We attended a conference yesterday at which the speaker, a gold fund manager, was extolling the virtues of gold based equities. While he did lay out the case for gold’s inclusion in an intelligent portfolio, he stated that gold was a monetary asset with no yield and thus no inherent rate of return. He also stated that the equities of gold producers did generate some form of current return in the form of dividends, stock buybacks. Combine this with the fact that these producers earnings were levered to the price of gold, and the potential returns available to investors in the equities of gold producers far outweighed the returns to investors in the metal itself.
This line of reasoning got me thinking about the choices that commodity investors face today. Lets take each of the arguments one by one.
1) Physical positions such as gold pay no interest and as such pay no current return: This is quite true, however in a negative real interest rate environment such as we have now, the opportunity costs for such an investment are essentially nothing which is close to most current dividend yields today
2) Equities produce dividends and stock buybacks: This all sounds well and good from a theoretical standpoint, but the reality is that these stocks have never been good dividend payers due to the highly capital intensive nature of their business. As far as stock buybacks are concerned, stock buybacks are optimal for shareholders at cyclical inflection points, which not coincidentally is the very period when these companies are conserving cash amidst a cyclical trough in cash flows.
3) Equities have leverage to the underlying prices: This is true in a normal flat input cost environment. However, this hardly describes the environment over the past several years where: royalty escalation, fuel cost escalation, wage escalation and permitting and environmental cost compliance escalation have all worked to significantly reduce the delta associated with operating earnings and escalating underlying commodity prices. In short, the equity bang for your buck has become less and less.
While my aforementioned points do not argue categorically one way or another in terms of positioning in either the physical or the associated producer equity, some of the hard and fast rules associated with such decision making should be challenged.
The Informed Contrarian 