Originally published: January 2019 (updated January 2022)
Gold stocks, meaning companies that mine gold or finance gold production, are currently out of favor.
It’s not a bad idea to add a little gold and/or gold stock exposure to your portfolio as a diversifier while it’s cheap, in my opinion.
This article takes a look at the role of gold stocks in a portfolio, and outlines two gold stocks I’m buying at the moment.
As a note, gold stocks can be a volatile group, and difficult to invest in. I generally think it’s a good idea for passive hands-off investors to have a small amount of gold exposure in a portfolio, but gold stocks themselves are best left to hands-on investors that don’t mind volatility.
Why Invest in Gold Stocks?
Over the long run, broad stock market indices tend to outperform gold and gold stocks by a lot.
Why? Because they are better at exponential compounding, with structural growth and dividend reinvestment. People who invest too heavily in gold all of the time tend to miss out on the biggest engines of wealth creation.
However, gold and gold stocks have historically been a great addition to a diversified portfolio, because there are certain environments where they absolutely crush normal stocks. Particularly, when stock markets become unusually expensive, they historically have underperformed gold over the following decade.
This chart shows the cyclically-adjusted earnings/price ratio of the S&P 500 in blue, and shows the 10-year annualized outperformance of the S&P 500 vs gold via the orange bars:
Chart Source: Lyn Alden (with data from Robert Shiller)
At current S&P 500 valuations, a century of data suggests that they are likely to underperform gold over the next ten years. Will that repeat for sure? No, and who knows. But among other things, it’s a variable that leads me to like having gold in my portfolio.
More broadly, having gold and gold stocks as a small part of a portfolio acts as a diversifier against currency weakness, stagflation, and economic instability.
As I wrote in my guide to precious metals investing:
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 or Turkey in 2021. Their currencies crashed hard in those years, but 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 historically helps smooth out total portfolio returns over the long-run.
Gold stocks are more aggressive. The power of them is that a small position, like 3% of a portfolio, could potentially go up 2x-3x or more in value during certain types of economic environments (especially stagflation), partially offsetting losses from a much larger portion of the portfolio invested in normal equities.
I like bitcoin as a diversifier as well, but it tends to shine at different moments than gold. Bitcoin historically does well when the economic growth is accelerating with tons of liquidity (such as measured by the purchasing manager’s index), including in 2011, 2013, 2017, and 2020. Gold, on the other hand, tends to hold its own more often when economic growth is decelerating, such as in 2019 and perhaps 2022.
The Problem with Gold Stocks
Although I like to own gold stocks at times, they come with a lot of risks.
Gold stocks have operational and financial leverage against the price of gold, which leads to more risk and volatility. When the price of gold goes up, good gold stocks typically go up even more. And when the price of gold goes down, both good and bad gold stocks tend to sink even lower.
Let’s say, for example, that the price of gold is $1,700 per ounce.
A gold company might be able to mine gold at a cost of $1,200 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 $500 per ounce in profit at current prices.
If gold drops to $1,200 then their profit disappears. If gold goes up to $2,200 then their profit doubles to $1,000 per ounce, even though gold prices only increased by 29% from $1,700 to $2,200.
And then along the way, if governments seize their mines in emerging jurisdictions, or they have geological challenges with their mines, or labor strikes, or a sharp increase in input costs, then they eat the difference with their profit margin.
The very best gold stocks can outperform gold over the long run, because they are basically short dollars and long gold, and gold has historically gone up a lot compare to dollars. The amount of gold in the world increases by about 2% per year or less while the amount of dollars in the world increases by about 8% or so per year. Meanwhile, the top gold miners can pay dividends and compound wealth over the long run like other high-quality companies.
However, the majority of gold stocks underperform gold over the long run because they use destructive capital allocation practices and deal with all of these previously-mentioned operational risks. They make acquisitions, expand mines, and take out debt during the peak of bull markets when everything is expensive, and then capitulate in bear markets, destroying shareholder capital. They then repeat this cycle after cycle.
The smartest gold stock managers, which are few and far between, use a counter-cyclical approach whereby they add capital into bear markets and extract capital during bull runs. Even they, however, have risks for things outside of their control, like mine exploration results, the cost of energy, complex labor/government negotiations, and operational challenges.
The result is that gold miners as a group have underperformed gold itself by a wide margin:
So, for a permanent portfolio holding, gold itself is better than gold stocks.
Gold stocks are useful when you are particularly bullish on gold, and when you stick with the highest-quality companies or the best risk/reward speculations. The best time to buy them is typically when gold is unloved and leading indicators of the economy, such as the purchasing manger’s index, are rolling over.
In addition, there are signs of structural change among gold miners. They are being a lot more disciplined with capex and debt in this cycle, and instead are emphasizing free cash flow and strong balance sheets for the most part. That’s a promising sign.
The safest gold stocks have:
- Low debt
- Low AISC
- Large reserves
- Or a royalty/streaming model
Riskier gold stocks with high debt and/or high AISC have more to gain when gold prices go up a lot in a short period of time. 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.
2 Gold Stocks I’m Buying For 2022
I have several percentage points of my portfolio in gold stocks, with a focus on large producers, diversified streaming/royalty companies, and ETFs that give me access to a basket of stocks.
Here are two that I monitor and hold, in addition to my ETFs.
Sandstorm Gold (SAND)
Sandstorm Gold is a medium-sized royalty/streaming company. I bought low, but didn’t sell high, and as a result I’ve held it for years through some wild swings in its stock price. It has been a nice portfolio diversifier since it goes up and down at different times than many of my other stocks, but I haven’t gotten to the hopeful endgame with this company yet.
Sandstorm was co-founded over a decade ago by two senior executives from Wheaton Precious Metals, and is still run by them. That’s what I like to see in a gold stock: leaders with long tenures and track records of success.
Some of the best-performing gold stocks of the past have been the royalty and streaming companies, since it’s inherently a less-risky business model than operating mines. Sandstorm is positioned as a company that could one day join the ranks of the biggest and most diversified royalty and streaming companies, but there is still a long road ahead.
The company funded its early growth by issuing a lot of new shares, but starting a few years ago, they reached a point where they could fund most new deals from existing cash flow rather than ongoing dilution. That’s when I started to get interested:
The company has solid growth, but the real payoff is expected by the mid-2020s decade when their massive Hod Maden mine is planned to come online. This will be one of the biggest and highest-grade gold/copper mines in the world and is expected to massively increase Sandstorm’s cash flows:
Chart Source: Sandstorm January 2022 Investor Presentation
The catch is that the project is located in Turkey, which has historically been a good mining jurisdiction but is going through a lot of political and economic turbulence in recent years. Sandstorm has a good domestic project partner, and as of late 2021 they completed the feasibility study and received environmental approval.
So, things continue to progress a bit more slowly than expected (as usually happens with mines), but overall it’s mostly on track.
From a valuation perspective, the stock is currently well below their historical average, although like most gold royalty companies, they trade at a premium multiple compared to miners:
Chart Source: F.A.S.T. Graphs
Sandstorm can be thought of as a long-term option with a positive carry that will mainly benefit from 1) gold price appreciation and 2) the success of the Hod Maden project.
If both of those two things go well, Sandstorm should be a significant outperformer, quite possibly going to 2x or 3x its current price. Otherwise, it would likely be a big dud.
In my view, this gives it a useful role as a portfolio diversifier as a tiny slice of a portfolio; it won’t just go up and down with the S&P 500.
Barrick Gold (GOLD)
Barrick is one of the largest gold miners in the world, and has a conservative balance sheet.
During the prior major gold market cycle, Barrick loaded up on a ton of debt and underperformed the price of gold by a lot.
However, Barrick and Randgold Resources merged at the start of 2019. Unlike Barrick, Randgold was historically exceptionally well-managed by its longtime CEO Mark Bristow for over two decades, and outperformed most other gold miners.
Bristow has been the CEO of the combined company ever since. The asset base of the company took more from Barrick, but the management of the company took more from Randgold. Bristow was a critic of Barrick’s management in the past, and for the past few years ever since the merger, he has had the chance to revitalize the company.
Barrick was already in the process of paying off its debt when Bristow took over, and he continued that trend. Barrick now has virtually no net debt (purple line below), and has record-high book value:
The company generates positive free cash flow, maintains low costs of production, has some good copper exposure along with its gold, and pays a solid dividend.
I like Barrick as a small position in a portfolio at current levels, along with gold stock ETFs such as the VanEck Vectors Gold Miners ETF (GDX).
Overall, I think gold and gold stocks are reasonably well-positioned for 2022, but with no guarantees. With US economic growth positive-but-decelerating, gold has as good a chance as any to wake up from its 18-month slumber and give investors a year of outperformance compared to broad stock indices.
Chart Source: Trading Economics
Independent Speculator Review
Many investors like to buy smaller natural resource exploration companies, including for gold and other commodities.
However, this is a very risky area and takes a lot of geological knowledge and deep due diligence on each company. As a macro investor and broad stock analyst, I don’t have the expertise to dive into individual gold, silver, oil, uranium, or copper projects, other than some of the biggest ones.
In other words, when I look at a commodity, I look mainly at the long-term macro case for that commodity, and then examine some of the biggest and safest ways to get exposure to it, or buy an index.
I often get questions from readers about if I recommend any gold/silver/resource analysts, since I don’t cover junior gold/silver/resource stocks myself. For years my answer was that I did not, because although there are some good ones out there, it’s known as a rather scammy industry, prone to sensationalism and bad performance.
However, I now recommend Independent Speculator, run by Louis James (Lobo Tiggre), for people that want to check out smaller and more exploration-focused natural resource plays. And for full disclosure, I added him to my affiliate partner list, which I use for services that I either personally use myself or that I’ve vetted and that I think cover areas well that I don’t focus on myself.
He has a clear track record, and is about as anti-hype and anti-sensationalist as one can be. He tends to focus on realistic expectations and risk management for his positions. I’ve been on his podcast twice, where I enjoyed discussing markets with him. He puts in the long hours to sort through individual small cap resource plays to find asymmetric opportunities for his clients.
If those sorts of targeted speculations are of interest to you as part of your diversified base of assets, then I recommend his work.