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It seems like just yesterday gold burst through $1,000 an ounce. It actually wasn’t quite yesterday, but it was only a year and a half ago. As you likely know the price now has shot through $1,800 an ounce. An 80% increase in roughly 18 months. Not bad.

But that doesn’t tell half the story. Ten years ago a person could have bought that same ounce of gold for under $300. A decade later such an investor would have made 6 times their money by holding gold. That is almost a 20% compounded rate of return. The power of compounding never fails to amaze.

I got nothing out of this huge gold price increase and I’m not likely interested in buying gold directly today either. Why ? I simply don’t like it as an investment. The price of gold is determined too much simply by the emotions of investors and not enough by its usefulness or earnings power. I simply can’t value it.

I understand the desire to own a hard asset, but I’d much rather own oil or farmland where the world’s growing population and limited supply also are making for a fundamental reason for price increases.

I guess I share the view on gold that Warren Buffett does. Consider this exchange from an interview with Ben Stein (Stein):

Stein:

“My first question, as I sit there on the couch in his office, is: "What about gold? Is this a classic bubble or what?"

Buffett:

"Look," he says, with his usual confident laugh. "You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils (NYSE:XOM), plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"

It is all well and good that I share Buffett’s lack of interest in gold. The unfortunate truth for Buffett, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholders and yours truly is that not being invested in gold has cost the whole group of us a LOT of money over the past decade.

I have no excuses for missing the run in gold. I followed David Einhorn as he repeatedly spoke on the time being right to invest in gold. His New York Times article from over a year ago nailed the current mess that is boosting gold prices (Times):

“The question we need to ask is this: If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money?”

But I can only invest based on what I believe to be true. I need conviction or I can be shaken out should an investment temporarily move against me. I’m certainly open to changing my opinion when facts merit a change, but when it comes to gold I don’t think the facts have changed. It still has very little functional value and little earnings power and I’m not going to invest in something whose value is derived only from how worried investors are about certain macro items. At some point prospects are going to improve and then what for gold prices ?

What I have noticed, though, in relation to gold that has my attention, is how significantly gold producers have underperformed the commodity that they sell. As a group, it seems that the stock market is not pricing their assets or production using anything near the current commodity price. If gold prices stay where they are, these companies are going to produce too much cash flow to continue to be priced the way they are.

I think one of three things likely have to happen.

  1. Gold equities will rise so that their assets and production are valued using current gold prices
  2. Gold drops and these equities don’t drop as much because they were never priced as though current gold prices were sustainable
  3. Gold keeps rising and the gold equities rise even faster because they don’t even reflect current prices and because of the leverage their earnings have to the commodity price (fixed elements to their costs).

Given that line of thinking I think it might make sense to go short gold and long the gold stocks. If gold keeps going up, the equities should eventually go up faster because they have some catching up to do just to reflect current prices. If gold stays where it is, the equities should increase as the market begins to believe that their earnings power will be based on current gold prices. And if gold drops, the equities should not drop as much because they are not priced for current gold prices.

I’m just feeling my way through this idea and some of the equities with large gold exposure that I’m looking at are:

  • Barrick Gold (NYSE:ABX)
  • Goldcorp (NYSE:GG)
  • Kinross Gold (NYSE:KGC)
  • Yamana Gold (NYSE:AUY)
  • NovaGold (NYSEMKT:NG)

I think this idea definitely has some merit as I’ve read enough to be pretty much convinced that gold stocks are significantly undervalued if you believe in current gold prices. A short gold, long gold equities trade might be the best way to both take advantage of the potential for sustained high or rising gold prices and protect you (or even profit) should gold prices reverse.

The key thing to remember is that the valuation gap between gold and the gold equities can widen even more from here, so a lot of patience could be required as you wait for this gap to close.

Source: It May Be Time to Short Gold and Buy Gold Equities