Gold-related securities are among the top holdings of our offshore partner Orbis' multi-asset strategies. Alec Cutler elaborates on the two ways Orbis, as a bottom-up investor, thinks about an asset that produces no cash flows: from a supply-demand standpoint, and versus currencies. Both are informed by gold’s key characteristics: it is trustless, rustless, shiny and tiny.
We like to view gold from a supply-demand standpoint, as we do for the price of any asset. Here, gold has two qualities that make it different from copper, iron ore and lithium. The first is that it is rustless. It doesn’t degrade over time, so all of the world’s gold is still in existence and theoretically available for sale. This means supply and demand are not purely a matter of mines versus consumers. Second, gold is shiny. Its primary function is not as an input to other products, but as jewellery, or a store of value. To those folks like Warren Buffett who call it a valueless pet rock, you have to ask how much they’d pay for a Rolex watch, or a Birkin bag, or to a younger crowd, a rare digital outfit on Fortnite. The value of anything is whatever someone else is willing to pay for it. In this regard, gold has been viewed for millennia as the best store of value available to most people. Being rustless and shiny makes gold a really nice pet rock to have around your finger or hidden away for a rainy day.
On the supply side, gold is tiny – that is, it is rare to find in the ground, and getting rarer. The supply of new gold has been slowly dropping over recent decades. Unlike something like lithium, humans have been scouring for gold for centuries, and the most bountiful deposits have been exhausted. Aggregate mine quality has been dropping for a very long time. This translates into higher and higher mining costs, especially with lower ore grade being met by higher labour and energy costs, plus increasing environmental expenses. Miners require a higher price to justify their higher costs.
On the demand side of the equation, while jewellery demand has been fairly constant, gold has long been the first stop in the wealth-accumulation process for much of the world. As the emerging world has been growing a middle class, demand for gold has accelerated in recent years. That has been boosted by gold’s fourth quality: it is trustless.
… we currently view holding a decent amount of gold exposure as prudent.
Gold is not anyone else’s liability, and that becomes more valuable as trust becomes more scarce. Coincident with the acceleration of populism and a re-bifurcation of the world into East versus West, both nations and individuals feel less trusting. On top of that, the US has weaponised the dollar system against its adversaries, cutting them off from SWIFT payments and freezing their central bank reserves. Unsurprisingly, central banks of adversaries and non-adversaries alike are buying gold, and we expect that to continue. Gold’s trustless quality is becoming more valuable as trust in the US dollar system wanes.
So, from a strictly supply-demand standpoint, the minimum price hurdle has been steadily increasing with lower mine quality and rising costs, and new demand is outstripping new supply and the urge to sell by current holders. So long as mining costs don’t fall and the drivers of mass demand remain, the price of gold should remain well underpinned.
Not quite a currency, but there are parallels
The other standpoint is to view gold versus currencies. Many scoff at this perspective, but being trustless, rustless, shiny and tiny makes gold very currency-like. Its validity as such has been proven over a long time, with its first official use by the Egyptians in 1500 BC. Further, it is the only currency-like asset that has not been devalued through governmental mismanagement.
It is important to remember that the number of dollars, pounds, euros or rands you see in an account is only worth what others are willing to give you in exchange. Unlike gold, where the supply is essentially fixed, all paper currencies suffer the same frailty – politicians or their appointees control the printing press, and their desire is generally to get re-elected and their time horizon only extends through their tenure. This makes them inclined to print, spend and give away as much as they are able to get away with. Recently, that has been a lot!
We … move the elements that make up the portfolio’s gold exposure around over time.
On the US government’s own forecasts (using assumptions we consider rosy), Federal debt to gross domestic product is set to rise from today’s 100% to 120% and beyond. Essentially, all of the increase is in mandatory programmes like pensions and healthcare. With more debt and ongoing deficits, interest expense creeps up. This year, the US will spend more on interest servicing its debt than it spends on its entire military. Higher interest expense makes deficits worse, necessitating further debt issuance to plug the hole. With more debt comes higher interest expenses, worse deficits, and yet more debt – it can become a spiral.
While every day, the camel appears to be fine under the weight of the straw on its back, the risk that the camel’s back breaks certainly exists, with very significant implications for markets and accumulated wealth. In this light, we currently view holding a decent amount of gold exposure as prudent.
Securing a piece of the golden pie
The next question is how to get that exposure. We do move the elements that make up the portfolio’s gold exposure around over time. The two investable elements are the commodity itself (through exchange-traded vehicles) and gold-related equities.
Recently, we’ve shifted some commodity exposure into the miners after they massively lagged the rising gold price, owing principally to their exposure to labour and fuel costs that inflated faster than the price of gold. This set up the very unusual condition whereby the gold miners’ profits dropped despite the price of gold hitting new records. After taking another deep dive into mining economics and interrogating management teams, we’ve developed increased conviction that the miners now have their costs under control, and should costs merely revert to historic increases, with the price of gold where it is, the likes of Newmont and Barrick Gold stand to produce prodigious amounts of cash flow.
Gold may just prove to shine brightest when the outlook appears to be dimmest elsewhere.
At the time of our big shift into miners in February, this market pessimism translated into double-digit prospective free cash flow yields. Miners have appreciated nicely since, but if gold, copper and oil prices simply stay where they are, Barrick currently trades at a 7.5% free cash flow yield. That’s a better yield than the average global stock, for a stock that is much less correlated with the rest! Those sorts of valuations look compelling to us, and are why we have exposure to the miners as well as the metal.
To sell or to hold?
The remaining question is what would make us sellers, and here, gold is not so different from the other holdings in our multi-asset portfolios. Every security is in a continuous competition for capital.
In our view, the most likely cause for us to sell gold will be to free up capital for better opportunities – if equities decline and gold holds up better, for instance, fulfilling its traditional diversifying role. A swing in the pendulum towards increased fiscal responsibility or reduced geopolitical conflict would also swing our views, and could make big swathes of the equity and fixed income universe more compelling on a fundamental view. While we hope for that improvement, it looks unlikely to us today. Gold may just prove to shine brightest when the outlook appears to be dimmest elsewhere.