Download the PDF, "Is Gold the Latest Investment Bubble?"

As of September 30, 2010, the following Funds had relatively significant investments in the precious metals and mining companies industry, as follows: Royce Global Select Fund, 17.50%; Royce Focus Value Fund, 15.80%; Royce Global Value Fund, 15.61%; Royce Low-Priced Stock Fund, 14.77%; Royce SMid-Cap Value Fund, 12.28%; Royce European Smaller-Companies Fund, 11.55%; Royce Select Fund II, 11.16%; Royce Micro-Cap Fund, 10.64%; Royce Value Fund, 10.40%; Royce Value Plus Fund, 8.94%; Royce International Smaller-Companies Fund, 8.81%; Royce Heritage Fund, 8.45%; Royce Premier Fund, 5.23%; and Royce Mid-Cap Fund, 5.11%.

David Nadel

Having been active investors in gold-mining stocks for more than a decade, we recently attended the Denver Gold Conference in Colorado. It felt not unlike an internet-company conference circa 1998 – record attendance, exuberant crowds, glamorous investor relations staff – and made us ask the difficult question: is gold investment in the bubble phase? We don't think so, but we're happy to debate it. Along the way, we even promise to explain why, for once, we disagree with Warren Buffett.

Gold's Recent History, Valuing Gold, and Global Supply & Demand

A 40-year History of trouncing stocks and Treasuries

Since 1970, gold has dramatically outperformed the S&P 500 and U.S. Treasurys. This 40-year span has seen a nearly 10-fold increase in the price of gold versus a 4-fold increase for the S&P 500 and a 3-fold increase for Treasurys.¹ While the recently concluded decade can be written off by most equity investors as the "lost decade," the price of gold has shown a remarkable record of holding its own through crises. It has mostly risen over the past 40 years, including through the Arab oil embargo in October 1973, the Iranian hostage crisis six years later, Mexican default in mid-1982, the massacre at Tiananmen Square in 1989, the collapse of the Soviet Union two years later, the Tequila Crisis of 1994, the Oklahoma City bombing a year after that, and the 1998 Asian currency crisis. Sure, gold languished below $350/oz during the heady years of the Tech Boom in the late 1990's, but since the terrorist attacks of September 2001, it has more or less climbed higher.²

Valuing Gold

The most common response I get when speaking with other investors about our weightings in gold-mining companies is, "How do you value gold? It has no intrinsic value!" Indeed, none other than the Oracle of Omaha, Warren Buffet, has said, "Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

In addition to pointing out that Martians tend not to be active investors, we'd like to begin answering the question by asking one: Gold is valued in U.S. dollars, so how does one value a U.S. dollar? The answer to that question may not be comforting for those with a knee-jerk faith in the Greenback. Here is the purchasing power of $1 dollar from 1914 to today:

Similarly, the following chart shows how many ounces of gold could be bought with $1,000, going back all the way to 1930! From nearly 50 ounces then, to less than one today!

Source: Bloomberg.

The Continental: These once had value in America too.

Folks, this ain't a pretty picture. The problem is that while the supply of gold is more-or-less finite, the supply of U.S. dollars (as with all paper currencies) is more or less infinite. Central banks around the world tend to like printing money.

• Whereas net gold production expands total supply by only about 1.5% per year, the supply of major currencies around the world has been expanding at a clip of 6-7 times this.³
• Lacking intrinsic value, paper currencies (including the U.S. dollar) can actually be quite difficult to value at times, varying widely in currency markets. Amid all this uncertainty, gold is, in a sense, the "real" money. During the past decade, gold has appreciated approximately 5.1-fold versus the U.S. dollar, 4.7-fold vs. the South African Rand, 3.3-fold vs. the Canadian Loonie, 3.1-fold vs. the Euro, and 2.8-fold vs. the Swiss Franc.⁴
• It takes approximately 8.1 ounces of gold to buy the Dow Jones Industrial Average today ($11,350 / $1,400 per oz). During different points of previous crises, it has taken just 1 or 2 ounces to buy the Dow: 1896, 1932, and 1980.⁵
• Consider the fate of the Continental. America's predecessor to the dollar was issued during the War for Independence from England. It lost not just most of its purchasing power—as the dollar has done—but fully 100% of its value. It took just six years, from 1775 to 1781, for this wipe-out to happen, from $240 million worth at issue to a mere footnote in the history books.⁶

Global supply & demand

The entire known supply of gold mined through history would fit roughly into a cube 60 feet on each side; that is to say, it would fit in the space underneath the Eiffel Tower.⁷ This total is 166,000 tonnes (1 metric tonne = 35,274 ounces). Meanwhile, annual mine supply, net of de-hedging, has been in the range of about 2,400 tonnes, or just 1.5% of total supply.

* The main components of gold holdings around the world are jewelry, central banks, investment and industrial.
Source: GFMS, Wikipedia

Jewelry

Jewelry is still the primary source of gold demand, but this has been trending downward for most of the last 10 years, from about 3,200 tonnes in 2000 to 1,750 in 2009, a roughly 45% decline.

• Despite high prices, jewelry demand is headed this year towards a peak in both China and India, both on a tonnage and gram/capita basis.⁸ Whereas the Chinese jewelry buyer tends to be quite price-sensitive with platinum, many Chinese view gold as a reliable store of value.

Industrial

Industrial (including electrical) demand has leveled off at about 610 tonnes last year, down about 18% from 2000.⁹

• About 70% of solar panels make use of photovoltaic cells that contain some gold.¹⁰

Investment

Picking up the slack dramatically, however, has been investment demand, in the form of ETFs and bullion.

• ETF holdings alone hit 2,150 tonnes in September, rising dramatically and relentlessly from barely anything just six years ago,¹¹ and roughly double China's central bank holdings.
• In the first half of 2010, one ETF—iShares Gold Trust, "IAU"—received 22% of all ETF inflows. It is now the second largest ETF, with $51 billion in assets vs. $66 billion for the largest, SPDR S&P 500 ETF.¹²
• Thanks to capital controls, Chinese consumers are limited for the most part to investing within their borders. Accordingly, they collectively hold about $4.5 trillion of cash savings in bank accounts – a sum which exceeds the combined GDPs of Brazil, India and Russia.¹³ And because such savings pay negative real interest rates, gold has become an attractive alternative investment.
• Investors have accounted for 25-30% of gold demand as of late, versus just around 10% of silver demand.¹⁴

Central Banks

Central banks collectively hold about 30,000 tonnes of gold¹⁵.

• The U.S. government holds about 8,130 tonnes, primarily in deep storage at Fort Knox, West Point and Denver. This equates to more than one quarter of all central bank holdings, but just 5% of total above-ground stocks.
• Germany and the IMF are the next-largest holders of gold, though each has less than half of the U.S.'s stocks.

The Bear and Bull Cases for Gold

Has gold reached its peak?

As we see it, investors are underweight gold and gold-mining shares. The dollar value of all the world's gold stores may seem substantial on the face of it, but the value is actually inconsequential relative to that of all the world's existing paper assets, measured at approximately $140 trillion. Factoring in real estate and other non-paper assets, the percentage of gold exposure against all investable assets appears much smaller still, especially compared to past periods of economic uncertainty.

We do not believe gold is in a bubble in constant dollars. Gold is often viewed as an inflation hedge, and on an inflation-adjusted basis, today's gold price is still about 40% below its all-time high set 30 years ago.

Source: Martin Murenbeeld, Dundee Wealth Economics

Nor do we think gold is in a bubble as measured in oil. An ounce of gold buys about 16 barrels of oil, not meaningfully above its 40-year average of 15 barrels.

Source: Martin Murenbeeld, Dundee Wealth Economics

When it comes to gold, I tend to agree with Jim Grant: "A bubble is a bull market in which the user of the derogatory term has failed to participate."¹⁶

The Bear case for the gold price

Incremental investment flows

It is clear to me that the price of gold in today's market comes down entirely to incremental investment flow and because of (admittedly modest) new supply, the price of gold needs incremental buyers every day just to tread water. With jewelry demand down, large and small individual investors, central banks, and institutional investors will have to continue ramping up their exposure to the metal. Of course, it is notable that the value of the U.S. Treasury market alone still exceeds that of the entire gold market globally.¹⁷

Flight to 'quality' or a rally in the U.S. dollar

The last true meltdown in global asset markets—late 2008-early 2009—saw the dollar rally substantially, while all commodity and stock markets cratered due to fears of deflation (and likely also due to forced liquidations and margin calls on the part of many large funds). Although a short-term dollar rally may again be in the cards, we remain cautious on the dollar for the medium to long term, driven by our bloated and rising current account deficit, yawning trade deficit, money-printing habit, and economic malaise. Future crises that carry the threat of deflation may again be met with yet more intensive efforts by central banks to fuel inflation.

BRIC slow-down

There can be no question that if emerging market growth slows markedly, there would be a widespread easing in inflationary pressures across the board, and the commodity cycle would reverse.

• Some critics have pointed to several factors that they maintain imply the Chinese economy is experiencing its own bubble, particularly with real estate investment dynamics on the ground in China. However, given the country's balance sheet and past policies of combating potential deflationary trends successfully, we see only a moderate risk that imbalances in China will spiral out of control.

IMF or central bank selling

The IMF has had a pattern of selling some of its gold in order to meet suddenly more urgent demands for cash on the part of needy countries that the bailout era has brought on.

• Italy holds nearly 2,500 tonnes; it already pledged its gold in the 1970s against loans; it has by far the largest holdings among the so-called "PIIGS" countries of Europe (Portugal, Italy, Ireland, Greece, Spain). However, central banks in Western nations have proven to be poor market timers in the gold category, selling closer to bottoms and buying closer to tops.¹⁸

For the foreseeable future, given highly uncertain macroeconomic outlooks and already delicate currency values, we think central banks should remain net accumulators of gold.

The Bull case for the gold price

Since the onset of the global economic crisis, the dramatic fluctuations in the value of the world's leading free-floating currencies has arguably undermined their credibility. Not surprisingly, there's talk in the air of a return to a (modified) gold standard. Theoretically, in the case of the U.S. gold would have to be valued at about $8,250 per ounce if it were to fully guarantee the U.S. dollar today.¹⁹ Clearly, the fact that gold is priced today at less than 1/6th of this level indicates that in the near term few are taking a return to a gold standard seriously as they did at the original Bretton Woods of 1944. However, some global leaders in monetary policy are now in fact advocating tying gold to currencies as a reference point to bolster their legitimacy. Robert Zoelick, the President of the World Bank who also served in the U.S. Treasury in the 1980's, argues in a recent Financial Times editorial piece that "the system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values"²⁰ and commented a few days later, "whether people wish to acknowledge it or not, we are moving towards Bretton Woods III."²¹ Regardless of your view on the use of gold in currency markets, we see several drivers for a higher gold price:

The incredible shrinking Dollar (and Euro, et al.)

The U.S. Federal Reserve has expanded its balance sheet by a factor of nearly three over the past couple of years, printing more than $1 trillion to buy Treasuries and in effect expanding the money supply.

• The Fed has recently rolled out another program of ongoing quantitative easing ("QE2").
• The U.S. dollar has lost most of its purchasing power over the last century, but while that decline was mostly gradual in nature, the recent decline has been more precipitous and shows some signs of accelerating from here.
• The list of currency debasements that have resulted from government money printing throughout history is quite a long and discouraging one. The U.S. and the EU seem to be locked in a race to the bottom with their currencies.

Gold prices rise when real interest rates are low

Several studies suggest that gold tends to rise consistently in negative real interest rate environments. There is a popular perception that the gold prices will stop rising as soon as the Fed begins to raise rates. We believe this perception is mistaken, and here is why:

• Gold tends to rise quite reliably whenever the real three-month T-bill rate is below 2.5%, and to fall when the real T-bill rate is above that level. Economist Michael Churchill recently cited a study which shows that since 1975 gold has risen at a 13.2% annual rate with a real three-month T-bill rate below 2.5%, and fallen at a 3.6% rate with a real three-month T-bill rate greater than 2.5%.²²
• The real T-bill rate is currently negative 0.78% (assuming official Consumer Price Index (CPI)), so if the past 35 years of history are any measure, the Fed will need to raise interest rates more than 300 basis points below the cut-off point at which, historically, gold has tended to fall.

Inflation is here, even if it's not official

We live in a strange time when we are told that the CPI is 1.1%, implying barely any inflation, but just about everything we need to buy in order to live has surged in price. We think it's just a matter of time until governments around the world have to recognize more official inflation than they have been thus far willing to acknowledge.

Fiscal imprudence

Trillion-dollar fiscal deficits in the U.S. are now the norm, and deficits in Western Europe, Japan, and other developed economies are also running at record levels.

• British economist John Maynard Keynes is far from dead in the minds of many government officials and the former or current economics professors who advise them. Governments appear to be on a treadmill of deficit spending to compensate for slack in the private sector and to sustain retiree and other social benefit programs.
• As Harvard historian Niall Ferguson succinctly put it in referring to struggling Portugal, Italy, Ireland, Greece and Spain, "PIIGS are US." Have a look at his debt-to-GDP projections below:
  

Trade imbalances and currency wars

Among the least courageous ways for a government to address a trade imbalance is to deliberately devalue its currency to boost exports. Today, unfortunately, too many countries find themselves in this boat, with the result being the beginnings of trade and currency wars. Again, gold is the safe-haven beneficiary of this kind of dysfunction.

Peak gold theory

During the past decade, the dollar-price of gold has quintupled, and yet net mining supply has not kept pace. This dynamic defies normal market economics. It has happened because, first, mining costs have generally been rising, and, second, it is becoming increasingly difficult to mine gold and to maintain resources. With much of the low-hanging fruit having already been picked this century, it is becoming more challenging to mine gold and to maintain resources.

BRIC and the commodity cycle

Commodities markets and paper assets have tended to experience 20-year bull cycles.²³ The current one is being driven overwhelmingly by the BRIC countries, whose combined population growth and wealth creation is producing the equivalent of the entire American middle class every few years, sharply increasing demand for scarce assets and leading to natural inflationary pressures.

Central bank buying

After peaking in 2005, sales of gold by central banks have dwindled to close to zero in 2009.

• While much of the developed world has decided to hang on to what it holds, new buying has emerged from the predictable countries of emerging wealth: India, Russia, China, and Saudi Arabia, among others. Even mostly impoverished Bangladesh recently made a relatively large purchase of gold.²⁴
• About 85% of the 30,000-tonne central bank gold holdings is realistically not available for sale, due to bureaucratic constraints.²⁵

Investing in Gold-Mining Companies Versus the Metal

Shares in gold-mining companies have not appreciated nearly as much as the commodity price of the metal itself, as the chart below illustrates. Since 1980, the Barrons Gold Mining Index/gold ratio has oscillated within a horizontal range. It briefly moved below the bottom of this range towards the end of the 2008 market crash, hitting a 50-year low in October 2008.²⁶

We see similarities in this situation to oil exploration & production (E&P) companies in the wake of the April 2003 invasion of Iraq. Most investors at the time treated the "spike" in oil prices as a temporary dislocation attributable to the invasion. While the oil price continued to hold its own through 2003 and rise in early 2004, these investors stubbornly held to the view that it would soon "normalize". But in doing so, they overlooked the fact that assuming just the current oil price of that period, oil E&P companies were staring at a future with greatly increased cash flow, earnings, and dividends. In other words, if you were a contrarian and bought E&P stocks then, you generally did a lot better than investing in the underlying commodity of oil.

Similarly, today's valuation of many gold-mining companies implies the gold price will soon "normalize" to a level far below current spot. We think there have been three main reasons for the underperformance of gold-mining companies, illustrated by Barron's chart above: mining costs, share dilution, and doubts about company quality. However, some of these key historic reasons are beginning to change, in our view, giving us a potential, highly positive catalyst for returns fueled by margin expansion, multiple expansion, and rising gold prices.

Bigger spread means fatter profits

Mining costs have been mostly rising for years, climbing 17% in the first half of this year to an industry average of $532/ounce! These increases have been driven by higher energy and raw materials costs.²⁷ However, the increase in such costs has been markedly outpaced by the rise in gold prices, meaning the spread that determines companies' profits is widening.

• As in just about any industry, we tend to like the low-cost producers better, all else being equal. While high-cost producers potentially offer greater upside to gold prices, they also run the risk of being less viable business models for the inevitable weak periods for gold prices.
• Latin America tends to be the lowest-cost region, although we have also found very low-cost producers (sub-$300/ounce) in Asia, too.²⁸
• By contrast, we have generally avoided South African gold producers because of their relatively high costs, and limited our South African precious metals investments to platinum, for which there are few investable opportunities outside that country.

Serial share issuance

Share issuance and excessive capital-raising have been the bane of the gold-mining investor for more than a decade. When gold prices were depressed in the late 1990s, it was difficult-to-impossible for mining companies to raise capital. Now that gold prices are healthier, many of these companies seem addicted to serial share issuance, which can cheat investors out of returns by diluting production-per-share, resources-per-share and, of course, earnings-per-share.

• To paraphrase the CEO of a leading Latin American mining company, which eschews share issuance, the less disciplined mining companies wind up "doing a better job of mining their shareholders than the ground."
• The lesson here is clear: Avoid companies that issue shares without discipline, and focus on companies that have a track record of growing on a per share basis and therefore creating value for shareholders.

Concerns about quality

Dating back to the Bre-X scandal of the mid-'90s and perhaps before, investors have often questioned both the essential quality of gold-mining stocks and the industry as a whole. Typically, these concerns stemmed not from something as dramatic as outright fraud (as was the case for Bre-X) but more from a perception that the industry was undisciplined about supply, greedy about capital-raising (see above), and stingy with dividends. This poor reputation was well-deserved in many cases, but we believe the quality of today's better-run companies isn't far below those of many industries.

• Managing more for returns on capital than pure production volume
• Focusing on costs and efficiency (costs/ounce, costs/ton of earth, etc.)
• Meeting operational milestones in mine development and exploration
• Functional, if not strong, labor relations; avoiding contentious environmental or regulatory scenarios
• Avoiding dilutive secondary offerings and undisciplined M&A
• Shareholder-friendly expansion of reserves

Overall, it appears to us that, as was the case with oil E&P companies after the Iraq invasion, investors today are underestimating the level of ongoing profitability and dividend income from the better gold-mining companies, assuming gold remains priced at over $1,000/ounce, let alone at $1,300/ounce. If reversion to the mean works here as it does in many other areas of investing, several years of underperformance by gold-mining shares should eventually lead to outperformance, once investors embrace the notion that current precious-metals pricing is appropriate for the long term.

Where investors have historically viewed gold-mining companies strictly as asset plays, it seems that we may be at an inflection point where they are increasingly viewed as resembling industrial companies producing a coveted product while also providing investors with reliable earnings, free cash flow, and generous dividend yields. With regard to the better-managed companies in this industry, we have held this view for ten years, and these very characteristics were part of what attracted us to the industry in the first place.

¹ GFMS, Ned Davis, PricedInGold.com
² Bloomberg
³ Contrarian Research Report, TIS Group, U.S. Gold
⁴ Bloomberg
⁵ Contrarian Research Report, TIS Group, U.S. Gold
⁶ Wikipedia
⁷ www.onlygold.com
⁸ World Gold Council, GFMS, Dundee
⁹ GFMS
¹⁰ Economist
¹¹ GFMS, Bloomberg
¹² GFMS, Ned Davis
¹³ CLSA
¹⁴ Economist
¹⁵ Wikipedia, World Gold Council
¹⁶ Grant's Interest Rate Observer, September 3, 2010
¹⁷ Wikipedia
¹⁸ Wikipedia, Bloomberg
¹⁹ QB Partners
²⁰ Financial Times, November 7, 2010
²¹ Agence France Presse, November 11, 2010
²² Michael Churchill, Churchill Economics
²³ Bloomberg, TIS Group, Ned Davis
²⁴ Dundee Wealth Economics, Bloomberg
²⁵ Dundee Wealth Economics
²⁶ Barron's, Contrarian Research Report, PricedInGold.com
²⁷ GFMS
²⁸ GFMS