Our investment process at RLAM global equities involves several stages of analysis, but can be summarised in just three: first, understand the business; second; work out whether or not it is a superior shareholder wealth creator; and third, if it is… value it.
If you can find a business you understand, are confident it is a superior shareholder wealth creator and it appears cheap relative to its current share price then you have found a legitimate investment opportunity (or at least you would have in our team).
How you actually expedite all of the above with investment advantage, effectiveness and efficiency is another matter and this is where our focus and expertise as an investment team resides. But this is a useful framework to make a few topical comments on gold stocks which we have discussed over the past week or so, as well as and many times over the last 20 years.
When it comes to understanding a gold miner it is a relatively simple thing to understand. A mine contains some gold embedded in ore that needs to be dug up and processed with as low a capital and operating costs as possible, and then sells this into the gold market at the prevailing (or a previously hedged) price. I won’t make too much comment on how to assess superior shareholder wealth creation in this space here, but it’s the valuation dynamics of gold stocks that are really quite different to most stocks, and without spoiling the punchline, that’s because gold itself really is quite different to other commodities.
So in terms of valuation, there are genuinely cases and environments where even the world’s best gold mines are simply a liability and worth nothing to shareholders, and there are other environments where their potential valuation could be truly enormous. Clearly it all relates to the gold price, but let me explain. In a bearish valuation scenario as a shareholder you might own a set of mines that have a lot of gold ore, but if it will cost $1000 an ounce to extract that ore, and the gold price is worth $800 then you do not actually own anything of value. It is just some soil and/or rocks. An extension of this would be that there is 20 million pounds of gold suspended in seawater (worth $640bn in today’s prices) but it would cost you more than $640bn to extract it making it ‘worthless’ (although if you have any ideas on how to get that cost down, please let me know).
Now normally markets ensure that commodities don’t fall below their cost of production for extended periods of time (i.e. avoiding this mine = liability problem) but gold is different. Gold is not consumed like food, or oil or copper. So when the price falls below the cost of production there is no significant loss of the underlying commodity from the system, which in turn guarantees supply-demand dynamics force prices back up. So this liability ‘trap’ is a risk for gold that is fairly unique.
On the flipside, in a world of zero interest rates and low bond yields, alongside huge monetary stimulus there is no real anchor for gold prices at the moment as the opportunity cost of taking cash out of the bank (or bonds) to buy gold is the lowest it has ever been. Not only that but it sure feels good when the gold goes up 20% and your cash in the bank hasn’t moved in nominal value. It feels even worse when someone else’s gold goes up 20% and your cash in the bank is still the same value. Should momentum really grip the gold price and/or systemic inflationary fears grip the world’s attention, gold is a unique commodity that could capture the world’s imagination and speculative desires. We note that you can even buy gold bars in your local Costco should you want to.
All this means it is hard to know what the limit to the upside is in any period, particularly when the world is vulnerable to asset bubbles like never before with zero interest rates. Given the significant operating and financial leverage in gold mining stocks and alongside the fact that some of them have a lot of gold in the ground there is the potential for tremendous upside when it comes to valuations. Gold stocks are effectively very geared plays on the gold price which itself might have limited anchors to the upside.
So the valuation for gold stocks is quite unknowable without knowing the long-term gold price (which we consider also unknowable) but we would note, given the above, that the range of potential outcomes for gold stocks is arguably huge – from zero to something that is a geared play on a commodity that doesn’t have any real price anchor. For us that doesn’t particularly constitute an ‘investment’ case, but for benchmark and index focused investors it does have risk management implications, and for the wider world it is perhaps an opportunity for what the famous investor and investment theorist Benjamin Graham highlighted as ‘intelligent speculation’, depending on your view of the gold price.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.