For thousands of years, gold has been used as money, a store of wealth,
fought over and sought after. Over the last 45 years, Western populations
have had a mixed impression of gold. A minority of the population understands
that gold is a monetary asset that should be held as wealth insurance. A
larger percentage of the population is confused about gold because of
mainstream sources of information. Many people consider gold a risky
investment when in fact gold bullion is not an investment at all, but rather
money itself. Just like any fiat currency held in a vault, gold does not pay
interest or dividends. Investors often look upon gold mining companies in the
same light as physical gold bullion. Gold mining shares are investments, and
can be good tactical investments from time to time. However, the
characteristics of gold bullion and gold miners are very different. In some
ways, those differences are similar to the difference between an insurance
policy and shares of an insurance company.
It is important to understand the role of gold as money in relation to
fiat currency. Governments and banks work hard to ensure that people retain
confidence in their debt-backed paper currencies, and in the economy in
general. Wall Street's message about the economy and the US dollar's strength
has to remain optimistic, because when people are uncertain and skeptical,
they do not invest in financial assets, and companies curtail new financings,
creating a negative feedback loop. Financing is Wall Street's lifeblood, so
it will always see "green shoots" and "recoveries around the
corner," just as it did in 1929, 2000 and 2008 while the market crashed
around it. Consumer spending and bank lending is what keeps the fiat shell
game going, and people do not borrow or spend when they feel uncertain about
their financial future. Gold, because it inconveniently serves as the truest,
irrefutable long-term indicator of the economy's health, has to be
discredited.
There are three essential characteristics of money: it must be a store of
value; it must be accepted as a medium of exchange; and it must be a unit of
account, meaning that it must be divisible and each unit must be equivalent.
Fiat currency has failed as a store of value, and it has no intrinsic worth.
How much does it cost to type in zeros on a computer screen or on a piece of
paper? Certainly less than it does to dig a mile into the earth to extract
and refine two grams of gold from a tonne of rock.
The US Federal Reserve was created in 1913. From its creation through to
this day, the US dollar has lost approximately 98.2% of its purchasing power.
On the other hand, gold has retained its purchasing power, rising from $20.64
an ounce in 1913 to $1,250 an ounce today. Throughout the ages, whether it be
in Roman times, in 1913 or today, one ounce of gold has provided a man with a
pair of shoes, a suit and a briefcase, or the equivalent.
A popular misconception about gold and gold miners being similar has to do
with the symbiotic relationship between the two. Mining companies have claims
to, or outright ownership of, gold that is in the earth. The gold resources
need to be extracted, processed and then sold to cover the costs of
operations for the company to make a profit. Gold in the ground is very
different than a gold coin that can easily be transferred from a seller to a
buyer. Mining companies are dependent on the price of bullion in relation to
fiat currencies. Specifically, if gold is too low in price, a mining company
is unable to extract the gold from the ground, because it is uneconomical.
Subsequently the value of the mining company's shares will trade at lower
levels, or the company could go bankrupt. The higher the price of gold, the
more economical it becomes to dig for lower-grade sources of gold. Mining
shares can move up significantly as gold moves higher, but that is not always
the case. Below is a chart of the HUI Gold Miner Index, which contains the
top unhedged gold producers in the world, compared to the performance of gold
bullion.
While the miners performed well from 2003 to 2007, over the past 20 years
the Index shows a loss of 13.9%, whereas gold is up 233%.
The 1970s provide a good example of how gold and gold miners perform
during inflationary time periods. In the late 1960s, Lyndon Johnson's
government was escalating the war in Vietnam and increasing government-backed
social benefits. This caused the US government to run ever-increasing budget
deficits. Prior to 1971, the US dollar, as the world's reserve currency, was
tied to gold bullion at US$35 per ounce of gold. Many countries started to
redeem their US-dollar reserves for physical gold bullion. The amount of gold
being delivered was unsustainable, and in 1971 Richard Nixon closed the
"Gold Window," eliminating the ability of countries to exchange
their US dollars for gold. Inflation spiked as the US increased its sovereign
debt load by funding unsustainable government outlays. By 1980, gold had
reached US$850 per ounce. Gold adjusted to the changing environment, and
increased in price in relation to the faltering US dollar.
It's interesting to see that gold bullion virtually doubled the return of
Homestake Mining Company (the largest gold miner in the world at that time).
This is another example of the difference between gold bullion and gold
mining shares.
From a risk perspective, there are major divergences between physical gold
bullion and shares of gold miners.
Gold Miner Risks
- Exploration risks - no gold, or not enough gold, will be
discovered.
- Feasibility risks - a company may discover gold, but at
current prices it may be uneconomical to mine.
- Management risks - mining companies face substantial
upfront costs and ongoing operating costs, and poor management can
destroy an otherwise viable asset.
- Pricing risks - as gold moves up and down in price,
individual companies can experience positive leverage-to-price
increases, or go out of business if prices fall too low.
- Geopolitical risks - governments can become unstable,
leading to unreasonable demands, confiscation of assets, and increasing
royalty fees.
- Financing risks - during bear markets, banks often
refuse to finance operations and, because the share price of many of
these companies is so low, raising equity becomes extremely dilutive to
existing shareholders.
- Environmental risks - mining companies often work in
remote areas that are ecologically sensitive. As well, dam and leach pad
failures happen from time to time, resulting serious environmental
degradation, and possible fines and litigation costs.
- Stock market volatility - mining shares often correlate
with the broad-based equity markets during downturns in the financial
markets. Mining shares are extremely volatile and can lack liquidity.
- Productivity and efficiency - mining companies often
face major engineering problems such as cave-ins, mill problems, labour
issues, increased energy costs, etc.
- Hedging policies - mining companies often lock into
price agreements that end up destroying shareholder value when major
changes in operating costs related to bullion prices occur.
- Jurisdiction risks - uprisings, war, political upheaval
and disasters are all common problems that mining companies face when
working around the world.
Gold Bullion Risks
- The risk of losing physical gold is significant if it is
not vaulted in a safe location.
- The value of gold is priced in relation to fiat
currencies. Monetary and fiscal policies are a major contributor to the
fluctuation in currencies.
- Supply and demand fundamentals affect the price and
availability. We believe that physical gold will soon be unattainable
for the average person, because it will be simply too expensive and
rare. Mine output is dropping as ore grades are getting lower and lower.
Over the last few years' miners have been processing high-grade
resources and leaving low-grade (i.e. uneconomical) resources in the
ground.
- Futures contracts bought and sold by institutions such
as central banks, hedge funds and banks can adversely affect the price
of gold, because there is more paper gold than physical gold.
Portfolio Comparison Guide
The major difference between physical gold bullion and mining stocks is
how they react within a properly diversified portfolio. Gold is the most
negatively correlated asset class to traditional financial assets such as
stocks and bonds. Physical bullion should be a significant part of the
strategic long-term allocation within a portfolio, whereas mining stocks
should be a small part of a tactical equity component during certain
conditions. Multiple studies show that a portion of physical gold held within
an investment portfolio improves returns and reduces risk, whereas shares of
gold mining companies increase the amount of risk within a portfolio, and can
negatively affect returns over the long run.
It is worth noting that gold bullion has appreciated more in price than
gold miners over the past 40 years, with much lower volatility.
Owning gold bullion is a form of wealth insurance, and will protect a
portfolio during market declines. Mining stocks can provide leveraged upside
returns during a rising dollar price in gold, but can exaggerate downside
risks during equity market declines, even though the price of bullion may be
rising.
There is a growing realization that all is not well in our world today.
The popularity of Donald Trump and Bernie Sanders is a direct result of the
decline of the US economy and political process. Globally, people are
beginning to lose confidence in the system. There are crises brewing all
round the world today. Governments, corporations and individuals are all
struggling with too much debt. Gold bullion has been trending higher for 15
years, and will continue to do so because monetary and fiscal policies will
not fix the structural issues that have been building unsustainably for
decades. Debt will continue to grow as government budget deficits continue
unabated. Central banks will continue to buy up government debt with currency
they have created out of thin air, euphemistically referred to as
Quantitative Easing. The value of fiat currencies will continue to erode,
because the path we are on is clearly unsustainable. Many gold experts agree
that gold will surpass $10,000 per ounce in the coming years.
In summary, mining shares are an investment that can make up a small
portion of the overall tactical equity allocation of a sophisticated
investor's portfolio. However, the facts show that gold mining shares are not
a prudent long-term strategic investment for most individuals. Physical gold
has a long history that spans thousands of years, and it should make up a
portion of every person's assets. The world's wealthiest people hold bullion
to protect their wealth. As Doug Casey, author and institutional investor,
says, "The hurricane hit in 2008, we have been sitting in the eye of the
storm since the last financial crisis and the full breadth of the storm is
beginning to hit us once again." Globally, the problems we face today
are markedly worse than those of the Great Recession. In the coming years,
portfolios without physical gold to offset losses in financial assets and
currencies will suffer.
