Sunday, September 2

Week 61 - Gold Miners

Situation: Owning gold appears to satisfy an emotional need for some investors. Until recently, most of the gold mined on a yearly basis was used to produce jewelry. Then in 2004 an exchange-traded fund (ETF) became available that allowed investors to own fractional shares of gold bars and pay low maintenance costs (GLD). An unexpected byproduct of this was to increase the level of speculation in gold, thus adding to supply constraints because production of gold rarely keeps up with demand.

So just what kind of investment is gold? Many terms are applied to answer that question. For example, “store of value, hard currency, safe harbor, hedge against inflation, easily transported wealth, hard asset, piggy bank, real money” are a few. The abundance of descriptors for the role that gold plays only goes to show how important gold is. For dispassionate readers of this blog, however, it’s just another counter-cyclical “hedge,” much like a US Treasury bond. The purpose of a hedge isn’t to increase your wealth. The purpose is to prevent a loss of principal, i.e., to protect your initial dollar outlay. The buyers are more interested in return of their investment than return on their investment. For this reason, they want a hedge that has a low or negative beta. The 5-yr beta for 12 gold mining stocks in the accompanying Table is -0.05 to 0.71 (with an average of 0.43--meaning those stocks go down only 4.3% when the S&P 500 Index goes down 10%). 

You may have asked: "How do I go about investing in gold?" The simplest way is to purchase shares of GLD or IAU (a second gold ETF). These are valued at one tenth (GLD) or one hundredth (IAU) the purchase price of an ounce of gold. Owning gold in one of these ETFs has an advantage over owning gold bars because transaction, storage and insurance costs are much lower. But keep in mind that you still get no dividend income and any capital gains will be taxed as income (because the IRS classifies gold as a collectible, like art). Another way to own gold is to take advantage of its scarcity in the earth’s crust, meaning that supply is likely to keep falling behind demand: You can buy stock in a gold mine. Then you’ll earn a dividend of ~1.7% (average yield for the 12 stocks in our Table) and get taxed half as much on your capital gains.

Our Table was constructed by screening a database of world stocks for 
   a) market capitalization greater than $2 Billion;
   b) Return on Investment (ROI) greater than 1%/yr;
   c) average 5-year ROI greater than 1%/yr.

Almost 2,000 names popped up and among those were 12 gold mining companies that we selected for closer examination (Table). For comparison, we show Annualized Total Returns spanning the ~8 yr period since the first exchange traded gold fund (GLD) became available, and compare those returns with those for the lowest cost S&P 500 Index fund (VFIAX). Four companies (AEM, BVN, IAG, GG) had Annualized Total Returns greater than 7% while losing less than 15% in the 2007-09 bear market, but only one of those has large gold reserves: Goldcorp (GG).

Bottom Line: Gold differs from other countercyclical hedges. Like US Treasury issues, it performs well during recessions. Unlike Treasuries, it performs badly during a depression but better during inflation. If you value these particular features, you can “double down” on your gold investment by owning stock in gold miners. Why? Because those companies own recoverable gold in the ground. Gold production has increased less than 1% a year for the past 13 yrs yet demand for gold (and therefore its price) has more than doubled. What’s the downside? The price of gold is volatile. Even though having it in your portfolio can mitigate stock market losses, you risk losing some of what you have invested in gold when the economy recovers. US Treasuries, on the other hand, will return every dollar you have invested. But what about the effect of inflation on gold vs. Treasuries? Gold wins while inflation is rising but usually doesn’t do as well over a complete economic cycle. US Treasury notes and bonds historically beat inflation by ~2%/yr whereas gold loses ~1%/yr.

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