Nick Sudbury uncovers the best funds and trusts to take advantage of stronger gold prices.
Governments around the world have announced an unprecedented level of monetary and fiscal stimulus to help get economies back on their feet after the lockdown. There is a good chance that this will eventually lead to in higher inflation, which could significantly enhance the value of gold and the mining stocks of companies that extract it.
The precious metal has historically been used as a store of value and can’t be undermined in the same way as a paper currency when the central bank turns on the printing presses. It tends to increase in line with long-term inflation, although there are plenty of bouts of short-term volatility.
Gold is the ultimate safe haven and is regarded as a form of portfolio insurance, but if you held it going into the pandemic you might have been surprised by its performance. When global stock markets plunged in late February and early March, gold sold off alongside them, as investors cashed in whatever they could to cover losses elsewhere.
It was a dramatic fall, with prices dropping from almost $1,700 an ounce to less than $1,500, but it is now back above where it started. The movements have been even more pronounced for gold-mining stocks, which essentially provide an operationally leveraged exposure to gold.
We have been here before
The weird thing is that we have been here before. At the start of the global financial crisis (GFC) in 2008, the Dow, gold and gold miners all sold off in unison. The latter two then bottomed out ahead of the wider market and went on to lead the recovery, as central banks cut interest rates and embarked on quantitative easing (money printing).
There followed three strong years during which gold increased from a low of $720 in late 2008 to a high of $1,900 in September 2011, with gold-mining stocks tracking higher alongside it. It is possible that we could see something similar this time around as investors anticipate the return of inflation, just like they did back then.
The policy responses we have seen in the last few weeks have been much quicker and more substantial than those enacted after the GFC, with the US, UK, Europe, Japan and others all wading in to support their economies. If you think of gold as a currency with no government credit risk, it becomes obvious why it performs well during periods of low interest rates and monetary/fiscal stimulus.
Gold could also appreciate if the economic damage is worse than anticipated or if tensions between the US and China escalate. The only scenario where it might struggle is if the authorities have got the amount of stimulus right and the global economy is able to recover without inflation getting out of control.
The return of inflation?
Analysts at Bank of America have forecast that gold prices will average $2,063 an ounce in 2021 and could hit a high of $3,000 within 18 months. The main reason for this is the action taken by the world’s central banks in response to the pandemic.
They say that the US Federal Reserve’s balance sheet as a percentage of GDP could rise by 20% to 40% this year. Interest rates in the US and most of the G10 economies will also probably be at or below zero for a long period of time as central banks attempt to push inflation back above target:
“The stimulus packages put together by central banks and governments around the world should create inflation”, says Adrian Lowcock, head of personal investing at Willis Owen:
“The measures consist of a combination of government spending and printing money (fiscal and monetary policy) so we could see inflation potentially rise rapidly.”
Gold generally increases in line with long-term inflation and the low interest rates should also help as it reduces the opportunity cost of holding it. The US has announced more stimulus than anywhere else, which could put pressure on the dollar, thereby making it cheaper for investors operating in other currencies to buy more gold.
Gold exchange-traded commodities (ETCs)
For most investors, the easiest way to gain exposure to the precious metal is to buy a gold ETC. These are designed to track the spot price less the associated costs, and in some cases are backed by the actual bullion, although others use the futures market.
The physically-backed ones tend to follow the gold price more closely with a good example being the $8bn WisdomTree Physical Gold (LON:PHAU), which has ongoing charges of 0.39%. Each underlying bar is held by HSBC (the custodian) and is segregated, individually identified and allocated, with the London vault inspected twice a year.
It is thought that physically-backed gold ETCs hold approximately 99 million ounces of the gold in bank vaults around the world. This would be worth around $173bn and it raises the question of what would happen if there wasn’t enough gold available to cover the demand.
At least one of these funds has opted to temporarily ‘soft close’ because of the pandemic. The Pictet CH Precious Metals Physical Gold Fund has taken this step because the coronavirus has significantly reduced the immediate ability of gold foundries to deliver physical gold bullion to the custodian, and the managers wanted to ensure that the investment is fully backed by gold.
It is impossible to know whether the other funds would all act as responsibly and even if they did, owning shares in a gold ETC is not the same as owning the actual gold. There is a fair amount of counterparty risk involved, with the fund’s trustees relying on the custodian and sub-custodians to source and store the gold for them. If there was a problem with these financial institutions, then the fund would be at risk, although I am not aware of any of them having gone wrong so far.
Buying gold itself would be safer, but you would need to source the purchase and eventual sale. There would also be transaction costs, the problem of how and where you store it and the issue of insurance, although you could always consider a service like BullionVault.com.
Gold-mining shares are vulnerable to short-term swings in the stock market and will fall with every other equity in a broad sell-off, but they could be on the cusp of some major earnings upgrades at a time when most sectors are struggling.
Ned Naylor-Leyland, manager of the Merian Gold & Silver fund, has recently said that the operating environment for gold miners looks better than it has done in decades:
“Margins are now set to increase in sustainable fashion as, along with collapsing energy (oil) inputs, gold/silver producer currencies such as the Australian dollar have fallen by 25-30% versus the US dollar.”
He points out that the gold/oil ratio − the cost of an ounce of gold relative to a barrel of oil − recently hit the unprecedented level of 100:1 and this provides a massive boost to the profitability of energy-intensive gold miners. For decades, this ratio had hovered between 20 and 30:1.
When you factor in the depreciation of the currencies in which the companies’ costs are denominated relative to the US dollar (their sales currency), it should add a massive amount to the bottom line, assuming these trends don’t reverse in the near future.
In many cases margins have increased from less than $100/oz to more than $500/oz and this should come through in the earnings figures. A good example is Newmont Mining (NYSE: NEM), which recently reported its first quarter results. These included a 43% year-on-year increase in sales, a 59% increase in operating profit and a threefold increase in free cash flow (after interest, tax, working capital and capital spending).
One of the main risks with these stocks is that the pandemic has led to temporary mine closures being enforced in countries such as Peru, Chile, Mexico and South Africa. This will have had a short-term impact on revenues and could threaten future production if there is a second wave.
The broker SP Angel has recently issued a buy recommendation on the emerging mid-tier gold developer Condor Gold (LON:CNR). The company is developing the La India gold mine in Nicaragua within a large, relatively underexplored, licence area with a history of previous gold production dating from the 1930s to the mid-1980s. Initial expectations are for the production of around 100,000oz of gold per year. They estimate the fair value of the stock to be 102.5p per share compared to its current mid-price of 56p. Chairman of Master Investor, Jim Mellon, is a director and key shareholder.
The best gold-mining funds
Lowcock says that economic recovery, following the pandemic, will take longer than some might expect:
“The end of the lockdown is only the end of the beginning, not the beginning of the end of this crisis. The damage done will take time to filter through and it all depends on consumer confidence, which is a big unknown. The fact is the recovery could take years and markets are likely to have bouts of volatility during this period, so don’t write off gold at this stage. It is an excellent diversifier and has proven its value during the crisis.”
Lowcock recommends the Blackrock Gold & General fund where managers Evy Hambro and Tom Holl adopt a disciplined approach, incorporating detailed commodity and company research, as he explains:
“At the company level, valuation analysis is rigorous and aims to find companies with the best exposure to commodity prices within an acceptable level of risk. This leads to an emphasis on larger producers with quality assets and ability to grow their production in a cost-effective way.”
The only investment trust operating in this area is the £27m Golden Prospect Precious Metals (LON:GPM) that my colleague Simon Cawkwell recently tipped. It holds a concentrated portfolio of gold-mining stocks, with the 10 largest positions accounting for just over half of the assets.
The managers increased the fund’s gearing to nine percent at the height of the sell-off, to enable them to add holdings at distressed prices. The portfolio has a relatively low exposure to stocks held by the large gold-mining ETFs, which means the performance tends to be markedly different to the rest of the sector.
GPM was the best-performing investment trust in 2019 and it has made an excellent start to 2020, which has helped it to close its average discount of 22% over the last 12 months to just six percent. If gold really does take off then this fund should magnify the gains considerably, although any weakness would also be amplified.
The massive level of government stimulus and record low-interest rates could easily result in the return of inflation, which would be beneficial for the value of gold and gold-mining stocks. Unless the global economy recovers more quickly than expected, these areas should do well while many others struggle to adapt to the threat posed by Covid-19.
FUND OF THE MONTH
Ben Yearsley, a director at Shore Financial Planning, says:
“I’m a fan of the Merian Gold & Silver fund. What I like most about it is that it offers a mix of bullion and gold/silver mining shares and the manager will vary the proportion depending on his overall outlook. I’m fairly sure this is unique within the fund world and means the manager can dial up or down the risk.”
Darius McDermott, managing director of Chelsea Financial Services, also recommends it for similar reasons. “Most funds in its peer group are unable to own physical bullion, making this a very different proposition. We like the manager’s willingness to alter its positioning to best suit current market conditions.”
In a more defensive scenario, the fund will own more bullion than stocks, with a heavier allocation to gold, but when the outlook for precious metals is more bullish, it will have a much greater proportion in miners and silver. At the end of April, the positioning was extremely bullish, with 77% invested in equities and only 17% in bullion.
The fund’s performance has been extremely volatile both in absolute terms and relative to its benchmark, which is 50% gold and 50% FTSE Gold Mines index. When he gets it right, the manager can really add value, as he did in 2019 with a return of 38.1% versus 25.3% for the benchmark, but the performance in the first four months of 2020 was poor.