Friday, February 21, 2014

Without the Glitter.

Gold as an investment

Gold is a speculative commodity.  It hedges very little.  It has not been a good long-term investment.  Mining gold can be a profitable business, however it is extremely cyclical.  Gold miners have learned to adapt to the speculation in their output.  Consequently, there are times when the stocks of the gold miners are attractive investments. 

Current supply and demand conditions in the gold market, as well as the response of the mining companies to recent market conditions, suggest that now may be an appropriate time to investigate the stocks of gold miners.  This posting discusses the issue and summarizes the Hedged Economist’s response.  However, the more important take away is that now is a good time for any investor to review his or her exposure to precious metals.

In previous postings on The Hedged Economist, both gold and gold mining stocks have been mentioned.  The April 5, 2010 posting on gold entitled “Gold: Be sure you know what you’ve hedged,” focused on debunking many myths that surround gold.  In many peoples’ minds it has taken on almost magical investment qualities.  As the posting pointed out, those magical qualities do not and never have existed. 

The May 16, 2010 posting entitled “Gold again” pointed out: “In the long run it isn't a very good investment, but as a short-run speculation, it has its moments.”  The August 20, 2010 posting, entitled “Worthrepeating and, yes, gold again,” compared the return on gold to other investments.  The comparison was made for a number of different time periods.  It showed that it is very hard, if not impossible, to find any periods where gold was other than a short-term speculation.

Gold miners are businesses.  Any investment related to gold has to be done with considerable caution.  However, gold and gold miners are two different investments.  Gold miners are businesses and regardless of the speculative component that influences the demand for their product, they produce a product that is subject to supply and demand.  They have costs.  They have financials.  They have stock prices.

The posting on May 5, 2011 entitled “Up, up and away in my beautiful balloon, or is it abubble?” discussed both gold and gold miners. The business of any miner can be evaluated using fundamental analysis just like any other business.  However, given the speculative component in the demand for their product and the lackluster performance of sector, is there any justification right now for putting in the effort to analyze individual mining stocks?

The answer is yes there are reasons to investigate the sector.  The first, and always the most important consideration, is how gold miners’ stocks fit into the investor’s portfolio.  The mining sector should be represented in a portfolio.  However, extractive industries are highly cyclical, and precious metals constitute very small portion of the sector.

As was mentioned in the posting cited above, The Hedged Economist can see no justification for holding much exposure to precious metals.  An average exposure of a couple of percent seems reasonable, but contrary to many prescriptions usually advanced when the price of gold has rising, there is no justification for a constant exposure of more than that.

If one holds a couple of percent exposure, the poor performance of gold miners, both in absolute and relative terms, will have reduced that exposure below the desired threshold.  The Hedged Economist has maintained a portfolio weight between less than 1% and up to 5% with the average being closer to 1% than five. 

There is no effort to maintain a stable exposure.  Rather, the exposure fluctuates within that range based upon the cyclical performance of the metal and the miners.  Often when the prices of the metal or the mining stocks advance, that exposure is reduced in order to take advantage of the price increase. 

The other side of the portfolio management, and the current situation, is that when the exposure falls because of a fall of the price of the metal or the price of the miners stocks, additional purchases are considered.  When prices are down, that is the time to consider additional purchases.  Thus, the portfolio suggests that it is a good time to consider investing in the sector.

Another reason involves the demand for gold.  Of course one has to guess, but it appears that a good deal of the speculative demand for the metal has abated.    It is only a guess, but there number reasons for making that guess.

First, the amount of gold being held to back the gold ETFs has decreased as their price decreased.  Gold held to back ETFs is definitely gold held on speculation.

Second, that guess or interpretation is consistent with warehouse inventories at theComex.  Thus, it appears that less gold is being held to meet the demand of speculators that trade on the Comex. 

Third, warehousing of metals is less appealing to banks in the current regulatory environment.  Banks are themselves speculators, and they hold inventory to facilitate the trading of other speculators. 

Fourth, that interpretation is consistent with the performance of gold versus certain gold mining stocks.  The Hedged Economist has held a small position (less than one percent of the portfolio) in Newmont Mining (NEM) for many years and has come to believe that certain divergences between the price-performance of gold and Newmont’s stock provides some information about the amount of speculation embodied in the price of gold. 

The bottom line is that there are reasons to believe that further downward pressure on prices from speculators reducing positions has stopped. 

By contrast, the physical demand for the metal has held up or increased.  Some of the demand is being repressed.  For example, import restrictions in India (one of the major consumers of gold jewelry) have kept the price of gold high in India.  There are estimates that the price of gold in India has been as much as $100 above the world market.  That sort of government intervention indicates that prices could increase in India without reducing the physical demand.  Elsewhere the demand for gold coins and jewelry has held up or increased as prices fell.

It is always good to remember that there is a huge physical inventory of gold in central bank vaults and warehouses.  Whether central banks add to those inventories is a wildcard in any demand projection.  It is also important as it relates to the third reason that now is an opportune time to investigate gold miners’ stocks. 

The third reason for believing that now is an opportune time to consider the stocks of gold miners concerns the supply of gold.  If central banks began to divest themselves of their gold, they could easily flood the market with far more gold than the miners produce.  There is no reason or announced plans for major gold-holdings central banks to sell their gold.

Another positive development regarding the supply is that gold miners have become more disciplined in their response to gold prices.  Developing a mine has very long lead times.  Consequently, often mines that were started during periods of high prices would come online when prices were depressed.  The consequent oversupply would further depress prices.  However, during the recent price decline gold miners have delayed or halted development projects in response to the price decline.

Part of that new discipline regarding supply reflects better management.  But part of it reflects the demands of the financial markets.  Some mines had to be delayed or halted in order to avoid further declines in specific company stocks.  That decline could reflect a market reaction by owners of the stock or by the company’s financial need to dilute their shares in order to secure adequate financing to pursue their expansion.  The result is that it does not look like gold miners will flood the market for the metal.

The same market reaction that has restrained the development of new mines has forced management to more carefully manage their balance sheets.  Consequently, one would expect some gold miners to be in good financial shape to expand production, take market share, and avoid pressure on their margins.

One can also apply technical analysis to the price of gold miners’ stocks.  In fact, BARON’S on February 12, 2014, posted just such a technical analysis in their Getting Technical feature.  The article was reprinted in the weekend edition as “More Support for Gold: Charts Take Bullish Turn.”

Aficionados of technical analysis may want to check out that article.  The Hedged Economist purchased shares in a gold miner (Gold Corp.  – – GG) on February 3 before the article was published.  The fundamentals and portfolio considerations rather than technical analysis were the driving influence.  However, given the advance in gold and gold miners’ stocks since February 3, some readers may find the technical analysis reassuring.  The Hedged Economist, not being an aficionado of technical analysis, is more reassured by the relative performance of miners versus the metal, and both miners and the metal relative to the overall stock and credit markets.

The confirmation that the markets have provided is extremely important.  Keep in mind, any decision related to gold is subject to revision at any time.  That is especially true of a decision that increased the portfolio weighting for gold mining stocks to 2%.  Two percent is above The Hedged Economist's normal portfolio weighting.  Nevertheless, for now, some gold miners look like reasonable investments.

No comments:

Post a Comment