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 my opinion.
This article takes a look at the role of gold stocks in a portfolio, and explains why there are four in particular I’m buying the most.
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 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:
- Low debt
- Low AISC
- Large reserves
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.
As I wrote in my detailed 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. 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 debt 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 my 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:
- Mining has always been a difficult business. It’s capital intensive and often involves difficult jurisdictions in poor regions of the world where corruption is high.
- Gold companies have little or no control over the pricing of their own product. They can only control costs to some extent.
- There is not a lot of institutional ownership in gold miners; it’s kind of the wild west with a lot of retail investors owning the shares.
- Gold mining is a small and fragmented industry, and management is not very good. CEOs in this industry tend to have low insider ownership, dis-proportionally high pay, and dismal results.
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.
For this reason, I’m very picky with buying gold stocks, and I have three main criteria for the ones I’ll buy:
- Buy when gold is out of favor, when gold is in a bear market and the economy is doing well.
- Only buy gold stocks with top-tier management teams with proven records.
- Focus on companies with low debt, low AISC, and especially streaming/royalty companies.
4 Gold Stocks I’m Buying in 2019
I keep about 4-5% of my portfolio in gold stocks, with a major focus on gold royalty and streaming companies. That being said, there are are also a small number of gold mining stocks I own due to their long records of good management, which is a rarity in this industry.
(This article was updated in August 2019 and is regularly updated.)
Franco Nevada (FNV)
Franco Nevada is one of the best-performing gold stocks in history. They gave investors approximately 400% returns since their IPO a decade ago, and dramatically outperformed the price of gold. This doesn’t even include their dividends:
They’re a streaming/royalty company rather than a miner. This means that instead of owning mines, they finance other companies’ mines.
Gold streaming/royalty companies pay money up front to help develop mines, and in return they get either a percentage of the profits from that mine, or they get to buy a certain amount of gold from that mine at a very low cost, like $400 per ounce.
All three major gold streaming/royalty companies (Franco Nevada, Royal Gold, and Wheaton Precious Metals) have outperformed the price of gold and the gold mining index over the past decade.
The business model of streaming/royalty companies is a lot safer than miners, because their break-even prices on gold are so low, at hundreds of dollars below mining AISC values. In addition, they don’t have the problem of overpaying for mines and acquisitions when the price of gold is high.
There are two main downsides of streaming/royalty companies compared to miners. First, because they are safer, they are also less explosive when gold prices go up a lot. Second, because the business model is so good, there is a risk that too many players will crowd out the space and reduce forward returns.
Franco Nevada is led by David Harquail, who has been the CEO since the company’s IPO, has overseen all this past outperformance, and has been a senior executive for many years when the business was private before that.
Franco Nevada also happens to be completely debt-free.
Sandstorm Gold (SAND)
Sandstorm Gold is a junior streaming/royalty company. They might be the next Franco Nevada in a decade.
Compared to Franco Nevada, Sandstorm is riskier but with more upside potential, and like Franco Nevada, Sandstorm gold is completely debt-free.
Sandstorm is earlier in its development process compared to major streamers like Franco Nevada, Royal Gold, and Wheaton Precious Metals.
In other words, the three big ones are already getting a lot of cash from streaming/royalty deals they made years ago. Although they are still making new investments, they’re in the “harvest stage”, enjoying results from investments long ago and hoping to continue that trend. Sandstorm, on the other hand, is earlier in the process, in the “planting stage”, so it has a lot more growth potential.
In addition, Sandstorm holds a stake in the Hot Maden gold development project in Turkey. This is expected to be one of the most profitable mines in the world when it is in production, but Sandstorm is quite concentrated in it. If this mine turns out great, or gets derailed for some reason or another, it would have an outsized impact (positive or negative) on Sandstorm.
Assuming flat gold prices, the Hot Maden mine is expected to nearly double Sandstorm’s cash flows when it comes online in 2022:
Sandstorm was co-founded about 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.
The company funded its early growth by issuing a lot of new shares, but going forward management doesn’t expect to have to dilute the existing shares any more.
Barrick Corporation (GOLD)
Barrick has a more challenging history than the other three on this list, but it’s a turn-around story.
On one hand, Barrick is now the largest gold producer in the world, with five out of the top ten mines in the world. Barrick enjoys assets with very low AISC, meaning it can survive periods of low gold prices that many other producers cannot.
On the other hand, management hasn’t been great historically. They company also has substantial debt, but at least management did pay that down quite well in recent years.
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. He’s a guy that knows how to manage a gold stock.
Bristow is the new CEO of the combined company. In other words, the new Barrick is more like a continuation of Randgold than Barrick. Bristow has been a critic of Barrick’s management in the past, so now it’s his chance to revitalize the company how he wants.
There’s some risk here, but as the largest gold producer in the world, with generally low AISC values, and a historically great CEO, I think it warrants a small position in a portfolio.
B2Gold is a relative small gold mining stock, but one of the most promising ones in my opinion.
The company was founded in 2007 by a group of executives from Bema Gold, when Bema was acquired by another company. It’s still run by the co-founders, and their track record is strong.
B2Gold over the past decade has built an increasingly diversified portfolio of mines with low AISC. They have relatively low debt as well.
One of the extra potential upsides is that B2Gold could be acquired at a premium price by one of the larger gold producers.
As a profitable company with a great portfolio, it’s a desirable takeover target in an industry that needs some consolidation. Most of the major gold producers haven’t been expanding their reserves in recent years because gold prices have been in a bear market, meaning that in order to grow some of them may increasingly turn to acquisitions.
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