Gold, the Safe-Haven Precious Metal, Begins to Lose its Lustre

Gold, the Safe-Haven Precious Metal, Begins to Lose its Lustre

In recent months, one of the big stories in capital markets has undoubtedly been how gold is losing its lustre. Just look at the 35-per-cent collapse in the S&P/TSX Gold Index year-to-date. What has often been suggested as a portfolio hedge or an alternative currency may, in fact, no longer enjoy the safe-haven status it has in days past — especially as it relates to gold-price volatility.

Exploring the decade-long journey that brought gold prices to precipitous heights reveals a fable premised on unprecedented household and sovereign-debt levels, central-bank intervention, impending inflation, and an emerging market buying binge driven by low interest rates. Together, these factors have not only created a picture-perfect environment for skyrocketing gold prices, but also, an untenable situation for the global economy.

So, what lies behind the recent collapse in gold prices? There are two factors.

First, the financialization of gold as an asset class, via the creation of more than 50 gold-levered Exchange-Traded Funds (ETFs), has attracted a lot of short-term speculative money to the precious metal. Investment funds and individual investors can now use these ETFs to easily bet on their views about excessive money printing, seemingly endless quantitative easing and inflation fears without taking delivery of physical ounces of gold.

A second, less obvious factor is the use of gold as collateral by sovereign governments and financial institutions to generate short-term liquidity. In times of distress, gold assets are monetized to settle the lenders’ obligations as seen in the fall of 2008. Furthermore, speculation of possible central bank liquidations, as we saw in April 2013 with the Cyprus banking crisis, can have as profound an impact on gold prices as the actual event.

These two developments introduce heightened potential risks such as buying binges and panic by speculators, as well as insolvency, credit crunches and liquidations among larger global economies such as China’s.

So what does this mean for gold equities? Despite gold being one of the best performing commodities over the past decade, gold equities have done significantly worse than the underlying resource due to incorrect assumptions of operating risks.

Some investors have steered away from the precious metals space for, among other reasons, its relative overvaluation. Indeed, the market has mispriced risks in the gold sector by applying unjustifiably low discount rates in valuation analyses. The discount rates don’t reflect the financial, operating or political risks of the underlying businesses of some of the gold producers.

Another significant factor affecting gold companies is the escalating cost of gold production. Over the past few years, gold companies have suffered from capital cost overruns, project delays and eroding profitability despite record-high gold prices. A correction in gold equities became inevitable as their robust valuations were brought to light by worsening fundamentals.

It’s difficult to predict the near-term direction of the gold price. Longer term, price will likely be a function of the U.S. dollar, inflation expectations and ultimately the growth and desire of emerging economies to diversify their sovereign reserves away from traditional currencies.

However, investing in gold companies down the road may be even more challenging than predicting underlying gold prices, as the increase in operating costs and discount rates persists. Today, few gold companies generate either positive free cash flows or competitive returns on capital. This may continue. As value investors evaluating any resource company, we are often guided by our understanding of the long-term marginal cost of production in addition to the demand profile of the commodity.

Investors should target gold companies that trade at a sufficient discount to intrinsic value using reasonable discount rates to properly reflect the inherent risks in the gold mining business and a conservative marginal cost of gold production. Contrary to Warren Buffett’s observation of the broader stock markets — “Be fearful when others are greedy and greedy when others are fearful” — gold companies are more likely to be attractively valued when fear is low, overall market optimism is high and gold prices have fallen below the marginal cost of production.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service.  The info provided in this article is compiled from our own research and is based on assumptions that we believe to be reasonable, accurate at the time the report was written, but, is subject to change without notice.