Gold’s risks and opportunities

Gold prices have surged this year in response to economic stimulus, low interest rates and investor uncertainty.

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In early August, the safe-haven asset hit US$2,000 per ounce for the first time ever recorded. And, with the commodity outperforming all other assets year to date with a roughly 29% return, some investors are giving gold a second glance.

Craig Jerusalim, senior portfolio manager at CIBC Asset Management, typically hasn’t been bold when it comes to gold.

“Throughout my investment career, I’ve perpetually been underweight gold stocks,” Jerusalim said in an Aug. 20 interview.

His stance was largely a result of the industry’s “horrific” track record of destroying shareholder wealth over time, he said, adding that self-serving management teams and flat to falling commodity prices during much of the past three decades were also factors.

“Even during those periods of rapid-rising balloon prices, like [in] 2006 to 2011, many of the majors rewarded managements with lucrative payouts, sunk excess capital into empire building and mergers and acquisitions, or plowed earnings back into much-needed development projects to sustain mine lives,” he said.

The industry has changed, however, with a greater focus on sustainability and quality, top-tier senior producers.

Currently, the fundamental backdrop for the commodity is “quite supportive,” said Jerusalim, who manages the Renaissance Canadian Dividend Fund and CIBC Dividend Growth Fund.

While the outlook for gold isn’t certain, boons include the potential for rising inflation and inflation expectations, negative real interest rates and a persistently weaker U.S. dollar.

Further, “Fiscal deficits, central bank balance sheets and stimulus measures are all flooding the market with ample liquidity,” Jerusalim said.

He also noted that supply-demand fundamentals are strong.

“Supply is not growing, as large-scale deposits are no longer being discovered,” Jerusalim said. “And even though jewelry demand is down, industrial use and, more importantly, ETF and central bank buying is making up for it.”

Factors to watch

Still, there are risks to monitor when investing in gold.

For example, mergers and acquisitions could increase, considering that mine lives are at generational lows — “This could be a risk or an opportunity depending on what price the majors pay,” Jerusalim said.

Geopolitics is another concern.

“When the commodity price rises, greed seems to kick in, and governments in certain riskier countries begin to demand a bigger slice of the economic pie,” he explained.

Financial risk must also be considered, though that hurdle is relatively low right now. “Balance sheets as a whole are actually quite healthy for the industry,” Jerusalim said.

To manage operating risk, he suggested a focus on senior producers. “Despite the odd misstep, the senior producers are generally good operators and offer much better diversification relative to the single mine operators,” he said.

Jerusalim also noted that margins for gold producers are at cycle highs, and, generally, when bullion prices rise, a good portion of that margin gets eroded by higher commodity prices and labour costs.

However, partly due to both Covid-19 and weak energy prices, “much more of that top line gain is falling straight to the bottom line today, which is clearly a positive,” Jerusalim added.

Another big positive is free cash flow — specifically, unallocated free cash flow that’s not earmarked for exploration and maintenance.

“At spot prices, if even a fraction of the unallocated free cash flow […] gets returned to shareholders in the form of dividends, it could suggest a yield well above the S&P 500,” he said.

As such, “Look for companies to continue raising dividends in the near term,” he added, similar to how Toronto-based Barrick Gold Corp. raised its quarterly dividend 14% recently after its second-quarter earnings statement. Barrick said its average realized gold price was US$1,725 per ounce in the quarter, a 31% year-over-year increase.

Overall, with the positive backdrop and increase in quality for many senior producers, “investors will likely benefit from having some exposure to gold stocks when properly incorporated into a well diversified portfolio,” Jerusalim said. “That’s even true for the high-quality portfolios.”

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