Gold Prices and Gold Stocks

Gold prices and gold stocks have historically shown a high positive correlation, which is not the case right now.  Investors are seeing their gold stock funds decrease in value at the same time that the price of gold bullion is increasing.  Why? Should investors continue to be invested in gold stocks?

 

A gold mutual fund manager gave us the following possible reasons for this short-term underperformance of gold stocks:

1. Higher energy, equipment, and labor costs have increased mining company costs.  With the higher price of gold and lower oil prices, some gold companies will be in a position to deliver strong earnings in the second half of 2011, if gold prices stay high.
2. Strong demand for all kinds of commodities is driving up the cost of developing new mines.  Early-stage producing mining companies, where all the land has not yet been explored, provide the best opportunity.  Successful exploration can lead to low cost expansion opportunities which enable a company to grow its business faster and more profitably than the gold industry as a whole.
3. Gold companies sell their gold in US dollars but their costs are in the local currency where they operate.  In several countries, such asSouth AfricaandAustralia, the local currency has strengthened against the dollar over the last 3 or 4 years.  This squeezes the company’s profit margin.  The reversal of this trend over the last few weeks has produced a currency loss for US investors but improved margins as a result could benefit share prices.
4. There is a positive relationship again between the direction of gold stock and the stock market in general.

 

Gold stocks still show strong characteristics and should be a part of a diversified investment portfolio:

1. Gold company profit margins are stronger now and improving with higher gold prices.
2. The current difference between the price of gold bullion and gold stocks gives investors an opportunity to buy the gold stocks at a discounted price.
3. Despite concern over higher expenditures, gold companies in general have been generating high levels of free cash which they can use to initiate or raise their dividends.

 

WHAT IS A MUNICIPAL BOND?

Municipal bonds are tax-free guaranteed IOUs from municipalities. The State ofNorth Carolinaand individual cities issue municipal bonds. Tax-free bonds are always guaranteed by the issuing municipality but the question is, if they are guaranteed, doesn’t that mean they are safe?  Unfortunately, we are seeing many municipalities and cities around the country that are facing bankruptcy and states that are not able to pay their IOUs.  The whole world of municipal bonds is now being faced with new strategies.  The credit quality of issuing municipalities is no longer something to be ignored. Credit rating companies like Moody’s, Fitch Ratings, and Standard & Poor’s are changing their rating calibrations. 

 

You can also get into municipal bonds by going into mutual funds of municipal bonds, closed-end municipal bond funds, and also ETFs which are popular right now.  Each of these pools of tax-free bonds is safer than buying the individual bonds.  You should not go into municipal bonds to play the market because you are competing with all sorts of experts and you don’t have the knowledge.  You should not hold them right now and do nothing because that is very dangerous.  You don’t do two things in my opinion:  (1) you should not be holding just a portfolio of bonds right now yourself and (2) you shouldn’t play the market because the whole world of municipal bonds has shifted.

WHAT IS A SECURITY?

In the investment world a security is usually a stock or a bond.  The investment world is divided between owners and lenders; between ownership and loanership; between stocks (equity) and bonds (debt).  You buy a company’s stock and or you buy a company’s bonds.  Stock represents equity or ownership in a company.  Bonds are a loan to a company (a debt) in exchange for interest income and the promise to repay the loan at a future maturity date.

MUTUAL FUND FEES

A mutual fund is a company just like IBM that has a manager who works on a salary.  The fund has expenses such as rent and utility costs in addition to the manager’s salary.  The manager buys and sells through a brokerage firm so he has to pay a commission. All of this is happening inside the fund. The mutual fund itself reports its income and expenses. The fee for managing what is happening inside the fund (the management fee) is one of the expenses. 12b-1 fees are also assessed. All of these are the expenses you pay each year as a percentage of the value of your investment. The ongoing expenses of the fund are disclosed in the prospectus. You should be working with a Certified Financial Planner, taking you into the prospectus and showing you what these fees are. You need to be comparing expense ratios as well as turnover ratios. That is something we do in our office.

 

You should be careful when you are working with mutual funds. The highest up front load or sales charge right now for mutual funds is 5.75% but most clients, at least the clients who come to our firm, end up paying much less or nothing at all because of larger investment amounts.  Mutual funds have breakpoints.  Virtually, nobody ends up paying the 5.75% because of these breakpoints – as your investment amount increases, the sales charge decreases as you pass each of these breakpoints. Working with a Certified Financial Planner will help you make sure that you are paying low fees and taking advantage of the breakpoints.

 

In my opinion, you should really look past the fees and look at the manager and what is happening with the manager’s performance when choosing a mutual fund.  Your financial advisor would be the manager of the fund managers, helping you evaluate the track records of each manager as you put your portfolio together.

UNDERSTANDING CHARITABLE TRUSTS

If you put property inside a Charitable Trust, the Charitable Trust can sell the property tax free meaning there is no capital gains tax.  The Charitable Trust is controlled by you because you become the trustee.  That’s the beauty of the Charitable Trust.  You avoid the capital gains tax and you never lose control.  The one problem with Charitable Trust is you cannot transfer property that has debt on it over into the Charitable Trust.  Once the property is transferred into a Charitable Trust, the money can be reinvested in a matter of weeks afterwards to where it is immediately paying a monthly check for the rest of your life on the entire amount.  You can find mutual funds inside the Charitable Trust that have averaged 8% for the last fifteen years.  The key to the Charitable Trust is the savings of all the capital gains tax.  Once you set the payout rate, if you put it let’s say at 6% or 7%, that is paid out every year on the entire amount.  That is still the best deal going.

WHO IS THE PERSON YOU ARE CALLING YOUR TRUSTED ADVISOR?

Investment professionals are supposed to give independent advice and judgment.  Warren Buffet says, “To be fearful when others are greedy and to be greedy when others are fearful.”  Put that into portfolio language and you are talking about rebalancing.  For “financial advisors,” one of the most important functions is to encourage clients to rebalance or sell what has gone up and buy what has gone done.  According to recent research, “financial advisors” have been unbalancing instead of rebalancing their clients’ accounts.  “Advisors” may have actually ended up exposing their clients to more risk rather than less risk.  Ever since October, 2007, many “advisors” have been letting clients go into bonds.  Those of us that know what may be coming would say “no, don’t do that; you need to go the other way.”  But “advisors” are afraid to be strong with their clients.  The question to be asked is what might account for this “sheepish behavior?”  Sheepish behavior is everybody being like sheep.  Why are they so cautious?  The “advisors” are afraid to encourage their clients to take more risks by going from bond funds to stock funds, which is what they should be doing. 

 

The second thing the research showed was that “advisors” are feeling, “when clients are strong-headed in one direction and they insist on being that way, just go and do what they want to do.  If not, you are going to probably lose a commission.”  “Advisors” are afraid to really tell their clients the truth and be strong with them because they are afraid they will lose commissions.  Well, those are not “advisors” are they?  They are representatives of brokerage firms.  They also offer funds but they are still brokerage firms.  The public is still seeing their so called “advisor” as an “advisor” instead of a broker.  The broker is paid commissions.  The “advisor” gets paid for advice.  That is the real problem here.  We are actually asking the question:  Why are so many of these “advisors” afraid to go ahead and set their clients straight?  The answer is they are afraid they will lose their commissions.  That is what it was all about. 

 

It is important to have a comfort level and your comfort level should be that your “advisor” will advise you properly.  If you are working with a fee-based “advisor”, doesn’t he have a fiduciary responsibility to put your interest ahead of his own?  That’s right.  In this particular case, the fiduciary should be pointing you to rebalancing.  The point is to work with a fee-based “advisor” that will recommend rebalancing as appropriate.  When things are going the wrong way according to what the “advisor” thinks is right, he needs to tell them, “No!  You don’t want to keep going in that way.  You are going to get yourself hurt.  You need to go ahead and listen to me.  I am your “advisor” and I want you to protect you by rebalancing.”

 

S&P Downgrade

WHO’S RIGHT, WHO’S WRONG?  Now this is really interesting.  On the one hand the S&P made a $2 Trillion dollar ($2,000,000,000,000!) error – so mathematically they shouldn’t have downgraded the US’s ability to pay its debts.  That’s why the White House is right in attacking S&P.

On the other hand, S&P, even acknowledging its mathematical error has bigger concerns.  They are concerned about the present administration’s inability to resolve economic issues.  In this case, S&P is right and the White House is wrong.  It’s not a matter of Republican or Democrat, “the downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what , in our view, would be necessary to stabilize the government’s…debt dynamics.” 

Again, on another hand, S&P should be ashamed of broadcasting a negative opinion of its own government, reeking havoc on the world wide markets.  This is Warren Buffet’s view.  The US economy and the strong US companies are in sound financial condition with excess cash and making profits. 

Nevertheless, S&P calling a spade a spade is really showing our dirty laundry to the whole world.  There is indeed a logjam in D.C.

China’s reaction as the holder of the largest amount of US debt (Treasuries) is probably the same reaction of most Americans.  In China’s editorial section of the State News Agency there is a scathing attack on America’s “debt-addiction and the short sighted political wrangling in Washington.”  In short,China feels we should live within our means and not be addicted to borrowing.  Just as a good financial planner tells his clients they shouldn’t have credit card debt….!

Interestingly, Buffet’s Berkshire Hathaway has just announced it’s 2^nd quarter profits at 74%.  Warren Buffet himself still feels the US is very strong and now is the best time to “buyAmerica.”

Bottom line: separate your political views and your economic views and hang on – Buffet is probably right.

More on Investing in Gold

As a Certified Financial Planner, I often get asked about the viability of investing in Gold.  In the previous post, I explained my position and that I typically only invest in gold through a mutual fund that invests in the stocks of mining companies because you are then investing in that fund manager’s historical performance.  As a follow-up to that post, I thought I’d share a letter I recently sent out to my clients that are invested in a mining company fund. 

I recently had a phone conference with the fund manager for a fund that I recommend and I am paraphrasing my questions and his answers in this letter:

Q: What is your perspective about investing in gold?

A: The main 2 reasons for investing in gold are: Potential protection against inflation and a hedge against the weaker US dollar.  Gold has a very low correlation with other financial assets and, therefore, provides a “safe haven” for many investors.  Gold production peaked in 2001 at about 2,500 tons per year when gold prices were at their low.  Production declined through 2008, then slightly up this year.  Production is still off the high levels in 2001.

Q: Why?

A: There was a huge spike in gold production around 1980.  The world went from making 35,000,000 ounces to over 80,000,000 ounces in the following 10-15 year period due to new technology and new gold mine regions such as Peru that were previously considered too economically unstable.  Mines are typically built with a 15-20 year life; the mines built in 1985 effectively played out in 2005.  In newer mines, you have to go deeper underground and to riskier places in the world.  As a result, mine production has been around the 2005 500 ton level for the past 5-6 years despite the fact that gold prices have skyrocketed over that period.  Half of the gold today is held in jewelry, 20% in central banks around the world, 20% in private hands (coins and bars), and 10% is fabrication to be used in airbags, satellites, windows, and domes on top of buildings.

Q: You are investing in stocks of mining companies, right?

A: I like gold equities right now because the companies have really good profit margins, unlike the first 20 years of the last 25 years.  Effectively, the companies are now running a $900-$950 an ounce cost versus a $1,400 gold price.  As a result, they are significantly different investments than they were previously because they are generating free cash-flow and have the ability to start paying and increasing dividends.  Companies that don’t have good projects will look to return the money to the shareholders through dividends.  Other companies have growth projects they want to pursue. 

Q: Are you saying you see a continual upward pressure on the price of gold because of more demand and less supply?

A: To the extent investment demand continues, the market is going to struggle to come up with the gold.  The 20% bank sector has become the net buyer.  The 10% in fabrication and the 20% in private hands are unlikely to be freed up.  Gold has to be pulled out of the jewelery market into the investment market.  The price will have to move higher to incentivize people to melt down their jewelry.  The demand has created this margin above the cost of mining where, historically, mine costs have set the price. 

Q: Don’t you feel that $1,400 an ounce is a scary price for people?

A: While the price is scary, there are rational economics behind it.  The gold market is pretty well-balanced right now.  There is still a healthy jewelry market despite how bad the economy is, and there is more demand from India and China and other places.  The mine supply is not growing that rapidly. 

Q: How many stocks are in your fund? Are they all gold stocks?

A: There are currently 75 stocks in the fund.  80% are gold stocks.  Gold stocks are good opportunities because the margins are so high.  He said they have about 8%-9% of the fund invested in platinum and palladium.  They are similar but palladium is lighter with slightly different properties.  About half of these metals go into automotive catalytic converters so this area is industrially sensitive since it is tied to auto sales.  The price for palladium is up to $700 an ounce but the cost to mine it is the same as to mine gold while the expense are much higher.  The fund has about 3%-4% in silver although he is more cautious here.  The supply is increasing but some historical uses have diminished, like photography and silverware. 

Q: How many of these companies do you actually visit?

A: The management team meets with a majority of the companies once per year, very often at conferences.  He said that he goes on a couple of trips each year and has an analyst who does the same.  They visit areas where they feel like there is a question to be answered or they need to get comfortable with a new region.  A couple of good examples: a weekend in Laos to understand how business gets done in a communist country in the middle of Asia in the jungle; a trip to Egypt because they were opening their first gold mine; and a trip to Australia because the company was having issues with their mine which he needed to understand.  My background is finance so I rely on the sales side or the metallurgists to visit and come back to give him a professional opinion.  The team spends a fair amount of time digging through reports that companies provide so they can see what the assets should be worth in the market and how much cash-flow to expect from that mine.

Q: What are your parameters for buying a new stock?

A: In 2001, the fund had only 22 holdings and was very concentrated in the highest quality companies with multiple mines.  The single mine gold asset had a high risk profile.  By 2005, as margins started improving, the same asset had an entirely different profile.  As a result, they moved into exploration stages.  Now, about 25% of the portfolio is in pre-production and does not generate any current cash-flow.  A lot of the larger companies don’t have the ability to find the deposits they need to maintain their production so they rely on acquiring smaller companies that find the deposits to develop. 

Q: Under what parameters do you sell a stock?

A:  The fund turnover has been only about 10% per year for the last 10 years.  I do have a couple of triggers for selling, however: 1) if things change — like if the production was much less than what was originally though, 2) it the political environment changes unfavorably, and 3) if gold prices start moving lower, I would reposition into fewer, higher quality companies.  Mostly there is an adjustment in position size rather than an exiting of the position entirely. 

Q: One of the things that attracted me to your fund was that you have only lost money for four years.  It is more important to my clients that we don’t lose rather than we make big dollars, especially for planning and retirees.  What risks are you facing now that could cause a big drop in your fund?

A: 2008 was a pretty unique set of circumstances.  The environment was a real buying opportunity because the fundamentals were actually holding up much better than the stock prices were.  The market was driven by lack of liquidity, a lack of people willing to step into an endless supply of selling.  The fundamentals did not justify the magnitude of the sell off.  Gold was actually the first sector to bounce back.  He further said that commodity prices are probably the biggest worry now.  Gold has been driven off those supply and demand fundamentals talked about earlier.  There is no good historical precedent for this much investment interest in the gold market at a time when there is as much liquidity as there is or any idea of how people might behave in this kind of environment.

Q: Do you keep a decent cash position for liquidations?

A: We have a lot of things in the fund that are fairly liquid barring an event like 2008.  Even in 2008, we didn’t see large redemptions.  A lot of people were buying into their long-term focus.  I don’t typically let cash build up beyond 5% because I want to be fully invested.  People are buying this product to have exposure on the gold market. 

Q: We have a bond bubble coming that I have been telling people about on my radio show for about a year now.  Do you see it having any effect on your fund?

A: Gold companies don’t use much debt, so from that perspective, their businesses don’t get affected by access to the bond market.  To the extent that people are looking for alternatives to owning bonds, I think the gold industry is actually benefitting from some of that concern.  Inflation, a weak US dollar, higher interest rates, all these things are positive for gold.  They have been encouraging people who have bond-heavy portfolios to consider having a little bit invested in gold as a hedge. 

If you’d like more information about this fund or investing in gold, please call our offices at 919-872-7000. 

Investing In Gold

  Excerpted from the October 17th airing of “Money Matters with Doug and Linda” which airs on 680 AM, WPTF on Sundays from 6-7 pm:

 

A caller had called in to our show asking about gold since he’s been hearing a lot about it as an investment strategy here lately given our recent economic woes.   If you’re curious about gold, here is what I told our caller that evening:

One can invest in gold in a number of manners.  One can buy gold bouillon, gold coins, gold exchange-traded funds or ETF’s, or one can buy gold through mining companies, stocks of those mining companies, or one can buy mutual funds that invest in stocks of gold mining companies.   I, personally, don’t like any of the first ones that I mentioned.  Usually, if I recommend gold for a client, it is through the mutual funds that invest in stocks of mining companies. 

Usually, what people want to know about buying gold as an investment, is what makes the price go up or down.   And, quite frankly, the price of gold typically goes up when there is a crisis, uncertainty, or political instability.  However, there is a lot of speculation when it comes to gold.    Gold is a non-correlating asset, meaning its value has nothing to do with if the stock market goes up or down or if the bond market goes up or down.   Typically, if the stock market goes up, the bond market goes down, and if the stock market goes down, the bond market goes up.   Gold doesn’t generally behave this way–there is no correlation.  Gold can go in the opposite direction.  That is why, if I recommend gold, I typically do so through the mutual funds of stock.  While past performance is not a guarantee of future results, I do prefer to invest with managers having solid track records. Another reason, I typically only recommend investing in gold through mutual funds is that the other forms of gold investments aren’t liquid.  You can’t sell them as quickly as you can shares of a mutual fund.  

To determine if gold is a good investment for  you should seek the services of a Certified Financial Planner;   you can call our offices at 919-872-7000 to speak with us or to schedule an appointment. 

Past performance does not guarantee future results.  Investing in gold may not be suitable for all clients and does carry risks including potential loss of principal.  Mutual fund shares are not deposits or obligations of, or guaranteed or endorsed by, any bank and are not insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency of the U.S. government.

Certified Financial Planner Board’s Consumer Guide to Financial Self Defense

As a certified financial planner, I routinely receive communications from the CFP Board.   This most recent communication, I thought worth sharing as it gives real-life examples of unethical advisor activities and how you can protect yourself.  

“CFP Board is proud to announce the release of our latest publication, “CFP Board’s Consumer Guide to Financial Self Defense.”

This new brochure, from CFP Board’s Consumer Advocate, Eleanor Blayney, CFP, shares important tips to help the public:

• Identify common “red flags” that signal an unethical or unqualified financial advisor,
• Learn what they can do to protect themselves,
• Take the steps required to select a qualified financial advisor, and
• Feel empowered when making financial decisions with the help of an advisor. 

Filled with unfortunate real-life anecdotes of consumers who experienced abuse at the hands of disreputable financial advisors — including many stories shared with CFP Board by CFP professionals who assisted these consumers in recovering from the effects of that abuse — the guide highlights the high standards of competency and ethics upheld by advisors who hold CFP certification. 

The guide is available online at www.CFP.net/financialselfdefense  or you can call our office at 919-872-7000 for a free copy.