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Send  Share  RSS  Twitter  24 Apr 2012

ASSET MANAGEMENT: The Gold Conundrum


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Gold has a very significant place in the history of both the world and finance, so its return to the front pages was always more a matter of “when” rather than “if”, says Takura Mahwehwe, Portfolio Construction Analyst at Cannon Asset Managers. Gold bulls have looked like very clever people for the last decade, during which the price has risen from below $300/oz to its current levels over $1,600/oz. And although off its dizzying peaks over $1900/oz, gold remains high relative to historical levels. As is to be expected with such a meteoric rise, the commodity became headline news everywhere and investors are inundated with research and opinions on where it’s going next. As we go into the second quarter of 2012, we have noticed renewed interest in the yellow metal and its likely future movements.So what is going on, why is gold at such highs, and does gold make investment sense‘

The drivers of the gold price are twofold – in times of uncertainty, gold is seen as a safe asset and when people fear inflation, they see gold as an asset that will retain its real value. Currently, there is plenty of well documented risk and uncertainty in the global political and economic systems. There is also concern that the effective printing of money, especially in the USA in the form of quantitative easing will ultimately result in inflation.

So while gold has experienced some strong tailwinds driving up its price, there are some risks associated with investing in the metal. The primary concern with investing in gold is that it is a purely speculative investment. Unlike many other assets, physical gold is non-productive and does not yield an income, thus returns are simply a function of price movements. The only way to make money from owning gold is to sell it to someone who offers you a higher price than the price you paid for it. In fact, gold offers a negative yield as it costs money to own it (storage, insurance etc.). Unlike most other commodities, it has less industrial use, meaning that once it is mined, it sits above the ground waiting to be resold.

Physical gold is, surprisingly, more risky as an investment than shares in gold mines. The volatility of the gold price since 1971 (when the gold standard was abandoned and the gold market liberalised) is 28.7%, compared to 18.2% for global equities (MSCI ACAW total return equity index). Another concern as far as risk is concerned is the shape of returns: gradual, more consistent returns are delivered by equities as opposed to gold.

Gold as an Investment Medium

Over the years, the use of gold purely as an investment medium has grown, as evidenced by the growth in the number and size of gold exchange traded funds (ETFs). It is now widely regarded as a separate asset class. But how should this asset be valued‘

Cannon Asset Managers’ research shows that, over time, dividends contribute more to the total return of equities than capital appreciation does. Since 1960, the real return from SA equities has been 7.7% p.a. Of note is that dividends comprise 4.6% of this, with capital gains contributing 3.1%. As gold does not generate an income, investors are entirely exposed to the vagaries of market prices. But by far the bigger problem is that fair values for asset prices are largely determined by their earnings or yield, as well as the character of those earnings. Since gold has no earnings, how can one determine a fair value for it and thus evaluate whether investing at a certain price is a good deal‘ Unlike most other commodities, since gold has little industrial use, its consumption demand can’t be modelled to derive a value.

As a purely speculative investment, it is necessary to estimate whether other investorsÂ’ sentiment will improve towards the metal or not. Estimating investor risk aversion can assist with this. Estimating future inflation can also help. Over time gold has been a good store of purchasing power, so gold as an inflation hedge is also a fairly common and justifiable factor, with research showing a meaningful correlation between the two over the years.

One theory of support for the gold price is an argument that, given the worldÂ’s financial problems, a gold standard might be re-introduced. In other words, make sure that all the money that is printed is backed by a physical amount of gold. We estimate that there is current 5,814m oz of gold currently above ground, and there is currently approximately $32.5tn of money in the world at the moment. This would infer that gold should rise to $5564/oz.

Possible Solution to Gold Valuation Problem

A possible solution to the valuation problem is to invest in gold mining companies which do generate incomes and are highly correlated to movements in gold, with a common perception that their prices are leveraged to the gold price. This is not the case. In South Africa, though, gold mining as an industry is in decline and is facing a number of major headwinds. All the easily-accessible gold deposits have been extracted and mines must now dig deeper to access what are lower grades of gold, at a greater expense and danger to workers. Wage increases and electricity tariff hikes have also, and will continue to, put significant pressure on costs. Historically, whenever the dollar gold price has risen, the rand has strengthened, offsetting the benefits for domestic producers of a higher gold price. Over the last five years, South African gold shares have largely underperformed investments in physical gold.

Certainly at the moment, it is possible to make a case for owning physical gold given global economic circumstances. However, it is a volatile asset that also underperforms other assets for extended periods of time. In addition, it is a purely speculative investment and, as with any sentiment-driven investment, is subject to the emotional whims of investors. While it is possible that gold may continue going up, we prefer to invest in assets that are not speculative but can be more accurately valued.

Investors, if they have a strong appetite for gold should rather invest in platinum. Gold only offers a bullet outcome; it will only keep rising if the bad news continues. Platinum offers a barbell outcome. If the bad news continues, it offers all the attributes of gold. However, if the bad news ends, and the global economy recovers, the industrial use of platinum in car manufacturing will also support the price. Which precious metal would you rather own‘

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