Sunday, February 26

Week 34 - The New Gold Standard

Situation: Gold has been a top-performing asset in recent years. When currencies are weak and interest rates low, some investors shift assets into gold because they become afraid of losing even more money. This can make sense if deflation doesn’t intervene and collapse commodity prices across the board. Gold prices often rise when stocks are down but gold is expensive to own. In addition to buy/sell commissions, there are ongoing fees for insurance and storage. Gold pays no dividends or interest, so interest rates also have to be low to justify these expenses. And, the higher the price that gold rises to the larger will be the investment that gold mining companies make in exploration and production. Within a few years, the resulting increase in supply might outstrip demand. In today’s market, the price of gold is almost 3 times the cost of production, causing played-out mines to be re-opened for another run using newer mining technologies.

The dilemma we’re discussing in this week’s blog is common: When investors face market pressures like those seen in the past few years, should they bail out of stocks in favor of owning commodities such as gold? We propose that the answer is to continue making a monthly investment in companies on the 2012 Master List (Week 27) that fulfill two criteria:
   a) have less than 45% of total capitalization from long-term debt (except regulated utilities);

   b) have a “durable competitive advantage” as defined by Warren Buffett (Week 30), which we define as no more than two down yrs in tangible book value (TBV) over the past decade, and a TBV growth rate of at least 6%/yr.

We find that 11 out of 30 companies on the 2012 Master List meet those conditions:

You’ll note that 5 of these companies are also part of the group of 11 companies representing the Dow Jones Composite Average, which we’ve dubbed the "Stock-pickers Secret Fishing Hole" (Week 29). We’ll focus on these 5 companies to make our point (see attached Table). 

The Table shows that gold has increased in price at the amazing rate of almost 20%/yr since July of 2002, when the stock market was bottoming after the 9/11 attack. By November of 2004, those gains led to introduction of the first exchange-traded fund (ETF) that allowed investors to purchase fractional shares of gold bars (GLD). A competing gold ETF was introduced 2 months later (IAU). Nonetheless, many “gold bugs” chose to stick with owning shares in gold mining companies because, historically, gold prices are volatile and can remain depressed for decades. Owning shares of a large gold mine can present less risk, i.e., the mine holds ~1,000,000oz of readily extractable gold reserves with a known cost of production (currently ~$600/oz vs. the market price of over $1,700/oz). It’s unlikely that a major gold-mining company like Newmont Mining (NEM) or American Barrick (ABX) would fail to make money in any given year. Both pay a good dividend and show price appreciation that tracks the NYSE Arca Gold Miners Index (GDX).

The total return for Newmont Mining (NEM), as shown in the Table, is 7.2%/yr for the last ten years using quarterly additions to a dividend re-investment plan (DRIP). This compares favorably to the most popular S&P 500 Index Fund (VFINX), which had a total return of 4.6%/yr. But NEM did much better during the credit crunch from 10/07 to 4/09, gaining 1% in value while VFINX lost 48%. This matters a lot to those of us who save for retirement by contributing to mutual funds through 401(k) plans as our main strategy. We took a big hit and won’t soon forget the sinking feeling we had every 3 months reading our 401(k) statements!

Now let’s turn to the 5 stocks we found in our favorite fishing hole, the ones with a “durable competitive advantage”: XOM, WMT, JNJ, NSC, and NEE. How did they do compared to NEM and VFINX? Taken together, these DRIPs had a total return of 8.65%/yr but lost 15.8% during the credit crunch (Table). This performance easily beat the S&P 500 index fund, and beat Newmont Mining in terms of annualized total return. But during those 6 quarters after Lehman Brothers went bankrupt, NEM was the place to have parked some money because it gained 1% in value. 

So which is better? Investing in a top-tier gold mining company for a return of 7.2%/yr and little risk of loss during a credit crunch (as long as a deflation doesn't take hold), or investing in 5 top-tier dividend growers for a return of 8.65%/yr and a temporary 15.8% price loss in a credit crunch? Bear in mind that all top-tier gold mining stocks exhibit considerable volatility and none have ever garnered an A rating from S&P. But over the most recent 30 yr period NEM did manage to almost hold its own against VFINX in terms of total return, albeit with long periods of depressed prices, particularly in the 1990s when the stock market was booming. That discordance is called "non-correlated price action" by traders and is considered a good thing. Why? Because the non-correlated asset goes up in value when the stock market goes down. Long term US Treasury bonds are another non-correlated asset that does well in a bear market. Dollar cost-averaging into these at over 15+ years can be expected to beat inflation by 1.8%/yr, whereas gold only beats inflation if you know when to buy and when to sell.

Bottom Line: After an awful decade for stocks and a great decade for gold, we find that a basket of 5 Buffett-style growth stocks still managed to outperform a typical top-tier gold mining stock by almost 1.5%/yr.

Note added in post-script: The importance of gold as a guarantor of sovereign debt continues to grow, as evidenced in the second bailout of Greece by the European Union (concluded in Brussels on Feb 20), "Greece's lenders will have the right to seize the gold reserves in the Bank of Greece..." (New York Times, 2/22/12, article by Rachel Donadio on p. A11).

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