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Friday 23 February 2018

Forget bitcoin and give unloved gold a chance

 

It's difficult to find cheap, unloved assets right now. Gold is one such exception
It's difficult to find cheap, unloved assets right now. Gold is one such exception

David Flynn

A recent Goldman Sachs report warned that valuations across stocks, bonds and credit are at their highest since 1900. At times like this, it's worth remembering what Warren Buffet said: "Be greedy when others are fearful. Be fearful when others are greedy."

It's also worth remembering that you will have a high margin of safety if you buy an asset cheap enough - because with a high margin of safety, a lot has to go wrong for you to lose money. However, when you buy something very expensive, you are very exposed if anything goes wrong.

It's difficult to find cheap, unloved assets right now. Gold is one such exception.

How do I know that gold is cheap? The gold-to-stocks ratio is trading at historically cheap levels. By that I mean that gold, relative to the cost of stocks, is cheaper than it has ever been in my lifetime (I'm 43).

We know that stocks in the west are actually cheap - when compared to bonds. If gold is cheap relative to stocks, it has to be cheap relative to bonds.

How do I know that gold is unloved? There is a lot of evidence, but let's look at cryptocurrencies. There are 1,475 listed cryptocurrencies with an aggregate total value of $1.1trn (€.809trn) I'm not going to suggest that the largest gold ETF in the world (GLD) represents the entire market, but that ETF only has market cap of $36bn - a fraction of the value on cryptocurrencies.

There are many possible catalysts for a major gold rally. The big one is that major central banks are moving away from easy monetary policies - which should lead to a rising cost of borrowing. For highly indebted economies, the cost of debt is going to compound, thereby creating a need to borrow more money.

Furthermore, the outlook for bonds is poor and so the prospects for positive returns on bonds over the next few years don't look good.

So if the outlook for bonds is so dire, why not just stay in equities? Most of the big cap stock indices are full of companies which will pay away earnings to service debt in the future. (Big cap companies are those with a market capitalisation of more than $5bn).

Gold tends to do well when equities do not.

What's really interesting is that gold stocks relative to gold itself (known as the gold stocks to gold ratio) are also historically cheap. Gold miners look much healthier than they have in years.

Their profit margins have expanded dramatically due to cost-cutting. Costs are down between 20pc and 30pc on average for the industry - yet the price of actual gold is $300 above the 2015 low.

Gold miner margins, after deducting all-in sustaining costs, are nearly $400 an ounce - almost as high as they were in 2010 when everyone loved gold mining stocks.

At some point the market will recognise this, especially if margins widen further with higher gold prices. Recently we have also seen the heaviest insider buying in gold since the 2015 low.

Two of my favourite gold stocks are Goldcorp and Yamana Gold. I've been bullish on them since just before Christmas, when I felt that most of the tax-related selling was finished for the year.

These stocks have risen a good bit since, but I see a very high margin of safety priced into both stocks and significant upside potential over the long run.

Big cap stock indices and bonds are priced for perfection. Gold is an insurance policy against the failure to meet what stock market valuations tell us are extremely high expectations.

David Flynn is senior investment strategist with Baggot Investment Partners (baggot.ie). dflynn@baggot.ie.

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