Gold Strategy--my take

 GOLD STRATEGY

Why does Gold play a part in a portfolio?

From my point of view, gold has some unusual characteristics which make it appealing as part of a portfolio. Firstly, it is not correlated to the financial markets be it equity or bond markets. Finding uncorrelated sources of alpha is a holy grail in investing. Gold has been used as a source of value for a long time and is freely exchanged. In the past gold has been convertible for currency by governments and had backed their currencies. That points to its legitimacy, IMO. Gold is unlike other commodities that are either exhausted on use such as oil or coal or have large industrial uses such as iron ore or base metals that have their pricing largely driven by their usage. Almost all gold ever mined is still in use or storage somewhere. The existing pool of gold available to trade overwhelms its annual production, unlike almost all other commodities. Most gold is held as a store of value, unlike other commodities. Therefore total potential supply and pricing are largely not dictated by current production like other commodities.

Gold the currency

From an investment perspective, gold should be viewed as a hard currency, IMO. Gold production increases at 1-2%pa. Money supply in the large developed economies increases by varying amounts but easily exceeds gold production, causing the ratio of money, say M2, to increase relative to gold, supporting an increasing gold price over time. The US m2 has increased by about 6% pa.

The investment case for gold relies on governments continually increasing the monetary base above the rate of gold production. It is hard to think that won't continue indefinitely.

Difficulty in valuing gold

There are two chief difficulties in valuing gold, especially in the short term. If we agree that the gold price is a ratio of the monetary base (MS) divided by the total gold reserves we get an “intrinsic” value for gold. Measuring the stability of that ratio is difficult. The ratio of the MS/total Gold ounces generates a reasonable baseline, but we must realise that the velocity of money will play a part and is almost impossible to identify or measure over the short term. That is, M2 can vary due to credit creation, so it is a good proxy but still a proxy. The velocity of money is the rate or speed that money cycles through the economy the faster it cycles the more apparent its impact (eg inflation), while if dormant its impacts are not apparent and will be less obvious. Having said that, the important fact is that MS growth exists and its ability to accelerate or decelerate should have a limited impact on gold over the very long term.  Expectations on how the MS grows and how velocity changes also impacts the gold price. We can see that if the money supply contracts the resultant shortage of USD for instance, leads to an increase in the US dollar price, that is interest rates and also that supports the USD. Therefore short-term moves in gold may be most probably influenced by those factors. Like everything in investing, it is not written in stone but the long-term trend is evident.

One way to view it is that MS growth drives the LT story and velocity through its impacts on inflation, USD, and interest rates, which provide movements around the trend.

That said we can see some correlations in the following charts. We can also see some interesting points.

 

Current pricing

The above graphs highlight two interesting outcomes for me.  Gold has done very well over the recent past but we can see serious lagging around 2015 and post-C19. The market waited a long time to gauge whether the excess money supply due to C19 would be withdrawn but has now decided that the reduction effort has passed. That is, we have a largely permanent increase in the MS. Both the US and the Euro appear to be in the easing cycle. Gold has responded to catch up.

Secondly, I have put in the CNY due to its size. However, it is not a freely exchangeable currency. You would have to think if it was ever freely exchangeable there would be serious buying of gold and probably many other assets by CNY holders.

Using this measure the gold catch-up has largely played its part.

Future?

In this framework, the future gold price is largely dependent on CB’s continuing to print currency. This ongoing debasement supports gold. There is the ever-present, low-probability outcome of a major government completely letting its currency go. That would be very bullish for gold but the second-order impacts are difficult to judge. There should be a small option for gold for this possible event.

The bull thesis is that CBs continue to issue currency. We have evidence that in the last two crises, the GFC and C19, were both met with aggressive currency issuance. There may be no other alternative in modern finance policy, given where we are in social contract and debt terms.

The bear case is that there is a permanent and large contraction in the money supply leading to a severe contraction, that doesn’t trigger a fear of financial meltdown. The further the CBs go down the currency issuance path the further away any long-term easy fix becomes. That is, the current policy continues to play for gold.

Like all assets gold can become expensive and cheap.

Ways to invest in gold.

I see four main ways to play the gold theme.

1.      Bullion. Is the purest play. Usually best owned through a gold-backed ETF. Bullion also is the most conservative way to play the theme, as there is no operational risk and less leverage, up and down.

2.      Royalty/streamers. These are companies that play in the space with contracts that derive income in a mix of ways but mainly avoid the expense performance of the miners. They usually take a stream of ounces, a percentage of revenues or a mix of both. Usually, the streamer pays a fair price for these assets and makes excess returns well down the track, when the operator expands the mine, the royalty company participates in the increased production, usually without any further capex. These are then usually a lower-risk way to play the sector and are in nature quite a long-term investment.

3.      Established miners. These are operational mines and depend on the attractiveness of their deposits and the operational efficiency of the management team in extracting the ore. These companies expose investors to operational risk to a greater degree than the royalty companies. Factors to consider are, the number of operational mines is important to diversify risk, and the quality and geography of the deposits. I have some interest here but only for well-run and with quality long-lived assets.

4.      Developers/Exploration. These are miners who have yet to develop a deposit or find a deposit. There can be an enormous risk as the deposits are developed into mine and the thesis here, IMO, moves away from a gold play and becomes speculation on successful development to a greater degree. That is fine if investors have a particular skill in identifying all the issues concerned with deposit development and want to take on that risk. I have limited interest here.

Two things are at play here, where we are in the gold price cycle, low, fair or full and how each subsector is valued, depending on how far through the above risk spectrum you want to position yourself given relative value.

The structure of portfolio exposure could move as more or less leveraged exposure is considered appropriate given the apparent relationship between monetary growth and the gold price. I expect to hold some gold exposure for the long term.

Most recent moves in the portfolio.

The mix now in my portfolio is Bullion 39%, Royalty/streamer 35% and Developed miner 25%, with overall 5.1% gold exposure but this mix is now a more conservative exposure given the catch-up in price. If gold rallies strongly from here I would reduce the developed miner and maybe keep the overall exposure flat.

That’s all I have DYOR