Insights
Gold and Gold-Mining Stocks as a Potential
Hedge in Equity Portfolios
In the past few years, gold and gold-mining stocks have been among the
weakest performers in our First Eagle Global, Overseas and U.S. Value
Funds. Given the dramatic decline in some of these holdings, clients have
questioned their presence in our portfolios.
We believe that gold and gold-mining stocks continue to have a fundamental place in our funds. We’ve organized this paper around the three major
reasons for this conviction.
1
In an equity portfolio, gold can be a potential hedge against the frailties of the
monetary architecture.
2
While gold-mining stocks can present many risks in comparison with gold
bullion, they can also present opportunities.
3
Investors who understand industry dynamics in depth and analyze gold
miners with careful discipline are best positioned to potentially capitalize
on the opportunities in gold-mining stocks.
Page 1
Gold and Gold-Mining Stocks as a Potential Hedge in Equity Portfolios
1
First Eagle Investment Management has long believed that exposure to gold and gold-related investments may be an
effective way to potentially hedge long-only equity portfolios against the frailties of the worldwide monetary architecture.
The power of gold to play this role has been demonstrated repeatedly in equity market
crises going back to the Great Depression. At times of extreme pessimism, gold has
tended to be buoyant and equities depressed; at times of extreme confidence, gold has
tended to be depressed and equities buoyant. This cycle is well documented. Over
the last 45 years, gold and the MSCI All Country World Index (MSCI ACWI) have
moved in opposite directions relative to world incomes (Exhibit 1). A hypothetical
portfolio that blends 50% equities (MSCI ACWI) and 50% gold bullion may be more
stable relative to World GDP per capita than either a portfolio that is 100% gold bullion or a portfolio that is 100% equities. While the hypothetical 50/50 equity and gold
portfolio may have the most stability relative to world incomes, we favor a portfolio
structure that has a majority in equities and a minority in gold, given the potential incremental return one may generate from equities through both dividends and judicious
stock selection. Nonetheless, we believe the potential hedging role gold can play is clear
for long-term holders of equities.
30%
25%
20%
15%
10%
5%
YE 2011
YE 2013
YE 2007
YE 2009
YE 2003
YE 2005
YE 1999
YE 2001
YE 1997
YE 1995
YE 1991
YE 1993
YE 1989
YE 1987
YE 1985
YE 1981
YE 1983
YE 1977
YE 1979
YE 1973
YE 1975
YE 1971
0%
YE 1969
Price relative to World GDP per capita in US$
Exhibit 1: Gold as a potential hedge
Gold relative to World GDP per capita
MSCI ACWI relative to World GDP per capita
50/50 hypothetical portfolio of gold and MSCI ACWI relative to World GDP per capita
Sources: MSCI database, Bloomberg, World Bank, U.S. Bureau of the Census. Data as of December 31, 2014.
For illustrative purposes only. One cannot invest directly in an index. Returns on gold-related investments have traditionally been more volatile than investments in broader equity or debt markets.
Page 2
Insights
Looking more specifically at the last 15 years, Exhibit 2 shows drawdowns for both the
MSCI ACWI and gold. In times of past market stress, gold has served as a potential
ballast against the extreme drawdowns in equities.
Exhibit 2: Drawdown
0%
-10%
Return
-20%
-30%
-40%
-50%
MSCI ACWI price return
-60%
Oct
98
Oct
99
Oct
00
Oct
01
Oct
02
Oct
03
Gold spot
Oct
04
Oct
05
Oct
06
Oct
07
Oct
08
Oct
09
Oct
10
Oct
11
Oct
12
Oct
13
Oct
14
Source: FactSet. Data as of December 31, 2014.
This makes sense to us because gold is a chemically inert element with few industrial
uses. As a result, as seen in Exhibit 3, it is the real asset class that is least correlated
with business conditions.
Exhibit 3: Beta†
Beta to S&P 500
Beta to ISM PMI*
1.2
1.6
1.0
1.4
1.2
0.8
1.0
0.6
0.8
0.4
0.6
0.2
0.4
0.0
0.2
-0.2
0.0
Copper
WTI**
Silver
Platinum
Gold
WTI** Copper
S&P
500
Silver Platinum Gold
Quarterly data over 10-year time frame 2004-2014. Sources: ISM, Bloomberg. Data as of December 31, 2014.
† Beta is a measure of volatility (risk) relative to the overall market. The higher the security’s beta, the more the price is
expected to change in response to a given change in the value of the market.
* ISM Manufacturing PMI Composite Index.
** West Texas Intermediate crude oil.
Page 3
Gold and Gold-Mining Stocks as a Potential Hedge in Equity Portfolios
Additionally, owning gold currently has low opportunity costs, as both the yields on
paper assets such as sovereign debt and the creditworthiness of sovereign debt (as measured by government debt as a percentage of GDP) are at generational lows (Exhibit 4).
Exhibit 4: Opportunity cost of owning gold
16
100
U.S. generic government 10-year yield
90
G-7 total government net debt as a % of GDP
14
Interest rate in %
Sovereign debt-to-GDP in %
80
12
70
10
60
50
8
40
6
30
4
20
2
10
YE 2011
YE 2013
YE 2009
YE 2007
YE 2003
YE 2005
YE 2001
YE 1997
YE 1999
YE 1995
YE 1991
YE 1993
YE 1989
YE 1987
YE 1983
YE 1985
YE 1981
YE 1977
YE 1979
YE 1975
YE 1971
YE 1973
0
YE 1969
0
Sources: Bloomberg, OECD, IMF forecast. Data as of December 31, 2014.
At the same time that we face the growing risk of generationally high debt-to-GDP
levels, the gold backing of the U.S. monetary base stands at exceptionally low levels
(Exhibit 5).
Exhibit 5: Gold backing of the U.S. monetary base
160%
Gold backing of the U.S. monetary base
140%
120%
100%
80%
60%
40%
20%
YE 2011
U.S. monetary base divided by U.S. gold holdings multiplied by the year-end price of gold.
Sources: Haver Analytics, U.S. Bureau of the Census, Federal Reserve Banking and Monetary Statistics 1914-1941,
Federal Reserve Bank of St. Louis Fraser database. Data as of December 31, 2014.
Using gold as a potential hedge is very different from investing in it on a stand-alone
basis. An institution owning gold as a potential hedge in an equity portfolio may be
untroubled when it declines in price because this has historically meant that, in general, equities are doing well.
Page 4
YE 2014
YE 2005
YE 2008
YE 2002
YE 1999
YE 1996
YE 1993
YE 1990
YE 1987
YE 1981
YE 1984
YE 1978
YE 1975
YE 1972
YE 1969
YE 1963
YE 1966
YE 1960
YE 1957
YE 1954
YE 1951
YE 1948
YE 1945
YE 1942
YE 1939
YE 1933
YE 1936
YE 1930
YE 1927
YE 1921
YE 1924
0%
Insights
2
While gold-mining stocks can present many risks in comparison with gold bullion, they can also present opportunities.
Our potential hedge consists of both bullion1 and mining stocks (for the purposes of this
paper, mining stocks refer to gold miners), despite the increased risk inherent in mining
operations. Gold bullion tends to be viewed as one of the safest ways to own gold because
it has the least risk. The asset is already out of the ground, so it is free and clear of mining
risk. It has limited counterparty risk—a gold bar is no one’s liability, so risk is generally
limited to storage. Nonetheless, despite some volatility and no yield, over the long run,
gold has appreciated in real terms due to its relatively fixed supply on a per capita basis.
On the other hand, gold stocks are leveraged, historically 2- or 3-to-1, to the gold bullion price, meaning that if the gold price falls 35% (it has fallen 37.7% from September 5, 2011, when gold peaked, through December 31, 2014), then gold stocks may
decrease 60% to 80% in the same time frame. In fact, gold stocks as measured by the
FTSE Gold Mines Index have declined 71.2%2 during this recent correction in the
price of gold. However, if the gold price increases, there may also potentially be strong
leverage on the upside—primarily as a result of operating, rather than financial, leverage. A good example of this was from April 2, 2001, when gold bottomed, through
December 31, 2003. During this period, the gold price increased 62.6%3, while the
FTSE Gold Mines Index increased almost three times as much rising 187.2%4.
From a potential hedging point of view, we believe that owning mining stocks has two
benefits: it can allow us, at times, to buy proven reserves at a discount to the spot price
of gold, and it can provide diversification in our potential hedge. We believe gold in
the dirt, owned via the mines, can be as useful as gold in the vault, and we view buying shares in gold-mining companies with proven reserves as a way to acquire gold that
has yet to be brought above ground. Because the spot price of gold generally exceeds
the cost of extracting it, the valuation of gold mining companies with proven and
probable reserves are sometimes priced at a discount to the price of bullion, even after
accounting for the cost of extraction.
Before one buys gold-mining shares, there are operational, labor, political, capital allocation, cost inflation, and exploration risks to consider.
However, mining also offers potential opportunities. While we focus our analysis on
proven reserves that can be acquired at what we believe is a discount to the spot price
of gold, and do not speculate on future discoveries, we sometimes find opportunities
to acquire a free option on gold resources that may be cost-effectively converted into
additional proven and probable gold reserves.
For the purposes of our potential hedge, we look to obtain access to the cheapest ounces,
whether through the miners or through gold bullion. We will generally have a minimum
allocation to bullion, but when it is not the cheapest way to access ounces and we feel we
are being compensated adequately for the risks, miners may offer an attractive alternative.
Within our potential hedge, mining stocks may offer diversification benefits in the
unlikely scenario that other means of access to gold become impaired. There is no such
thing as a “risk free” asset, and one need only look back to Roosevelt’s Executive Order
6102 of 1933, which forbade the hoarding of gold, to understand that even gold bullion
isn’t free and clear of risk. During this environment select gold-mining stocks provided
more-attractive results to shareholders than gold. In our view, the possible diversification
benefits of mining stocks, when purchased at what we feel is the right price, outweigh
any negative impact of increased equity beta that they introduce to the potential hedge.
1 The First Eagle Global, Overseas, U.S. Value and Gold Funds each invest in gold and precious metals through an investment in wholly-owned subsidiaries of each of the respective Funds organized under the laws of the Cayman Islands.
2, 2, 3 Source: Bloomberg
Page 5
Gold and Gold-Mining Stocks as a Potential Hedge in Equity Portfolios
ETFs: A thumbnail history
At First Eagle, although permitted to, we prefer not to include gold ETFs
in our funds because we see them as less secure than bullion. An ETF is a
paper asset that varies in value with the price of gold, and due to its relatively recent creation, it has not been stress-tested. In our view, to serve
as a potential hedge for negative events, gold should be free and clear of
“On paper, every trade is a winner, counterparties pay you off, and all
rules work.” (Roddy Boyd, Fatal Risk)
Until, as shown in Exhibit 6, they don’t.
Exhibit 6: Counterparty risk can be substantial
3,000
2,500
35
AIG CDS 5-year
Lehman Brothers stock price
30
25
2,000
20
1,500
15
1,000
10
500
0
Jun-08
5
Jul-08
Aug-08
Sep-08
Oct-08
Lehman Brothers stock price in US$
The first gold ETF, Gold Bullion Securities, was introduced in Australia in 2003. The next year, the first U.S. gold ETF appeared—SPDR®
Gold Shares (GLD), which is marketed by State Street Global Advisors. GLD is a trust that the World Gold Council established in order
to create a more efficient market for gold, where prices would not
be distorted by the costs of insurance, storage, and transportation.
SPDR® Gold Shares has grown into the world’s largest gold ETF, with
approximately $30 billion in assets. The next-largest gold ETF, BlackRock’s iShares Gold Trust, has roughly $6.5 billion in assets.*
counterparty risk. We don’t want to face the possibility that our gold has
been lent out or will be unavailable due to other unforeseen risks.
AIG CDS in bp
Gold ETFs were created to give investors a relatively easy way to
obtain exposure to the price of gold without the inconvenience and
expense of owning and storing gold coins or bars. Investors in an
ETF may or may not directly own the metal, and when they sell their
shares, they almost always receive cash rather than bullion. In addition, the process of converting shares into bullion can be complex
and protracted.
0
Source: Bloomberg.
* Source: Bloomberg, December 31, 2014.
The inclusion of the securities mentioned above is not to be interpreted as a recommendation to buy or sell.
3
Investors who understand industry dynamics in depth and analyze gold miners with thoroughgoing discipline are best
positioned to potentially capitalize on the opportunities in gold-mining stocks.
The conventional structural reason given for the weak share-price performance of the
gold miners is the success of gold ETFs. Prior to the launch of the first ETF, the only
two options for access to gold were mining shares and the physical metal. ETFs now
offer a third choice, which is easy to buy and sell. Some observers contend that because
they are so attractive to investors, ETFs have absorbed much of the liquidity that otherwise would have flowed into gold-mining stocks.
We disagree. While it is a statistical fact that gold-mining shares have, on average,
underperformed the price of gold since ETFs became sizable, we don’t see a causal
relationship. Such divergence between mining stocks and their respective underlying commodities has occurred in other subsectors of the materials industry. Taking
diamonds as an example, we analyzed the Composite Rough Diamond Index against
an equally weighted basket of diamond-mining producers, showing that the diamondmining producers have decoupled, over a long period of time, from the diamond prices
without the existence of any diamond ETF accounting for that pattern. The Composite Rough Diamond Index dropped from $127.0 per carat in May of 2007 to $107.5
in February of 2009, during the global financial crisis, but recovered and was trading
at $227.7 as of December 2014, representing an overall 79% increase during this time
period. Conversely, our basket of diamond miners also declined during the crisis, dropping from 178.8 in May 2007 to 22.2 in February 2009, but it has lagged the diamond
price rebound and was trading at only 60.4 as of December 2014, representing a 66%
overall decrease during the same time period.5
Page 6
5 Source: Bloomberg, December 31, 2014.
Insights
If, indeed, the gold ETFs were cannibalizing gold equities, the effects would be visible
in almost every gold stock. But, in fact, some gold stocks performed well in 2014,
even as the price of gold declined. Royalty companies are a good example here: despite
a negative year for gold in 2014, most royalty stocks posted gains, with some of the
larger companies returning over 22% for the year.
In our view, the true cause of the decline in gold-mining stocks lies elsewhere—in an
endogenous risk crisis within the mining industry as a whole. Gold, diamonds, and the
ores of many base metals have been depleted and are becoming scarce. Today, exploration tends to be costly and its rewards uncertain, as most of the easily found reserves
have been located. In the case of gold, global discoveries have declined since 2006.
Across the mining industry, new projects are more expensive than those of the past,
and higher capital expenditures have generally eroded mining companies’ free cash
flow margins. Cost escalation in the last up cycle was exacerbated by a China-fueled
boom in base-metals extraction, which tightened the market for both labor and capital.
We believe these pressures have now abated.
We want to buy shares of high-quality gold miners when, based on the current spot
price of gold, we think their company valuations have fallen well below the value of
their proven and probable reserves. While this requires patience, it is not an impossible
goal. When the gold market is depressed, it’s not unusual for good companies to trade
at fair or even attractive prices.
When determining which gold miners to purchase, we review whether we are being
adequately compensated for the associated risks and whether we have a sufficient margin of safety. For us, a key caveat in evaluating stocks for a potential hedge is to avoid
permanent impairment of capital. A company with a lot of debt on its balance sheet
Page 7
Gold and Gold-Mining Stocks as a Potential Hedge in Equity Portfolios
may have very good assets but still get into trouble. If the price of gold falls below the
miner’s profitability threshold and it can no longer service its debt, our estimate of the
margin of safety evaporates.
We analyze gold stocks in painstaking detail. We look first at a company’s capital
expenditures to see what its capital structure can withstand. Second, we examine the
debt and the cash on the balance sheet to see how resilient the company would be to
lower gold prices. Third, we analyze the debt schedule payments; fourth, the bond
covenants. And fifth, we look at some soft indicators, such as management’s tendency
to undertake mergers and acquisitions.
We also conduct a systematic mine-by-mine analysis. We evaluate the gold reserves,
cost of production, capital expenditures, and cash flow for each mine, and we combine
these results into an evaluation of the company as a whole. Additionally, if the company has any mines located in countries where the threat of nationalization or increased
royalties is even a small possibility, we adjust accordingly.
Some miners have very good exploration teams and are able to build reserves and add
value. This is vitally important because at the end of the 10- or 15-year life of a mine,
all that’s generally left is some processing equipment. Many companies are producing
more than they’re able to replace in the form of reserves; they cannot find enough gold.
These companies are shrinking. They may provide investors with a return of capital
but, unless their shares were purchased at a significant discount to the runoff value of
their reserves, not a return on capital.
It’s not difficult for gold companies to boost reserves through acquisitions, but if the
transactions are not planned and executed with discipline and/or the price paid is too
Page 8
Insights
high, acquisitions may erode value rather than build it. We believe the correct yardstick for a miner is not reserves per se but reserves per share. We seek companies that
are increasing reserves per share, production per share, and free cash flow per share.
Fresnillo and Randgold Resources are good examples of mining companies that we believe have met this standard. Fresnillo increased gold production per share by 120.0%
and reserves per share 129.2% over the last six years, while Randgold increased production per share by 130.0% and reserves per share 70.3% over the same time period
(Exhibit 7).
Exhibit 7: Production and reserves on a per share basis
Fresnillo
[Production in oz per share * 1000]
1.2
Randgold Resources
[Production in oz per share * 1000]
16
14
1.0
12
0.8
10
0.6
8
6
0.4
4
0.2
2
0.0
Fresnillo
[Reserves in oz per share * 1000]
14
300
12
2017E
2016E
2015E
2014
2013
2012
2011
2010
2009
2008
2017E
2016E
2015E
2014
2013
2012
2011
2010
2009
2008
0
Randgold Resources
[Reserves in oz per share * 1000]
250
10
200
8
150
6
2014
2013
2012
2011
2010
2008
2014
2013
2012
2011
0
2010
0
2009
50
2008
2
2009
100
4
Sources: Annual company reports and company estimates. Data as of December 31, 2014.
Some gold companies are attractive primarily because they are very resilient and can
withstand a lower-gold-price scenario. We have a very strong bias toward these companies, but we will not buy them unless we believe they provide us with our required
margin of safety. We look for resilient companies that have the discipline to undertake
only those growth projects that may have a high internal rate of return.
Some turnaround situations also interest us—companies that are working to restore
profitability at specific mines, trying to integrate recent acquisitions, or working to improve capital allocation discipline. These stocks may represent a relatively inexpensive
way to purchase ounces of gold.
In addition to miners, we may also own shares in royalty companies, which finance
gold-mining operations in exchange for a percentage of the miners’ production. This is
a business model that we like. In periods when the price of gold is depressed and banks
Page 9
Gold and Gold-Mining Stocks as a Potential Hedge in Equity Portfolios
are reluctant to lend, many miners turn to royalty companies for financing. Many
royalty companies have been able to acquire assets and replace reserves at the bottom
of the cycle, and their shares have generally been attractive.
Conclusion
In an ideal world, our gold potential hedge would be unnecessary because confidence
in the monetary system would be so strong. But that is hardly the world we see around
us. Debt levels are high, geopolitical tensions abound, and the global financial architecture faces challenges. In short, we have to anticipate that faith in paper currencies
will waver from time to time and that—in the context of a broader equity portfolio
that to some degree relies on the health of the financial system—our gold potential
hedge may serve investors well over the long term.
We will continue to construct our potential hedge with both mining shares and bullion. We understand that we have to be highly selective in choosing miners, some of
which have clearly failed to adjust to an environment where gold is increasingly scarce.
But there are also well-managed companies that are in much stronger positions today
than they were when the price of gold peaked, in 2011. Owning their shares can give
us access to ounces of gold at attractive prices that may make our potential hedge all
the more effective for investors.
We should also add that in a broader equity market that is arguably expensive, goldmining companies generally are one of the few industry groups trading at what we feel
to be a discount to the replacement value of their assets, which makes them a potential
hedge with a value character.
Page 10
Insights
This page intentionally left blank
Page 11
The commentary represents the opinions of Matthew McLennan, Head of Global Value Team and Portfolio Manager, Thomas Kertsos, Associate
Portfolio Manager of the First Eagle Gold Fund and Senior Research Analyst, and Max Belmont, Research Analyst, as of May 31, 2015 and is subject
to change based on market and other conditions. The opinions expressed are not necessarily those of the entire firm. These materials are provided
for informational purpose only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed.
The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security. Past performance does not guarantee future
results.
Investment in gold and gold related investments present certain risks, including political and economic risks affecting the price of gold and other precious metals
like changes in U.S. or foreign tax, currency or mining laws, increased environmental costs, international monetary and political policies, economic conditions
within an individual country, trade imbalances and trade or currency restrictions between countries. The price of gold, in turn, is likely to affect the market prices
of securities of companies mining or processing gold, and accordingly, the value of investments in such securities may also be affected. Gold related investments as a group have not performed as well as the stock market in general during periods when the U.S. dollar is strong, inflation is low and general economic
conditions are stable. In addition, returns on gold related investments have traditionally been more volatile than investments in broader equity or debt markets.
Investment in gold and gold related investments may be speculative and may be subject to greater price volatility than investments in other assets and types of
companies.
The holdings mentioned herein represent the following percentage of the total net assets of the First Eagle Global Fund as of September 30, 2015:
Gold Bullion 6.37%, Gold Bullion Securities ETF 0.00%, SPDR Gold Shares ETF 0.00%, BlackRock iShares Gold Trust 0.00%, Fresnillo 0.38% and
Randgold Resources 0.00%. First Eagle Overseas Fund: Gold Bullion 5.53%, Gold Bullion Securities ETF 0.00%, SPDR Gold Shares ETF 0.00%,
BlackRock iShares Gold Trust 0.00%, Fresnillo 0.37% and Randgold Resources 0.00%. First Eagle U.S. Value Fund: Gold Bullion 7.03%, Gold Bullion
Securities ETF 0.00%, SPDR Gold Shares ETF 0.00%, BlackRock iShares Gold Trust 0.00%, Fresnillo 0.42% and Randgold Resources 0.00%. First
Eagle Gold Fund: Gold Bullion 17.83%, Gold Bullion Securities ETF 0.00%, SPDR Gold Shares ETF 0.00%, BlackRock iShares Gold Trust 0.00%,
Fresnillo 5.18% and Randgold Resources 5.74%.
Standard & Poor’s 500 Index is a widely recognized unmanaged index including a representative sample of 500 leading companies in leading
sectors of the U.S. economy and is not available for purchase. Although the Standard & Poor’s 500 Index focuses on the large-cap segment of the
market, with approximately 80% coverage of U.S. equities, it is also considered a proxy for the total market. One cannot invest directly in
an index.
MSCI All Country World Index captures large and mid cap representation across 23 Developed Markets and 23 Emerging Markets countries. The
index covers approximately 85% of the global investable equity opportunity set. The index is unmanaged and is not available for purchase.
The FTSE Gold Mines Index Series is designed to reflect the performance of the worldwide market in the shares of companies whose principal activity is the mining of gold. The FTSE Gold Mines Index encompasses all gold mining companies that have sustainable, attributable gold production of
at least 300,000 ounces a year and that derive 51% or more of their revenue from mined gold. The index is unmanaged, is available with dividends
reinvested and is not available for purchase.
Investors should consider investment objectives, risks, charges and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the Funds and may be obtained by asking your financial adviser, visiting our website at www.feim.
com or calling us at 800.334.2143. Please read our prospectus carefully before investing. Investments are not FDIC insured or bank guaranteed,
and may lose value.
First Eagle Funds are offered by FEF Distributors, LLC. www.feim.com
First Eagle Investment Management, LLC 1345 Avenue of the Americas, New York, NY 10105-0048
F-I-GLDWP