Exchange-traded commodities weigh on gold stocks

ETF Securities chairman Graham Tuckwell made front-page news this month with an aggressive forecast of a $US3000 an ounce gold price. Tuckwell’s firm has $US25 billion under management, much of which is in gold exchange-traded commodities (ETCs), so his bullishness is expected.

His other comments on structural forces affecting the gold price and gold shares earned less attention but were more important. I interviewed Tuckwell, this year’s wealthiest debutant on the BRW Rich 200 with a $775 million fortune, at an ETF Securities briefing I moderated this month.

His first insight was that huge global growth in gold ETCs has added between $US100 and $US150 an ounce to the gold price. ETCs track the performance of an underlying commodity or index and are traded on an exchange like shares. Hoarding gold to provide physical backing for ETCs means issuers are reducing the supply of gold on the market.

The second insight was that valuation multiples for gold producers had reduced because of global growth in gold ETCs. Previously, investors who wanted exposure to gold bullion would typically buy gold shares and in doing so may have bid them up relative to other mining stocks.

Investors who want pure exposure to bullion can now just buy gold ETCs and overlook gold equities, unless they believe a gold company’s management, prospects or valuation provide a strong case that the stock can give a greater return than from bullion. Investors should require gold stocks to outperform gold bullion, given stocks have additional company and market risk.

Australian gold shares have badly lagged gains in the gold price over the past few years. A higher local currency dampened gains for some producers, exploration and production costs rose, and a lack of mergers and acquisitions in the gold sector weighed on sentiment. Most of all, gold shares were caught up in broader sharemarket volatility.

Most gold analysts I talk to recommend gold stocks over bullion. Their logic is sound: after years of lagging the rising gold price, gold stocks are poised for gains when global sharemarkets stabilise. That may be true but it’s hard to be enthusiastic about gold stocks when sector leaders such as Newcrest Mining have a one-year total shareholder return of minus 41 per cent. Investors who bought Newcrest for exposure to gold were also exposed to a range of company-specific risks.

Gold bulls who watched the US dollar gold price almost triple over the past five years must be hugely disappointed by the collective performance of local gold stocks. The S&P/ASX All Ordinaries gold index, which Newcrest dominates, has returned nothing on an annualised basis over five years to July 31. Over three years it gained 1.19 per cent and over one year shed 35 per cent.

It is hard to believe the gold sector can perform so poorly when gold bullion has been on a decade-long bull run. Some Australian gold stocks, of course, have done exceptionally well, but too many gold companies have destroyed shareholder value.

Watch for more takeovers in the sector this year.

Investors face the prospect of a higher gold price as the European Union tries to stimulate the economy and if the US Federal Reserve engages in a third round of quantitative easing. Tuckwell believes it could take another five to seven years before Western countries have enough courage to stop printing money to solve their problems. He sees gold potentially going higher than $US3000 an ounce.

I, too, favour gold, although I’m not nearly as bullish as Tuckwell. Gold could retest its previous high of $US1900 in the next 18 months if central banks keep printing money and lay the groundwork for the next global economic problem: an outbreak of inflation.

The other problem is global equity markets. Expect a long, slow recovery in the Australian sharemarket over the next year or two, punctuated by bouts of high volatility. In a weak market, and with resource stocks losing favour, it is hard to see gold stocks taking off.

Investors who just want exposure to gold, either to trade from their view on gold bullion or to improve portfolio diversification, should stick with gold ETCs. Adding gold stocks to portfolios can reduce diversification if too many assets are correlated with the sharemarket and move in the same direction. Gold bullion does not have this problem.

The next question is: should you buy an ETC that is unhedged for currency movements and profit when the Australian dollar falls, or use one that eliminates currency risk? Earlier this year I favoured unhedged, such as the ETF Securities’ gold ETC. I now believe investors should eliminate currency exposure because the Australian dollar is heading higher, and currency risks add another complication for those seeking pure gold exposure.

The BetaShares gold ETC, which is hedged against currency movements, looks like being the best choice. Those happy to take currency risk, and potentially profit if the Australian dollar falls, could consider the ETF Securities gold ETC.

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