What is important is how we might express this in our portfolios. This is not a speculative “trade,” nor is it a hedge. In studying a number of miners it reminds me a great deal of the pharmaceutical or biotechnology industry. In the case of pharma, product development often takes a decade or more of research and development and then trials. Once a product is approved, the margins are enormous because all of that R&D has been expensed (or capitalized) in prior years. So it is a distorted picture. Think the same of mining. A decade to get approvals, assays, coring and then mining infrastructure in place. Then you mine and sell it and operating costs are not that large.
It is interesting how the media continues to talk about how gold has lost its luster and has fallen precipitously. But it really hasn’t. It began the year at $1,200 and is around the same level3. Another point I find very interesting is that bond yields for the major and intermediate gold producers remain very low. This gets to my point about the profitability of this industry and the cash generating ability once developed. We have in our gun sights a couple of bonds in this space that offer what we see as a good yield. We are seeing these companies generate free cash flow and expect it will continue at levels nicely below current prices, so a very good credit investment from our perspective but with the potential upside we see coming from a changing world. Many gold miners will continue shrinking capacity as prices fall below “sustaining costs.” These sustaining costs include capital investments (maintenance capital expenditures) to maintain a flat reserve level. But as is the case for many commodity producers, there is about a decade worth of production available with minimal additional spending necessary, allowing for plenty of cash generation potential. Ironically this lack of growth is a huge positive for credit investors.
What many investors don’t grasp is that you can actively position businesses and industries in a fixed income portfolio the same way you can equities. The difference is that we get paid every day as our securities accrue interest and we have finite outcomes via stated maturities, which helps us remain patient.4 We don’t require earnings growth or beating Street estimates to make money. We just need the companies to pay their bills and generate some free cash flow, what we see as perfect for the subdued economic environment we see going forward.
1 Currency Composition of the Official Foreign Exchange Reserves, www.imf.org. Data as of Q2 2014.
2 Tanaka, Takayuki, “Russia boosts gold reserves to soften sanctions,” Nikkei Asian Review, http://asia.nikkei.com, October 7, 2014.
3 Data sourced from Bloomberg, as of October 28, 2014.
4 Bonds and loans have a stated maturity date as the ultimately outcome, barring a security default. However, there may be reasons that a bond or loan is taken out or redeemed earlier, such as due to early calls or tenders at premium prices. Actual results may differ materially from the stated maturity.