Shaun le Roux, Fund Manager at PSG Asset Management
Gold is currently raking up all-time highs and drawing renewed attention. While trading at these levels (and the inevitable market excitement that follows) could be signs that the price of gold is potentially due for a correction, this does not negate the important role it can play in portfolios over the long term. In fact, we believe the metal’s role is currently amplified, and that gold stocks offer a particularly attractive opportunity.
Recency bias leads to investors extrapolating recent experience. Fourteen years of exceptional performance by US equities, which dominate global stock indices, has seen the emergence of broad complacency about the persistence of this trend. Yet, there is another asset class that is in a secular bull market that is getting very little attention: gold. Indeed, gold is still hardly owned by retail or institutional investors in the West. These investors are also prone to drawing attention to the poor performance by gold stocks relative to the gold price over the past two decades. As a result, we conclude that they underappreciate the valuable role that gold (and gold stocks) can play in a diversified portfolio. This is because the post-GFC (Global Financial Crisis) world of secular stagnation and inflated financial asset prices has masked the benefits that gold has provided over other time periods, and also over the longer term. We believe we are entering a new financial era that requires new strategies to protect and grow capital, and that gold is an essential tool in this environment.
If you look further into economic history, you will appreciate the value of gold as a store of value. It is the asset class that investors reach for when they lose faith in other assets. It holds its value because its supply is essentially fixed, in contrast to fiat currencies, which are inevitably debased over time as monetary bases are expanded. As the chart below shows, all fiat currencies have maintained only a fraction of their purchasing power over the past century. Furthermore, the rand gold price has compounded by 13% per annum over 50 years and its performance has not only been remarkably strong and consistent, but also often comes at times when other asset classes like equities and bonds perform poorly. Indeed, gold serves as strong insurance against currency weakness and geopolitical risks, making it an excellent diversifier.
Gold as a store of value
Sources: EEAGLI, using Bank of England, Japan National Bank, Goldprice.org, Federal Reserve Bank of St Louis.
There are times when this long-term role of gold in a portfolio is either enhanced or reduced. It is generally a poor time to own gold when in a goldilocks environment of low inflation and strong economic growth (which favours equities). And, rising rates are a headwind to gold because gold yields nothing and there is a cost to storage: higher rates therefore increase the relative attractiveness of cash in the bank. Gold also tends to do poorly when the US dollar is strengthening. Accordingly, the gold price strength of recent years (and particularly in recent months) amidst dollar strength and higher fed fund rates is unusual and noteworthy. The strongest explanation for the decoupling of gold from the dollar and US interest rates is the significant accumulation of gold in the foreign exchange reserve accounts by various developing countries, especially China. Their appetite to hold US treasuries has likely been negatively affected by not only the weaponisation of the dollar through the confiscation of Russia’s reserves and exclusion from the SWIFT payment system, but also by mounting concerns around the US fiscal situation.
We think we are in a secular bull market in gold. Over the past seven years, we have witnessed an explosion in Western monetary bases that have largely been funded by government debt. There are no signs of any appetite to reverse the unsustainable fiscal policies of modern times, and we see no way out besides eventual monetisation of the debt that is being accumulated. To us, higher inflation in the future is the least painful remedy against this unsustainable debt path. In this environment, we anticipate strong demand for real assets that preserve their purchasing power, especially precious metals.
Notwithstanding a strong bull market between 2003 and 2011, gold stocks have generally been poor investments over the past two decades. Large cap gold miners are broadly at similar levels to 20 years ago. Yet the gold price has risen more than five-fold over this period (refer chart below). Clearly, a buy-and-hold strategy has not served investors in this sector. There are a few explanations for the poor performance by gold stocks over this period. These include: rapid rises in input costs that more than offset higher realised prices (especially over the past decade), declining production, increasing exposure to challenging jurisdictions and poor capital allocation. Current market sentiment with respect to gold miners is poor and valuations are attractive. It appears that the market expects the poor relative performance to persist.
Barrick vs gold price
Sources: Bloomberg and PSG Asset Management
We see numerous scenarios in which certain gold stocks could significantly outperform the price of gold during a secular bull market and, as a result, we prefer gold stocks over physical metal in our portfolios. Firstly, the sector has experienced considerable consolidation, with many of the larger gold miners now positioned for enhanced operational performance and better cost control moving forward. Current valuation levels are particularly attractive when compared to the metal itself as well as other equities, which bodes well for future returns.
Additionally, there are other overlooked attributes based on recent trends. Importantly, gold and gold stocks are often negatively correlated with equities and other risky assets, meaning gold tends to rise when stock markets decline. We believe this inverse relationship is amplified by the current macroeconomic environment, which is characterised by elevated global equity valuations, aggressive equity positioning, rising geopolitical risks and unsustainable fiscal policies.
Historically, gold stocks have significantly outperformed physical gold during secular bull markets. This is because the stocks are leveraged to higher realised prices relative to a cost base of which a large proportion is either fixed or will rise at a slower pace than revenues. Furthermore, in such markets, investors begin to assign value to the optionality of potential underground reserves and resources that are incentivised to be brought to production at higher prices. Many gold stocks are currently cheap relative to existing cash flows, let alone likely cash flows in an environment of higher future prices or increased levels of future production.
We follow our globally integrated process to identify selected gold stocks (both miners and streamers) that meet our investment criteria. Our clients own higher quality companies that are well positioned to harvest this environment, with strong management teams and sufficient diversification of mines across a variety of jurisdictions.
We argue that the role that gold can play in a portfolio as both a store of value and a diversifier has become underappreciated in modern times. It is our view that we are now in an investment era where the market is waking up to the value of gold in a risk-conscious portfolio. In this context, gold stocks look like a very attractive opportunity.
ENDS
