At one extreme, I know investors who have their entire portfolios invested in a combination of gold, gold equities and cash. Underpinning this view is a deep distrust of central bank money printing, sky high and rising Government debt, alongside dangerously high equity and bond market valuations. The unavoidable endgame is runaway inflation that will cause real interest rates to plummet to negative levels not seen since the 1970s. In this scenario gold – and by extension gold equities – will be one of the few investments that do well.
At the other end of the spectrum, investors such as my colleague Simon Gergel harbour philosophical objections to the very idea of gold as an investment. This line of argument usually runs something like this:
“Gold is an asset that has no practical use other than very minor industrial applications. It costs money to store it and yet it pays no income. Most of the gold ever mined is sitting in vaults somewhere and could come back to the market at any time. This, combined with the lack of practical use, make gold impossible to value and therefore un-investible.”
As someone who thrives on controversy, I cannot avoid being drawn to this debate. Initially I was very much in the un-investible camp, however over the years I have revised my view to what I think is a more practical standpoint.
The metal itself has never held much appeal to me as an investment. And whilst I agree it is difficult to come up with any firm objective measure of value, the plain fact is that the price of gold has tended to go up over time (admittedly with a lot of volatility!) as governments throughout the ages have debased the value of money. Moreover this isn’t just a recent phenomenon. Gold has behaved this way for thousands of years. I may not like it from a philosophical perspective, but this is the reality. Better to accept it and see if there might be ways to profit from it. And here I think gold mining (gold equities) offer more prospects for mispricing than does the metal itself.
In this post I will outline my framework for thinking about gold equities as potential investments. In the next post I will make a few observations on state of the industry today.
In my 2015 blog post “Mining – the big money has already been lost” I explained, with the help of a number of charts, how I think about the broader mining sector. A key conclusion was that from a long term perspective the industry is actually less cyclical than most people think.
When profit margins are very depressed (as they were in 2015), there are powerful forces such as cost deflation, capacity cuts and high grading that tend to bring profitability back to average levels quicker than expected. The reverse is true when margins are elevated. It is at these cyclical extremes when this mean reversion doesn’t get priced into valuations, thereby creating potential buying opportunities at the bottom of the cycle and selling opportunities at the top.
It is possible to put the gold mining industry through the same sort of analysis, however there is one critical difference. Whilst the long term price of, say, copper will ultimately be determined to some degree by the cost of production of copper, the same cannot be said for gold. Indeed there is evidence the relationship actually works the other way around – i.e. that the cost curve adjusts upwards or downwards to whatever the gold price happens to be. This is illustrated in the following chart from Exane BNP Paribas which tracks the gold price back through time versus the cost of production across the cost curve.
You can see that cost curve has tended to move up and down with the gold price itself. There are two reasons why this happens.
Firstly, annual gold demand is only a very small percentage of the outstanding gold stock. This means that a supply side response to a fall (or rise) in gold demand won’t necessarily cause a rebalance in the gold price as there may simply be more (or less) of the demand being met from existing stocks.
Secondly, there is a huge variation in profitability across gold mines. Even individual gold mines often have some shafts or pits that are far more profitable than others. This means the gold mining industry is capable at operating to some degree at almost any gold price.
To me, this suggests that any investment in a gold mining equity should demand a very significant margin of safety, certainly greater than for a copper miner for example. Only assets that are low (or have the potential to be low) on the cost curve should be considered because only these assets will be able to stay profitable in lower gold price scenarios. Anything else is speculation. And of course a low valuation is absolutely necessary to compensate for the cyclical downside risk.