A golden dilemma

PORTFOLIO POINT: There is a mismatch between the gold price and the direction of the stockmarket at present, but it needn't be an either/or proposition for investors.

I am sitting on the horns of a dilemma. An unpleasant feeling, not only for the obvious reasons, but because, as one gets older, more experienced and 'wiser’, one should have an innate feel for things such as the direction of economies, markets and companies. However, I find that the more experience I accumulate, the less certain I am – initially. Then I put myself through a process of analysis, whereby I reject the impossible, retain in the background the improbable, search for the likely and eventually make my conclusion with a high degree of certainty.

To further explain my process: I analyse only the macro – world and country economies, geopolitical events, market psychology and the like – not individual companies. This I leave to the experts, on whom I rely to pick the best stocks within the parameters and sectors to which the process leads me. It is of some comfort to be able, later on, to blame someone else when those stocks underperform...

Sounds like a worthwhile research process? It is. Regrettably it doesn’t always work out as predicted. However, if it results in correct forecasting 51% of the time, I am doing better than most. Thankfully this has been the case over my investing career (thus far'¦).

Incidentally, there is a distinction between sitting on a fence and sitting on the horns of a dilemma. Both are uncomfortable, but sitting on a fence is a decision one makes, while sitting on the horns of a dilemma is the result of being unable to make a decision.

To explain the dilemma on whose horns I find myself: I am pondering which to invest in, the stockmarket or gold. Despite constant messages of gloom and doom, I am bullish on the market. But the gold price is in a solid uptrend. So, the first horn relates to what appears to me to be a too-high correlation between the recent direction of the stockmarket and the gold price. Logic calls for an inverse correlation between the two; uncertain times = strong gold price and weak stockmarkets, and vice-versa. My stockmarket bullishness is based on my analysis that the US is in recovery and will have a positive influence on the world economy. In the post-GFC environment, the US is reinventing itself once again. Remember the '70s, when foreign car manufacturers (Japanese in particular) made huge inroads into the US, and in the '80s, when foreigners (Japanese in particular) were mopping up distressed US assets? In both instances, the US reinvented itself and came back stronger than ever, helping to bolster global confidence. My long-term observation is that the combination of competitiveness extant in American society and the encouraging political environment leads to reinvention whenever things go awry. I predict that this will continue in the post-GFC environment.

So, US corporations are now doing brilliantly, not only due to the low US dollar; their balance sheets are in great shape, they have shed excess overheads and continue to innovate – just look at the latest results. However, the upturn is not yet reflected in the US Indexes, which are still cheap. Investors’ focus should move away from the negatives of Europe (mild recession, anyway) to the US and, importantly, to the emerging BRIC economies. They are of far greater importance to investment markets than the Old World PIGS.

Now the second horn: the gold price, up some 25% over the past year. Gold is an anachronism – a commodity with little practical use, most of which is dug out of the ground, refined and then redeposited under the ground. There are few valid arguments to hold an asset that provides no income, costs money to store and, for all intents and purposes, has no practical use. In its favour there is falling supply, currency/inflation fears and global geopolitical anxiety. However, even including these factors, rational analysis has a hard time making a case for bullion. But the market is emotional and global buying is likely to continue.

So the mismatch between the gold price and the direction of the stockmarket are the two horns on which I sit. Which one should I invest in?

Resolving the dilemma...

Firstly, the stockmarket: I am confident that, barring a new and almighty global economic downturn, stockmarkets have factored in the EU problems but not the upside of the US and BRICS. Furthermore, corporations are healthy and profits are growing. Conclusion: I am sanguine about the stockmarket. One horn removed.

Secondly, gold: if economies falter once again will gold rise? A deflationary environment is not good for gold. If economies continue to grow and confidence improves – as I expect – will gold fall? An inflationary environment is good for gold, but central banks’ paranoia about inflation and a not-overly-robust global economy leaves me relaxed about inflation. So I am led to conclude that the gold price will be a reflection of growing demand from consumers (particularly China and India) and from some central bank buying which will lead to a somewhat higher bullion price. Second horn removed.

I have now convinced myself that I can invest in both the stockmarket and gold. It’s a nice feeling.

But investing in bullion is not a very effective way to make money. So I need to examine the idea of investing in gold shares.

Existing gold producers do not excite me, for three reasons. Firstly, they are well analysed, therefore pretty much correctly valued. Secondly, management has a habit of destroying value by hedging when they should not and not hedging when they should. Thirdly, gold shares have substantially underperformed bullion in recent times – see for example the chart comparing Newcrest and bullion over the past year. The only positive I can make for investing in an existing producer is if it is expanding production – and the hope that there will be a catch-up in due course. But I cannot rely on this.

This draws me to conclude that the most rewarding way to invest in gold is to buy into companies which have discovered a commercial orebody and are now progressing towards production. The logic is simple: investors dislike companies which are likely to need to continue to approach them for more funds, hence this category is often substantially undervalued. However, a company with proven reserves, moving towards production (and thus no need to make further calls on shareholders) is likely to be substantially upgraded by the market when it achieves cash flow. These are two magic words for investors!

My rationale is that even if the gold price goes nowhere, such companies will be re-rated on the upside when they achieve production.

There are a number of gold companies which fit this low-risk, high-reward strategy and, while I do not make specific recommendations, I do have a substantial holding in (and am chairman of) Carrick Gold Limited. Briefly, the company owns a substantial area just 50k from Kalgoorlie so infrastructure, personnel etc is readily available. Three deposits have been delineated; one will be in production by the end of this year, with a second likely to commence soon thereafter. All three will start as open pits, with the potential to go underground later. And the company has plenty of cash and no debt. Oh, and it has very good management.

The chart below shows that it, like Newcrest, has substantially underperformed the bullion price. However, it has considerable upside potential if it is revalued from an explorer to a producer. Established mines like Newcrest do not have this upside. There are a number of companies in a similar position to Carrick and, of course, one should spread one’s investments.

So this is the methodology by which I attempt to remove as many uncertainties as I can by a rigorous process of elimination and logic. It results in a portfolio of low-risk, high-upside investments.

And I find that I can be bullish on gold while remaining bullish on the world economy.

Oh, and a final thought.

I could be wrong'¦

Laurence Freedman has spent his entire career in investment markets, initially with the Gold Fields Group, then BT Australia.

In 1980 he founded the EquitiLink Investment Management Group, which grew to a global company with operations around the world and over $3 billion under management when sold in 2000.

He was a member of the syndicate that bought the Ten Network, of which he became a director, taking it out of receivership and helping to make it the most profitable media network in Australia for some years, before selling it in 2004.

He currently manages his private investment portfolio of international shares, property and fixed income securities and mentors a number of resource, biotech and technology companies.

He is chairman of The Freedman Foundation, a philanthropic foundation that assists and supports young Australians and finances a broad range of medical and scientific programs and organisations.

In 2001 he was awarded the Order of Australia for service to the community, to medical research, the arts, and to business and investment in Australia.

Laurence Freedman will be an occasional contributor to the Eureka Report when, according to him, “I have something to say.” He is also active on Twitter.

* In an earlier version of this story, the graphs were incorrectly described as comparing the miners' shares with the Australian dollar.