Gold Miners - Value Traps In Waiting?

When searching for investment ideas, one thing that seems to work is the search for the weak hand. Relatively uninformed investors, or simply those who are making non-economic and indeed incorrect assumptions are often a good starting point to research the other side.

With that mind, the fact that the U.S. Mint has run out of small gold bullion coins to sell is particularly interesting. This is a mini gold craze which parallels the institutional interest but is unique because:

1. The small denomination implies mostly retail interest, e.g. those who don't have that much money to begin with. They are therefore forced to buy the small denomination.
2. The illiquid/indirect nature of the buying. One can buy GLD etf to get the same exposure with much higher liquidity. Given the world avoids anarchy (and even then), no one is forced to accept gold as payment and therefore is by definition fear-based buying.

Hypothesis: the buyers of such coins are relatively well-off people but non-investors. They see the ads on cnbc (you know which ones) to buy gold and hear that gold has outperformed the market in the last decade. They have never bought/traded commodities and hearing the massive money printing believe that buying gold is the prudent thing to do. However, not liking the volatility of futures they choose to buy a coin, something physical.

Gold mining stocks follow from that same defensive logic - they are real businesses after all. They make sales based on gold prices and in addition provide operating leverage. If it costs them 500$/oz to mine the gold and the price is now $1000 but then moves to 1500, their income doubles. On the other hand,  the gold price only moved 33%.

But is this leverage accurate? Consider this table from Barrick Gold's annual report (page 83)

 Cash costs increased by roughly 43% (=584/409) over two years. What about gold itself?

Gold etf (physical) increased by roughly 20%, roughly half that amount.
In other words, the world's largest miner had negative operating leverage in one of the most consistent bull gold markets in the last 20 yrs.

As a result, gold miners may be trading at low fcf and earnings multiples, but may deserve such low multiples. They may therefore be a value trap.  This is not even considering that most miners' do not have a consistently profitable business even in the last few years.


Disclosure: I am short GDX (etf of gold miners).

The Market as Rock, Paper, Scissors

I recently came across this old paper about a meeting between Ed Thorp and Warren Buffett in the late 1960s. Buffett had recently closed his famous partnership after the bull market in the past few years left few undervalued securities to buy. Afterwards, former clients asked him to evaluate a money manager: Ed Thorp.

Compound interest is the first (popular) discussion that's worth repeating:

if the Manhattan Indians had been able to invest the $24 for which they sold Manhattan in 1626 at, say a net return of 8%, their heirs could buy it back now (1968) with all the improvements

This is just the beginning, however:

Buffett then brings up the "three very strange dice." Labeled as A = A=(2, 2, 2, 2, 5, 6), B=(1, 1, 4, 4, 4, 4) and C=(3, 3, 3, 3, 3, 3), two people can play a game where each chooses a dice to roll. The person with the highest number then wins that round. Interestingly enough, through repeated games (and deduction) it can be shown that A > B, B > C, but C > A. They dice are intransitive. As a result, the 2nd person to pick a die should always win in the long term by # of wins if he/she recognizes this. Just like rock paper scissors, no pick is universally best.

In other words, in such a game and indeed the market a strategy's success is often very much dependent on the others being employed. I would argue that the very reason for value's outperformance in 02-03 post-dot-com crash is because of the focus on speculative technology stocks. Similarly, active investors want more short term speculators and index funds because they would provide the other side to profitable buys. On the other hand, if everyone is preaching value or quality businesses a la nifty-fifty, value investors may want to stay away.

This phenomenon is indeed well-known already, but the examples above and detailed in Ed Thorp's paper show just how pervasive and powerful this quality is.
 

The More Things Change, The More They Stay The Same

Reading Liaquat Ahamed's Lords of Finance this weekend, I came across this bank run:

"[The Bank of England's] reserves fell from over $130 million on Wednesday, July 29, to less than $50 million on Saturday, August 1,when the Bank, attract deposits and conserve its rapidly diminishing stock... announced it had raised its interest rates to an unprecedented 10 percent. 

Yes, it sounds like the Black Wednesday that we know in 1992. Bank of England spent billions of pounds to raise rates to 10% and higher in a costly and futile attempt to prop up its currency and stay in the ERM. Soros made his billions and indeed his name by making over a billion dollars for his investors.

But this is not recent - the year is 1914. Full quote is below:

"[The Bank of England's] bullion reserves fell from over $130 million on Wednesday, July 29, to less than $50 million on Saturday, August 1,when the Bank, attract deposits and conserve its rapidly diminishing stock of gold, announced it had raised its interest rates to an unprecedented 10 percent. 

This occurred at the beginning of World War I, when the world was still following the gold standard and therefore banks were forced to honor a preset exchange rate with gold. Unfortunately, no central bank had 100% of deposits backed in gold (by design) and so when bank panics to a country-level as in a world war, no bank is safe.

What surprised me was that even though 78 years had passed, the same bank faced the same run and responded the same way, by raising rates to 10% (and beyond). Granted it was gold vs. foreign currency reserves, but does that matter? Isn't gold just another currency? One whose supply changes/fluctuates just like any other? Or actually, it continues to grow:

(Source: Gold Standard)

While the issue of the gold standard is more than just this bank run, it does seem like currency/bank crises are not that different. Whether it is pounds, dollars, gold, silver, or baseball cards, all currency/banking systems can and do come under pressure in similar ways.

Are Hedge Funds Too Big to Outperform?

Given that hedge fund assets are 8-10% as large as mutual fund assets, is the asset class too big to outperform? 

Soros's argument is that given the prevalence and power of hedge funds as an asset class, they cannot outperform. It is almost a tautology that not everyone outperform the market, but has this alternative asset class reached such a stage? The hedge fund tendency to lag equity markets are a recent phenomenon and to be fair, is a not exactly a fair comparison. After all, if alternative investments are meant to be less correlated with the market, doesn't that by definition include the possibility of under-performance?

Nonetheless, there is no shortage of studies showing how smaller managers outperform larger ones. Moreover, asset growth often goes to the larger, established ones and ones with the most best marketing/sales force. Perhaps the best example is this article about changes in the industry, quote below:

[Hedge Funds] need to excel in three areas which include: having a high quality product offering, a marketing message that clearly and concisely articulates their differential advantage across all the evaluation factors investors use to select hedge funds, and finally, a best-in-breed sales strategy. This sales strategy can be achieved by either building out an internal sales team, leveraging a leading third party marketing firm, or a combination of both. Firms that do not excel in each of these three areas will have a difficult time raising assets.

Compare this quote with this article from nymag from a few years ago:

It doesn’t take much. To run money, which is how managers refer to what they do, requires little more than a few computers. Zach’s boss likes to say, “I could run $100 million by myself.” The theory is that they’ve got an almost athletic gift for investing. They’re the type who can, as one manager did, call the direction of the market correctly 22 days in a row. They don’t want (or need) the kind of marketing, sales, and investor-relations apparatus that comes with, say, a mutual fund.

Now, the latter is of course hyperbole, but to me the intent is clear. The core of managing money to outperform is to focus on investing/trading, not top-notch third party providers, sales/marketing etc.

In short, the alternatives industry is not so alternative anymore, and in my opinion the institutionalization of the industry is exactly how most (and in aggregate) won't outperform.

*Funny doc I came across while researching marketing docs: this looks like a well-put together marketing presentation, and they have pwc as auditor + citco as fund admin, both large, well-known providers. Unfortunately, they had a sad ending.

The Most Bullish Article I've Seen This Cycle

State-Wrecked: The Corruption of Capitalism in America was a nice lunch read today. Written by David Stockman, former congressman and Reagan's budget director from 1981 to 1985, the article (in my opinion) accurately sums up the negative global economic viewpoints. The Malthusian warnings range from socioeconomic inequality in America to unsustainable debt/deficits that will cause this latest bubble to "explode," but the flaws in his argument make me far more comfortable owning US stocks. I now go line by line:

The Dow Jones and Standard & Poor’s 500 indexes reached record highs on Thursday, having completely erased the losses since the stock market’s last peak, in 2007. But instead of cheering, we should be very afraid.

Over the last 13 years, the stock market has twice crashed and touched off a recession: American households lost $5 trillion in the 2000 dot-com bust and more than $7 trillion in the 2007 housing crash. Sooner or later — within a few years, I predict — this latest Wall Street bubble, inflated by an egregious flood of phony money from the Federal Reserve rather than real economic gains, will explode, too.

Agreed - the market does rise and fall and the cycles may indeed be extreme. The market (let's say S&P 500 for specificity) may indeed fall greatly sometime in the next few years (1-10?), but isn't that true in general? Let's take the 13-yr period before the bubble years of 90s+, from 1977 to 1990. Surely, things were different then? Not really - S&P started '77 @ 107 and only began the year above that number in '80, three years later. Then the market made new all time highs for 3 years on the back of- you guessed it - debt-fueled investment and fell 22% in one day in 1987.

Point is - saying market is going to crash later is like saying it will rain later. Not exactly new information and given the vague timing says only one thing: fear without catalyst.

As for the Fed printing - where exactly is this phony money vs. real money? Is it at the central bank? Not exactly, Fed is essentially creating money to pay for the U.S. debt (in qe), so actual cash is going to whoever is selling the us debt has cash. Does the new owner of the cash ask him/herself - "this is fed money, I'm going to spend it on xyz vs. non-fed money, I will spend it on abc."? I don't think so. Cash = Cash. Admittedly, there is still a distortion to the free market, because that person may not have sold if fed was not bidding so high - the bear reasoning is that Fed is buying for non-economic reasons, and the best reasons are in the free market (I paraphrase). But is the free market always right? Or more specifically, are market determined prices best for long term economic growth in say gdp per capital or total GDP? But more importantly, the Fed is distorting the market, but since when has there been a market with no distortions?

I can go on with the later paragraphs (and can do so if there is interest), but what I think Stockman is saying is that the great "Keynesian" experiment failed - i.e. government meddling in free markets does far more harm than good. Never mind national defense, infrastructure as public goods for which the free market has shown not to be good at. Given that the experiment began (from this article) in world war II when gdp per capita was 12k vs 39k now, I think the below analogy is apt:

Joe (5 yrs old): I'm sick. I have xyz symptoms.
Doctor: looks like you have abc illness i- rest, get fluids, take this medicine for it.
Joe: Awesome! I got better in 1 week!

Joe (now 10 yrs old): I'm sick. I have wxyz symptoms.
Doctor: looks like you have abcd illness i- rest, get fluids, take this medicine for it.
Joe: Awesome! I got better in 2 weeks!

Joe (now 15 yrs old): I broke my leg playing soccer.
Doctor: will need to x-ray, put in bandage, you might not get full motion back.
Joe; WHAT? I need to play soccer! THIS IS ALL YOUR FAULT DOCTOR - MEDICINE DOESN'T WORK.

**As for my bullish view - these may be the sellers of equities in the market now. Would I take the other side? Probably.