Key Takeaways
- Gold’s unique risk-return characteristics give it the rare ability to maintain its real value in both inflationary and deflationary environments while also serving as a potential hedge against extreme equity market drawdowns and thus as a source of resilience for stock portfolios.
- There are several ways for investors to gain exposure to gold, all of which have different risk-return profiles and liquidity attributes. Bought at the right price, both gold bullion and gold-related equities offer investors the potential for attractive long-term returns while mitigating downside risk.
- First Eagle actively but patiently manages our relative allocations to gold bullion and gold stocks from the bottom up. Generally, we seek to own high-quality gold companies we view as undervalued based on the current gold spot price, and we will keep client capital invested in bullion until such opportunities emerge.
- At First Eagle, gold serves as a potential hedge and an additional source of resilience in portfolios that seek to prevent the permanent impairment of capital. While we don’t presume to forecast movements in the price of gold, we believe its long-term historical performance makes a strong case for gold’s continued value as a potential hedge.
Entering 2020 there were a variety of indicators—including massive sovereign and corporate debt balances, the continued debasement of man-made money, and heightened political and geopolitical tensions—to suggest that the long-lived business cycle stood on unsteady ground. Of course, no one had forecast that a global pandemic would soon bring economic activity to a virtual standstill worldwide and send a wide variety of risk assets tumbling.
Left-tail events like these highlight the value of a strategic allocation to a long-duration potential hedge that can help provide portfolios with a source of resilience in a wide variety of adverse circumstances. Gold has filled this need in many of our diversified portfolios at First Eagle for decades. The metal has served as a store of value for millennia, and its unique risk/reward characteristics have enabled it to maintain its real purchasing power over time across disparate macroeconomic environments and through numerous existential threats, providing investors a perceived “safe haven” in their times of need.
There are several ways for investors to gain strategic exposure to gold, all of which have different risk-return profiles and liquidity characteristics. Bought at the right price, gold bullion and goldrelated equity ownership in miners or streaming/royalty companies may offer investors the potential for attractive long-term returns while mitigating downside risk.
Gold: In the Vault or in the Ground
Given the inherent uncertainty of the gold market and the many complex factors that drive its movement, we believe investors are best served by a strategic exposure to gold as a potential hedge against adverse market conditions. There are several ways for investors to gain such exposure to gold, each with their own risk-return profiles and liquidity characteristics. Bought at the right price, both gold bullion and goldrelated equities may offer investors the potential for attractive returns while mitigating downside risk.
Gold bullion tends to be viewed as one of the most conservative forms of gold ownership because it carries the least risk; the asset is already out of the ground, so it is free and clear of mining risk, and it has minimal counterparty risk. On the other hand, a bar of gold offers no yield and costs money to store, which means that gold bullion may not always be the most cost-effective way to invest in gold ounces.
As a potential hedge, gold in the dirt can be as useful as gold in the vault—if the company digging it can meet our strict qualitative criteria and be obtained at the right price. Buying shares in gold mining companies with proven reserves is a way to acquire gold that has yet to be brought above ground and can sometimes be a cheaper way to gain exposure than buying bullion. This approach is riskier than bullion, however. The performance of miners tends to be leveraged to the price of gold, meaning that changes in the price of the underlying metal—higher or lower—can have an outsized impact on the stock price of miners. Miners also face the operational risks of getting gold out of the ground and the potential political risks related to the countries in which mines are located, among other challenges common to industry participants. Nonetheless, gold mining stocks may offer investors differentiated opportunities; historically, the ability of certain higher-quality gold miners to increase their production per share and/or gold reserves per share over time—whether through operational execution, countercyclical capital allocation or exploration success—has added value for shareholders.
Gold royalty and streaming companies are a subsector of the gold universe that historically has provided investors with some leverage to the price of gold but with less risk than owning the stock of miners. Rather than operating mines, royalty and streaming companies provide financing to a miner in exchange for an ongoing economic interest in the mineral production of a property. While a royalty agreement gives a company a claim on a percentage of the revenue generated by a mine, a streaming agreement entrails the right to purchase the metals produced by the mine at a predetermined, discounted price. To diversify their risk exposure, royalty and streaming companies typically will have agreements on multiple mines at various stages of production or development.
As an investor, First Eagle actively manages our relative allocations to gold bullion and gold stocks from the bottom up and does so in an extremely patient way. Generally, we seek to own gold companies we view as undervalued based on the current gold spot price and our assessment of their quality, and we will keep client capital invested in bullion until such opportunities emerge.
We consider potential gold-related equity investments along four key characteristics.
- Valuation. We take a mine-by-mine approach to establishing our estimate of a miner’s intrinsic value, using only the current gold spot price and never modeling assumptions about the future path of prices.
- Resilience. Inherent in our desire for a long-duration potential hedge is the need to identify miners with the ability to execute across changing operating and financial environments over time. To do so, we consider a company’s exposure to the many risks the mining business entails—not only operational and financial risks, but also technical, political and other concerns—and the quality of the management team in place to navigate them.
- Optionality. We try to own miners that we believe offer growth, either in production per share or gold reserves per share. Optionality is partly a function of having a quality management team with demonstrated success in effective operation, conservative capital allocation and exploration.
- Duration. We seek long-duration holdings—companies with long mine-lives, solid balance sheets, management team depth and good sustainability practices that support their social license to operate.
Managing Through the Pandemic
Though mining companies have not been unscathed by the operational disruptions related to the current pandemic, the industry in general has proven to be resilient in this time of crisis. Interestingly, this durability may be partly the result of the uncommon geography of the mining business. With most mines in isolated locations—including parts of the world that have been threatened by previous health crises like Ebola or tuberculosis—operators have long been motivated to maintain onsite medical infrastructure and comprehensive health protocols, which has provided them with the tools and experience necessary to stage a coordinated response to the risks posed by Covid-19.
Given what we view as a high-quality management team, Newmont is a prime example of a miner prepared to meet the challenges of Covid-19, and its operational prowess has been on display in 2020. With rigorous protocols already in place, the company was able to be proactive in managing its mines to protect local communities and infrastructure while at the same time mitigating the pandemic’s impact on its business. Though Newmont had to put a number of its mines in care and maintenance1 due to Covid-19, we believe its robust balance sheet and thoughtful management should help it ride out the current period of uncertainty. In contrast with broad market trends—year-to-date through the end of May, 40 companies in the S&P 500 Index have suspended dividend payments while another 18 have cut them2 —Newmont increased its quarterly dividend 79%.3 More good news came in mid-May, as Newmont announced it would soon reopen four of the five mines it had placed in care and maintenance.4
Similarly, Barrick Gold has continued to execute through the challenges posed by the pandemic, with strong production results and low costs driving improved free cash flow in first quarter 2020. Barrick has drawn on previous management experience with Ebola outbreaks in Africa to formulate a plan to promote the safety of its employees and communities in the face of Covid-19. The company has maintained its annual production guidance for 2020 with only a slight adjustment, due not to the pandemic but rather a lease dispute on its Porgera mine with the government of Papua New Guinea. We believe the company’s prudent management team and strong and diversified asset base positions it well to manage through the current trying environment.
Turning to streaming companies, Wheaton Precious Metals maintains a high-quality, low-cost portfolio of precious metal purchase agreements related to 20 mines in operation, nine development-stage projects and one mine in care and maintenance. Well diversified, these agreements are linked to 17 different mining partner companies located in 11 countries and include claims not only on gold but also meaningful interests in silver and, to a lesser extent, palladium and cobalt. Despite pandemicrelated suspensions of six of its mining assets in Mexico, Peru and Canada, Wheaton posted a 50% year-over-year increase in operating cash flow during the first quarter, which allowed the company to reduce its net debt while raising its quarterly dividend payment.5 With a strong balance sheet and ample liquidity, in our view, Wheaton should successfully weather the current crisis and potentially be able to further bolster its financial position or to find opportunities to acquire attractive mineral stream interests.
A Compelling Potential Hedge Against the Seen and Unseen
At First Eagle, we take the humble view that while disruptive episodes are inevitable, they also are impossible to predict. Because of this, many of our diversified portfolios maintain a strategic allocation to gold as a long-duration potential hedge against adverse outcomes. Of all the available potential hedging options, both real and financial, we believe gold’s unique risk/return characteristics enable it to serve as a source of resilience in the widest variety of adverse circumstances—including both inflationary and deflationary environments as well as in equity bear markets—while also supporting real purchasing power across market cycles.
For example, our positions in gold bullion and gold stocks enabled us to benefit in periods like 2019, when gold appreciated in value alongside equities, as well as during periods like first quarter 2020, when high levels of volatility battered risk assets in general. The cash and cash equivalents we maintain in our diversified portfolios has enabled us to buy gold and gold stocks when we believed valuations pointed to attractive opportunities; similarly, our gold holdings serve as another form of portfolio liquidity to be deployed into equities more broadly should relative valuations dictate. Though the road ahead remains highly uncertain, we believe gold’s characteristics— including its stable real purchasing power over time, countercyclical price dynamics, versatility, resilience and long duration—make it the most compelling form of potential hedge against both the seen and unseen risks investors face.
1. “Care and maintenance” refers to an operational phase in which production at a mine has been halted temporarily but the mine continues to be managed to preserve the stability of the site and its equipment and the safety of the surrounding communities and environment.
2. Source: Barron’s, as of May 31, 2020.
3. Source: Newmont, as of April 21, 2020.
4. Source: Newmont, as of May 19, 2020.
5. Source: Wheaton Precious Metals, as of May 6, 2020.
The opinions expressed are not necessarily those of the firm and are subject to change based on market and other conditions. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy, hold or sell any security. The information in this piece is not intended to provide and should not be relied on for accounting, legal, and tax advice.
