Thomas Winmill manages the Midas Fund, a gold sector mutual fund. We talked recently about investing in gold.
—Charles Rotblut, CFA
Charles Rotblut (CR): What role does gold play in a typical individual investor’s portfolio?
Thomas Winmill (TW): Gold has certain industrial attributes that make it desirable: It doesn’t tarnish, it’s very malleable, and it can be spun into very fine wires and flattened into very fine films. But most of the gold that has ever been mined is basically in bullion form, where it just sits around and “stores value” for governments, individuals, and institutions across the world.
I would say that its main investment role is to appreciate in currency terms. In other words, although currencies historically have depreciated as governments produce them in excess of the economy’s growth rate, hard assets such as land and gold have tended to maintain their value in constant currency terms. So that’s an important role for gold over long periods, because it has limited mining production and can’t be spun into existence the way a government can spin additional currency into existence.
A problem with gold is that there’s a carrying cost. If you borrow to buy gold, there’s interest cost, and there’s opportunity cost if you use cash on hand to buy gold because that cash could have been used to otherwise invest in interest-bearing securities or equities or some other asset class that has a current return. Gold bullion offers no current return and has a negative carrying cost.
I guess the question then for most investors is: When would you want to own gold, and in what amounts? To answer this, investors basically have to make a decision as to whether they are active or passive.
If they’re passive investors, I would say they would want to maintain a smaller position in gold, say 5% to 10% of total investment assets. However, some investors already have a substantial exposure to hard assets relative to their overall net worth because they may own equity in a house.
For those of your members who are taking a more active approach to managing their portfolios and are considering the potential advantages of gold, I would say the first thing to estimate is “what is the growth rate of the economy relative to the expansion of the amount of currency?” If the rate of currency increase is at or less than the economy’s growth rate, they might seek less exposure to hard assets such as gold, and they might want to have more exposure to financial assets. On the other hand, if they estimate that the currency creation rate exceeds the economy’s growth rate, it would seem more likely than not that currency will start to lose its purchasing power.
In the last 10 years, gold has outpaced the inflation rate and we, at Midas, believe gold is going to continue to do so. Right now there’s apparently little inflation in the system, maybe due in part to declining house prices and the deflating effect of the de-leveraging process.
In our view, however, while there’s been a de-leveraging in the private sector there has also been a re-leveraging of the government sector. I think it’s a bit of a shell game in terms of whether the U.S. is actually de-leveraging. We believe, on the whole, that there is an enormous amount of continuing leverage in our system that has to be funded.
In these circumstances, we would favor hard assets. And among hard assets, I would say gold has a very positive role for U.S. investors because the holding of gold is not taxed. Real estate is taxed.
But generally speaking, because of the negative cost of carry, I’d say a person who is looking for retirement income should limit their investment in gold to, say, 5% of their investable assets. A younger person who can perhaps deal with the volatility and lack of income inherent in owning gold could go up to 10% or 15% of their assets.
The Midas Perpetual Portfolio fund has a target asset allocation strategy: 20% to gold bullion, 5% to silver bullion, and allocations to Swiss-franc-denominated Swiss Confederation bonds, hard asset securities, large-cap growth stocks, and U.S. dollar assets. The fund provides instant diversification. It’s for investors who are seeking to invest in a way that can incorporate multiple foreseeable outcomes for the economy.
CR: If an investor is looking at bullion or mining companies, which is the better way to get exposure to gold?
TW: If they are well managed, gold mining companies can offer gold-like returns with a positive carry through sustainable dividends and operating leverage. Operating leverage means that if there’s an increase in the price of gold, then there will be a greater percentage increase in the operating earnings of the mining company.
For example, let’s say an investor bought gold at the price of $1,000 an ounce. And the price of gold goes from $1,000 an ounce to $1,100 an ounce. That’s a 10% increase in the price of gold and that’d be a 10% return on the investor’s money. To illustrate a mining company’s operating leverage, let’s again assume gold is $1,000 an ounce. And let’s say it costs our mining company $400 an ounce to produce an ounce of gold, so operating earnings would be $600 an ounce. Again, let’s assume the gold price went up $100, from $1,000 an ounce to $1,100 an ounce. Our mining company’s margin would go from $600 to $700, an increase of approximately 16%. Because you have an operating expense inherent in the mining company of $400, you would have inherent operating leverage. That is a good thing when the gold price is increasing: a 16% increase in operating earnings on a 10% gold price increase.
But in addition to that, our work suggests that the companies enjoying the best stock appreciation are those with growth profiles. Midas Fund seeks to invest in precious metals mining companies that offer growth, not only in revenue and margins that can come about from increases in the metal price, but also unit growth. We like to see unit growth in the ounces of production of gold and silver and unit growth in ounces of reserves.
Two final tidbits for those investors who may wish to take advantage of the operating leverage and growth inherent with good management teams in mining shares: first, diversify; second, employ net present value analysis.
You need to diversify because the mining business is a challenging one. Lots of things can make a promising mine go from profitable to unprofitable, and a lot of them are unforeseeable. They can be political problems, rock falls, rain, labor strikes, metallurgical issues, all kinds of things that are hard or impossible to detect or assess in the course of performing typical investment diligence. Therefore, diversification is very important.
Net present value analysis is key to valuing a mining business, unlike a typical industrial company such as, say, Coca-Cola. Coca-Cola can probably find enough water, sugar and caramel coloring to produce Coca-Cola from now until the end of time. They’re never going to run out of their basic ingredients. And you can apply such things as price-earnings ratios and so forth very successfully.
A mining business is different because a mine ends. You find a deposit and you mine all of the ore out of the deposit; then you close the mine and you don’t have a business anymore. Rather than put a price-earnings ratio to, say, the mine’s earnings the year before they close the mine, you have to say: “What is the present value of that one more year of extraction of ore versus the market price of that company’s stock?” With a multi-mine company, you should try to ‘net present value’ each of its major assets. That is a complicated process.
CR: If an individual wanted to try to ‘net present value’ a mining company, what information would they look for and where would they get it?
TW: The best places to get information are company statements found at the SEC website (www.sec.gov) and the Canadian equivalent website, called SEDAR (www.sedar.com). At SEDAR, look for the 43-101 statement. The 43-101 statement gives a more technical explanation of how the company has determined the amount of reserves and resources in their mining portfolio.
An ounce of gold goes into the reserve category when it is determined to be economically extractable. The closer the ounces are to the reserve category the more reliable, within certain limitations, your net present value of the ounces will be. The disclosures might say “well, to get these 100,000 ounces out of the ground will require $100 million of capital to develop the mine. And then sustaining capital each year will be X, Y and Z over these three years and we expect these current costs.” You would plug all of those things into your spreadsheet, assume a gold price, and apply a discount factor, and you would come up with a ballpark net present value.
One of the things a lot of people new to the mining sector find very off-putting about gold mining companies is that they will typically do a net present value of a company’s properties and then find that the company’s shares trade at a multiple—somewhere between one and two times, or even higher—of their net present value. And some would say, “Well, why would I ever invest in a company that has all these apparent risks inherent in mining yet whose market cap trades at a multiple of net present value?”
It’s because precious metals companies have a kind of ‘optionality’ in them. One type of ‘optionality’ reflects the fact that a company’s revenue and profit can increase simply by the price of gold increasing—without further capital investment by the company. So the market is also taking into account the “time value” of the company as an option on the gold price. In essence, a mining company could be viewed as a long-dated warrant on the price of the underlying metal. You might do kind of a Black-Scholes valuation of that optionality and add that to your net present value calculation.
|Fund||Total Return (%)|
|Midas Fund (MIDSX)||-1.3||83||-60.7||31.7||44|
|Precious Metals Category Average||4.7||45.4||-28.1||23.3||31.5|
|Midas Perputual Portfolio (MPERX)||0||17||1.2||4||3.9|
|Multi-Asset Global Category Average||-0.4||26.9||-27.4||9.5||15.1|
|Source: Steele Mutual Fund Expert/Morningstar, Inc. Data as of 7/31/2010.|
CR: One of the problems I have with precious metals is how to value them. How do you know when it’s time to buy and when it’s time to sell?
TW: At Midas, we look at currency creation versus growth rate. At the moment currency creation seems to be, and could be for a while, much greater than the growth rate.
In the George W. Bush administration, the purchasing power of the dollar, in just that eight years, declined about 20%. And during that period the inflation rate was moderate. I’m sure your members know that 2% to 3% per year doesn’t sound like much until you compound it.
Whether you’re Chinese or Argentinean or Russian or South African, your society seems to ascribe value to gold. For whatever reason, when investors get uncomfortable with their currency—whether it’s rupees, rubles, yen, yuan, or dollars—they often bid for gold, causing its price to rise.
CR: In terms of currency creation, are there any key areas you look at to try to gauge?
TW: At Midas, we look at non-partisan financial reports. I like the American Institute for Economic Research and the Peterson Institute, I think they both do a pretty good job. The Peterson Institute is headed up by the former head of the U.S. Office of Management and Budget). I also look at OMB information. The World Bank and the International Monetary Fund ( also have good data. I try to triangulate data from different sources. We don’t tend to give as much weight to central bank figures, such as information from the central bank of Japan or the central bank of China, even the central bank of the United States. I like the Institute for Supply Management because they seem to have pretty reliable data.
CR: You’re just really looking at the pace of the economic growth?
TW: Right. So look at the gross domestic productfigures as kind of a broad measure of overall economic activity. You could look at the creation of credit throughout an economy.
CR: What could cause the current long-term rally in gold to end?
TW: That is the question we get all of the time. We analyze gold on four factors. The factors start with the near-term factors and go to the longer term. Near term, I look at the fear factor generated by geopolitical events. The fear factor is the hardest way to make money because the gold price immediately shoots up. It’s very hard for individuals or institutions or anybody to make money because the gold price almost instantaneously reflects any news.
A medium-term factor would be fundamental supply and demand, covering items such as mine supply, central bank buying and selling, jewelry demand, and so on and so forth. And these we think can influence the price a month to six months out.
Longer-term factors are the fiscal situation in the United States and its monetary policies. We believe these factors are most important. We talked about the fiscal situation earlier. The monetary policy we haven’t talked about concerns interest rates. The Federal Reserve target rate of 0 to 25 basis points means that the opportunity cost in holding gold is small because borrowing is relatively cheap. And if you take the money you would otherwise invest in gold and put it in a bank account or a money market fund you get almost nothing. Current negative real interest rates—in other words, interest rates less the inflation rate—are very bullish for gold, we believe.
So, where is gold going to stop? If someone can tell me what, over the next six months to six years, will become of interest rates, economic growth rates, government fiscal deficits and government monetary policies, then I’d be able to answer that question. No one really knows.
If we were to see significant cuts in the federal budget, I would say that the gold price could probably suffer as a result because it would show that there’s fiscal discipline in Washington D.C.
CR: There is an argument that gold, on an inflation-adjusted basis, is still well below its record highs. Any comments?
TW: The peak that gold reached of about $850 an ounce in 1980, some people said was about $2,300 an ounce in constant dollars. However, gold was at that peak for about two to three microseconds, or perhaps a little longer. I think not much later it was around $700 and then it was back to $600. In those terms, gold today is close to the levels it was in constant dollars or maybe it’s a little bit under those levels.
We do think it’s important to keep in the back of your mind what can happen when the crowd goes crazy, but we try to look at more fundamental factors. How much currency is out there? What is the economy’s growth? How much economic wealth is there divided by currency?
Where could gold go? Let’s decide which currency we’re talking about, and how much of the currency is being created.
Gold is a better way to not have to worry about this country and that country. Basically, most currencies over time lose their purchasing power. If you look over any 100-year period, almost all currencies lose purchasing power, period. It’s so easy for a government to meet a current obligation by just printing up more currency.
CR: If an investor is looking at gold compared to a currency exchange-traded fund (or a currency mutual fund, do they invest in both or weigh one versus the other? How do they make that choice?
TW: We think gold is better because it represents a basket approach to hedging. Gold can appreciate against all currencies. You could get the foreign country’s currency situation completely right, but you have to judge that currency versus the U.S. dollar and that can be frustrating.
CR: Switching gears and going back to the portfolio allocation: If someone’s looking at gold compared to another commodity—say, an oil fund, natural gas fund or even an agriculture fund—is there a situation where they should maybe consider both or do you think it’s one or the other?
TW: I don’t think gold does well relative to other commodities in a positive commodity-type environment because it doesn’t have industrial applications. If you’re thinking that there is going to be an uplift in economic activity then you might want to get exposure to other commodities after doing supply/demand research. If you want precious metals in a time of economic recovery, consider platinum, palladium, or silver, which all have industrial applications.
Gold could be said to have two sides: a commodity side and an alternative-currency side. So far in our conversation we’ve been talking about gold as an alternative currency. Gold as a commodity is concerned primarily with global supply and industrial and jewelry demand factors. When gold is being viewed primarily as a commodity, it often seems to underperform other commodities.
CR: One last question. Are mining stocks more likely to be influenced by gold or the market? Or, are they more of a hybrid in terms of how they actually act?
TW: They’re hybrid. In 2008, gold was up and gold stocks were down. Gold stocks should be assessed on the basis of stock market capitalization versus net present value. With companies mining ore deposits that will last 25 more years, you could probably meaningfully put a price-earnings ratio on them or a price to cash flow. In 2008, gold stock prices declined while gold held steady because of market compressions to multiples such as price to earnings and price to cash flows and so on or because of market demands for increases in the discount rates used in net present valuations. In these periods, gold mining stocks behave much more like general equities.
When multiples are stable for general equities, then gold stock prices tend to rise and fall on fluctuating gold prices. It depends what period you’re in.