”. That often misattributed moniker was in fact directed at the flawed gold exchange standard used between 1922 and 1939, rather than gold itself. In fact, Keynes was an advocate of gold for much of his career, a case we believe has persisted through to the 21st century.

The gold bulls are out in force in 2016, which has been a very good year for gold so far. In fact, the metal has been one of the best performing asset classes since January, thanks to a massive increase in demand. According to the World Gold Council, demand hit 1,290 tonnes in the first quarter of the year – an increase of 21 per cent year on year – due to huge inflows into exchange-traded funds and bets by institutional investors. Those who have argued that this rally will fade amidst further hikes in US interest rates and resilient equities markets have been disproved until now. Since mid-February, the dollar-denominated price of gold has traded between $1,200 (£838) and $1,300.

The case for gold in 2016

These inflows have been driven by two sets of concerns. The first, sparked by equities’ descent into a bear market in January, involves event risk. According to James Butterfill, head of research and investment strategy at ETF Securities, investors have made record bets on gold this year “not as a volatility hedge, but as an event risk hedge”. Anecdotally, his company’s clients believe the chance of a negative, unforeseen event has increased this year, and the three worries foremost in institutional investors’ minds are Brexit, the US presidential election and Greece.

This is a marked contrast to 2015, when markets were fixated on the US, which was meant to show signs of economic growth, begin steadily hiking interest rates, and step away from quantitative easing. But at the same time, markets gradually started to acknowledge that a shift in monetary policy could not remove the risk presented by a series of potential shocks. “If you looked at the economic optimism barometer around 18 months ago, people were expecting us to be in a much more confident state than we are now,” says John Mulligan of the World Gold Council. “Events have combined to create a picture of risk.” An increasingly uncertain global economy faced with an expanding list of unpredictable events benefits gold prices.

The second major reason why gold has done so well this year is the now widespread use of unconventional monetary policy. The central banks of the eurozone, Denmark, Sweden, Switzerland and Japan are all currently pursuing negative interest rate policy (NIRP), either to encourage lending and inflation, or to prevent steep currency rises. Meanwhile, the Federal Reserve is committed to a negative real rate policy, by allowing inflation to rise faster than headline interest rates. With more than $10 trillion-worth of government securities now providing negative yields, large institutional investors are on the hunt for ways to avoid this new cost. Gold does not provide a yield, but at least the costs of keeping it in storage are slim; a fact that has prompted the world’s largest reinsurer, Munich Re, to build its stockpiles of the yellow metal. All this suggests that a negative real interest environment should help gold, as investors look at the commodity as a near-zero coupon bond.

Beyond 2016: the long-term case

Regardless of the recent experiments in monetary policy, and an uptick in what Donald Rumsfeld would have called known unknowns, there are plenty of reasons to believe the long-term case for gold is strong. Some are improbable or dystopian, but are nonetheless worth considering. Chief among these is the fact that fiat money systems invariably end or mutate, while gold remains gold. It’s rarely possible to predict the end of paper currency systems – and moreover, it might be easier to imagine nuclear war than the end of the US dollar, the world’s de facto reserve currency – but the fact remains: gold has preserved its value as myriad civilisations have come and gone.

More pressingly, there are reasons to doubt the enduring strength of the US dollar, whose pre-eminence, lest we forget, spans just over seven decades. During that time, the country’s debt levels have ballooned, and are expected to rise appreciably with interest payments in the coming decades. In recent years China has been a big buyer of US debt, but began offloading Treasury bonds last year and has its own mounting debt crisis. And its solution to its own debt issues – to shore up its banks’ liquidity by flooding them with cash – is one of the many reasons why the yuan is an unstable alternative to the dollar as the world’s reserve currency. Either way, there are distinct fears that the only way countries can repair their balance sheets and emerge out from under their debt mountains will be to devalue currencies. When that happens, people turn to gold.

Since the financial crisis, there’s clear evidence that central banks are buying more and more gold, reversing the decades-long trend of government selling. A large part of that swing to demand is due to Russia and China, in particular, which sees gold as a key support to the internationalisation of the renminbi. China’s deep cultural affinity for gold is also a reason why its citizens are the biggest buyers of bars and coins in the world. Longer term, it is unclear whether the mining industry – which has not discovered significant gold deposits for decades – can keep pace with this demand.

In short, then, gold is not just an indestructible material with a high value-to-weight ratio, but a relatively inexpensive form of protection against currency debasement and hyperinflation. Long before the global economy was financialised, people recognised that gold is no one else’s liability. That observation is not going to die.

 

Getting exposure

Unless you invest in mining stocks – more of which later – gold brings no prospect of income. Short-term profit in the metal is of course possible, if you are able to trade the daily or even monthly movements in exchange traded funds (ETFs) or spot prices. We prefer a longer-term approach: the dollar-denominated gold price has rallied this year, but even if this pares back towards $1,000, we think there are reasons for confidence in the metal, as a type of non-correlated insurance policy.

There are several ways to get exposure to gold, each providing varying degrees of volatility. The simplest place to start is with physical gold, which can be done by buying jewellery, or more economically with coins and bars.

Owning physical gold comes with one distinct advantage over paper assets: in the event of a major global recession, there’s no guarantee that the value of gold securities and equities will survive a major financial market crash, as investors rush to the door in a bid to liquidate their holdings. And unlike other alternative assets – such as art, wine or stamps – gold is not only easy to store, but won’t degrade and has an enduring and liquid market.

In countries where there is a deeper cultural attachment to owning gold as a store of value, such as China, it is relatively easy to buy gold bars and coins on the high street. The UK bullion market is not as developed as this, but you can still buy gold securely in branch, by phone or online from a wide range of sources, including Sharps Pixley, The Gold Bullion Company and Bullion by Post.

Other than spreads and delivery costs, the biggest issue is likely to be where to keep the gold, especially when purchasing amounts you’d rather someone else looked after. This obviously comes with storage and insurance costs, but beyond this the most important points to consider are ease of access and the reputation of the vault operator or custodian. The best operators should have long track records, and be able to provide customer and insurance references.

 

Paper gold - exchange traded products

Owning physical gold is nice in theory, but even if you have somewhere secure to store it, at some point you will probably need to worry about who is going to handle the stuff. Understandably, those concerns are not for everybody, but one popular way to get exposure to the price of gold is through an exchange traded product (ETP).

We have previously guided that the best ETPs are backed by gold bullion, rather than synthetic funds, which are comprised of gold futures contracts that track the future price of the metal. Synthetic exchange traded commodity products, for example, can be hit by volatile swings in the future price of gold. The popular ETFS Physical Gold (PHGP) is a good example of a sterling physical fund, and charges just 0.39 per cent annually to cover storage and insurance costs, 10 basis points more expensive than the lesser-known Source Physical Gold P-ETC (SGLP).

Another distinction to make is whether a fund offers not only custody and logistics support, but immediate redemption in cash or gold on request. Investing in these types of fund – such as Sprott Gold Bullion Fund or the Cayman-listed Physical Gold Fund – involve owning units in a fund, rather than the physical gold itself, but they come with the promise of physical gold if needed.

Golden equity

For some investors, gold – whose price is determined by more than just the industrial supply-demand factors attached to most commodities – is volatile enough on its own. Others, usually with a higher tolerance for risk, are tempted to multiply the upside (and hopefully escape the downside) of gold price movements by investing in gold mining stocks.

The potential benefits are twofold. Firstly, profitable gold miners are able to pay dividends, which neither physical gold nor gold ETFs can match. It doesn’t take much of a jump in the gold price for the free cash flow which underpins those payouts to leap; for example, a gold miner with all-in sustaining costs of $1,000 an ounce will see its profit margin double if the gold price increases from $1,100 to $1,200. Because gold miners are a leveraged bet on the metal’s price, their shares have naturally outperformed gold so far this year.

“For gold miners, the question is: does the expansion in margins through the rising gold price offset the massive cuts in capital expenditure?” asks ETF Securities’ James Butterfill. The broader question this implies is whether the sector’s earnings growth – currently highly priced – is sustainable. Mr Butterfill points to the 1.1 times dividend cover across the sector – more in line with less risky utilities stocks – as evidence that the market is asking too much of gold mining investments. What’s more, that metric is likely to come under further pressure, given the 41 per cent peak-to-trough fall in capital expenditure. On a fundamentals basis, investors tempted to buy gold stocks may have better luck with less highly-rated miners, which are broadly subject to the same extraction and energy costs.

Gold picks

Nonetheless, there is no denying the appeal of gold mining stocks, if you think the gold price will rise in the near term. Investors who choose to do so should look out for a few of the characteristics demonstrated by some of the stocks we have been keen on in the last year.

A low-cost profile is of foremost importance. Randgold Resources (RRS), whose shares are up 53 per cent since we tipped them in January, is a case in point. The company has stakes in a number of mines across Africa, including Mali, Côte d’Ivoire and the Democratic Republic of Congo (DRC), and is cash-generative at prices well below $1,000. In the course of the next decade, the Loulo-Gounkoto mine in Mali and Kibali mine in the DRC are each expected to produce more than 600,000 ounces of gold a year at total cash costs of $600 an ounce.

What’s more, Randgold has lots of cash on its balance sheet and is committed to steady dividend hikes, although its high current valuation – at 29 times Canaccord Genuity analysts’ forecast earnings for 2016 – means the yield isn’t a major bull point for the stock.

Another of the continent’s gold miners, Pan African Resources (PAF), comes with a far stronger income case. The group, whose Evander and Barberton projects near Johannesburg are set to produce around 200,000 ounces of gold in the year to 30 June, has a forecast yield of 3.8 per cent, according to Peel Hunt. Despite a sharp recent share price appreciation following what amounted to a convoluted share buyback, the stock still trades at a discount to the sector at just 10 times this year’s forecast earnings. Last year’s steep drop in capital expenditure might prove a concern, were it not for excellent cash flows ready for reinvestment, the long life of Pan African’s high-grade mines and low level of balance sheet risk.

Accordingly, Pan African is one of the lowest-risk gold miners on Aim, a market that does not usually reward bottom fishers searching for highly geared commodities plays. One stock that falls into this category is Shanta Gold (SHG), currently in the midst of a balancing act to pay down debts and expand operations at its New Luika mine in Tanzania. We think Shanta can emerge from that high-wire escape, particularly in light of a recent deal with its bondholders that shifts an onerous repayment due in 2017. And while a hedging agreement means the first 32,000 ounces of gold produced between April and September this year will be sold at just $1,172 each, this year’s expected production ramp-up – together with all-in sustaining costs below $800 an ounce – has led finnCap to forecast adjusted earnings per share of 1.6¢ for 2016, or just over five times the share’s 6p price tag. The longer the gold price holds above $1,250 this year, the greater the chance Shanta’s stock has of re-rating.

A combination of production expansion and debt reduction also defines Petropavlovsk (POG), the Russian gold miner chaired by Peter Hambro which narrowly avoided bankruptcy at the start of 2015. Recapitalised and with construction for the pressure oxidation hub it abandoned in 2013 now back on track and carried by a third party, Petropavlovsk is set for an enormous boost in production. This should come at little additional expense. Not only is the company adding up to 127,000 low-cost ounces a year by 2020 through the acquisition of junior miner Amur Zoloto, but a plan to construct underground operations at its Pioneer mine for just $9m is set to contribute between 130,000 and 180,000 ounces of production per year from 2017.

Although he stresses his views are not representative of his company, Mr Hambro believes that today’s cocktail of geopolitical and economic tensions can only be supportive of gold prices. “I was born at the end of the second world war,” says the City grandee, “but now is about as worrying a time.” It is not uncommon for gold’s miners to be temperamentally bullish about the metal’s prospects, even if like Mr Hambro they have more first-hand experience of the commodity’s volatility than most.

Not all share this outlook, however. Although his company’s stock hit a near-three year high last week, Fresnillo (FRES) chief executive Octavio Alvídrez recently said he sees “no clear catalyst that would support a return to higher prices”, in explaining a decision to slash capital expenditure budgets for 2016. The short-term effect of this decision has been to widen the Mexican miner’s profit margin, and with it its price-to-earnings valuation.