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Gold stocks, meaning companies that mine gold or finance gold production, are currently out of favor.
That’s why it’s not a bad idea to add a little gold and/or gold stock exposure to your portfolio as a hedge while it’s cheap in our opinion.
As a note, gold stocks can be a volatile group, and difficult to invest in. We generally think it’s a good idea for passive hands-off investors to have a small amount of gold exposure in a portfolio, but a gold stocks themselves are best left to hands-on investors that don’t mind volatility.
Why Invest in Gold Stocks?
The price of gold and gold stocks jumped sharply in the aftermath of the U.S. subprime mortgage crisis and the European sovereign debt crisis, with the peak being in 2011. The following chart shows the gold miners ETF (blue line) vs the S&P 500 (red line) during that time:
Since then, the United States has had a long period of economic growth and Europe has been relatively stable, so there hasn’t been much interest in buying gold or gold stocks as a hedge in recent years.
The gold industry hit a bottom in the beginning of 2016, and has had a mild recovery since then, but is still historically cheap.
Gold stocks are levered against the price of gold, meaning they are more volatile. When the price of gold goes up, gold stocks go up even more. And when the price of gold goes down, gold stocks sink even lower.
Let’s say, for example, that the price of gold is $1,200 per ounce.
A gold company might be able to mine gold at a cost of $1,000 per ounce. Gold companies generally measure this by their all-in sustaining cost (AISC) per ounce. So in over-simplified terms for the purpose of example, they make $200 per ounce in profit at current prices.
If gold drops to $1,000, their profit disappears. If gold goes up to $1,400, their profit doubles to $400, even though gold prices only increased by 17% from $1,200 to $1,400. If gold goes to $2,000 per ounce, that’s $1,000 per ounce in profit, or 5x what they made at $1,200 per ounce.
The safest gold stocks have:
Riskier gold stocks with high debt and/or high AISC have more to gain when gold prices go up a lot. This is because they are on the verge of insolvency when gold prices are low or moderate, and can be saved by high prices.
On the other hand, safer gold stocks with low debt and low AISC don’t jump quite as fiercely when gold goes up, but they survive better through the full market cycle if gold gets historically cheap.
The Role of Gold and Gold Stocks in a Portfolio
Having gold and gold stocks as a small part of a portfolio acts as a hedge against currency weakness, inflation, and economic instability.
The price of gold is affected by multiple things, with no perfect correlation to any one thing. However, real interest rates are one of the major inputs that can affect the price of gold. The real interest rate is the difference between a safe investment like a Treasury bond, and inflation. During times of very low interest rates, the interest yields of premium saving accounts and Treasuries may be lower than inflation, meaning that people who are saving diligently are still losing purchasing power. In contrast, during periods of higher rates savers in those instruments may get a real return over inflation.
Gold is an ancient form of money, something that stores value over millennia by keeping up with inflation of fiat currencies, albeit with substantial volatility.
If savers have the option of holding gold that keeps up with inflation and maintains global purchasing power over the long term even in the event of a catastrophe, or holding fiat currency that is currently paying negative real interest rates (rates that don’t keep up with inflation, thereby losing purchasing power), then suddenly gold becomes quite appealing to store wealth in. Higher demand for gold can lead to higher gold prices.
On the other hand, if savers can get a decent real interest rate above inflation on their savings accounts and safe bonds, then the desirability of holding gold diminishes. Lower demand for gold can lead to lower gold prices.
Gold, however, is also impacted by volatility in the markets. When investors get scared, they often turn to gold and drive the price up. Therefore, while interest rates play a major role in gold valuation, they are far from the only variable involved.
Look at examples of financially troubled areas of the world like Argentina in 2018. Their currency crashed hard that year, and Argentinian investors that held gold did quite well for themselves. Being diversified into assets outside of your home country’s currency, including gold, can help quite a bit during times like that.
Holding a small bit of gold in a portfolio is a safe hedge; something that is not very well correlated with stocks and bonds, and therefore helps smooth out total portfolio returns over the long-run.
Gold stocks are more aggressive. The power to them is that a small position, like 3% of a portfolio, could potentially go up 2x-3x or more in value during an economic crisis, thereby helping to partially offset losses from a much larger portion of the portfolio invested in normal equities.
The world has very high dept levels now; higher than in 2007 before the global financial crisis. Most countries can’t sustain high real interest rates without running into a financial crisis. That’s a rather bullish scenario for gold over the long run, when fiat currency bank accounts have perpetually low real interest yields.
In addition, many countries are trying to distance themselves from the U.S. dollar, which has been the world’s leading reserve currency in the post-WW2 era. Russia, for example, is buying massive amounts of gold year after year, including buying straight through their 2015/2016 recession. They’ve increased their gold reserves by 5x over the past decade, from 400 tons to 2,000 tons.
Having a small allocation to gold, and perhaps some gold stocks if you’re a bit more hands-on, makes a lot of sense in our opinion. Who knows what will happen to the price of gold during the next major recession if there is more quantitative easing, even lower interest rates, and political instability.
At the very least, having a little bit of gold or gold stock exposure may make for better sleep at night.
The Problems with Gold Stocks
All that said, gold stocks as a whole kind of suck, to be blunt.
Gold stocks as an industry have been terrible at capital allocation and have given investors dismal long-term returns.
As shown in the chart below, gold miners as a group have vastly under-performed the price of gold, the very thing that they produce:
This was during a period that included record high gold prices followed by moderate prices, and all they did by the end was cut investors’ money in half.
There are a lot of reasons for this, including:
The result of all this is herd behavior. When gold prices go high, gold miners invest a lot of money in new mines and acquisitions. But when gold prices fall, it makes those investments turn out very bad. It’s like they never account for the possibility that high gold prices might be brief, and usually are.
We have three main criteria for the ones I’ll buy: