As active managers, we embrace both a top down and bottom up investment philosophy as we look for opportunities for investment. One such potential opportunity we are seeing from more of a top down, thematic approach is in gold. Before anyone thinks I have lost it, I am simply talking about bonds in some of the lower cost miners. Always remember the advantage of being a debt investor: you aren’t looking for or in need of a quick trade or turnaround. What you are looking for are survivors. We only need our companies to keep the lights on at the bottom of the cycle. Those companies that do this often capture huge rewards. Darwin was a questionable biologist, but should have won the Nobel Prize in economics. Darwinian economics (“survival of the fittest”) often plays out in down cycles. Those that make it through can end up with pricing power and increased market share, and thrive in the long-term. Think of auto suppliers who survived the terrible period from 2005-2009. They have been making a great deal of hay in the last five years.
I am not a gold bug in any way and am not looking for some type of inflation protection. What I am interested in is gold’s potential reaction to the ultimate reality that global Central Bankers, in my opinion, are in fact nothing more than government bureaucrats. The insanity of thinking that they can control economic outcomes or steer the globe is utter insanity. At what point will people begin to lose faith in the whole process? I have often mumbled to myself that gold makes no sense and has no fundamental or industrial value. And fiat (paper) currency does? Throughout the history of man, gold was a store of value and medium of exchange. It wasn’t until Nixon ended Bretton Woods for good in 1971 that the world did not link some portion of their money supply to gold. China, Russia, India, Korea and Japan combined hold around two-thirds of all foreign exchange reserves (total US dollar foreign exchange reserves are estimated to be around $12 trillion by the IMF1). As the following article indicates, it seems like Russia and China are not exactly enamored with the option of holding their reserves in the US dollar, and Germany and France are already way ahead of them:2
Attending the St. Petersburg International Economic Forum in May, Putin stressed to reporters that it is important to deposit gold and currency reserves in a rational and secure way. Many market observers expect Russia to increase its gold holdings over the next few years, as the ratio of gold in its foreign reserves is still smaller than those of France and Germany, whose gold holdings are around 60% of total foreign reserves….China, which has been critical of the sanctions against Russia and has strengthened economic ties with the country, has also been increasing its gold holdings in recent years. Some market watchers predict that if China and Russia, which have adopted a confrontational approach to Western countries, further increase their gold holdings, the dollar’s status as a key currency could be shaken.
Nikkei Asian Review, http://asia.nikkei.com
Since a large percentage of the remaining reserves are held by countries considered the developing world it seems to me that these cultures may be much more comfortable with gold over paper. Given the soaring dollar, the collapsing euro and China’s failure to make the yuan a reserve currency, perhaps we all will.
What is important is how we might express this in our portfolios. This is not a speculative “trade,” nor is it a hedge. In studying a number of miners it reminds me a great deal of the pharmaceutical or biotechnology industry. In the case of pharma, product development often takes a decade or more of research and development and then trials. Once a product is approved, the margins are enormous because all of that R&D has been expensed (or capitalized) in prior years. So it is a distorted picture. Think the same of mining. A decade to get approvals, assays, coring and then mining infrastructure in place. Then you mine and sell it and operating costs are not that large.
It is interesting how the media continues to talk about how gold has lost its luster and has fallen precipitously. But it really hasn’t. It began the year at $1,200 and is around the same level3. Another point I find very interesting is that bond yields for the major and intermediate gold producers remain very low. This gets to my point about the profitability of this industry and the cash generating ability once developed. We have in our gun sights a couple of bonds in this space that offer what we see as a good yield. We are seeing these companies generate free cash flow and expect it will continue at levels nicely below current prices, so a very good credit investment from our perspective but with the potential upside we see coming from a changing world. Many gold miners will continue shrinking capacity as prices fall below “sustaining costs.” These sustaining costs include capital investments (maintenance capital expenditures) to maintain a flat reserve level. But as is the case for many commodity producers, there is about a decade worth of production available with minimal additional spending necessary, allowing for plenty of cash generation potential. Ironically this lack of growth is a huge positive for credit investors.
What many investors don’t grasp is that you can actively position businesses and industries in a fixed income portfolio the same way you can equities. The difference is that we get paid every day as our securities accrue interest and we have finite outcomes via stated maturities, which helps us remain patient.4 We don’t require earnings growth or beating Street estimates to make money. We just need the companies to pay their bills and generate some free cash flow, what we see as perfect for the subdued economic environment we see going forward.
For more on our thoughts on current market conditions and outlook going forward, see our recent piece, “Rome is Burning.”
RSS Feed
