This investment thesis also appeared on the investment platform, SumZero.
There are decades when nothing happens; and there are weeks when decades happen.
Vladimir Lenin
There is an old Russian novel, A Hero of Our Time, by the great Mikhail Lermontov, whose title alone is delicious. It is the story of Pechorin, a Byronic figure representative of an age when, to quote Lord Macaulay, a man aspired to be “proud, moody, cynical, with defiance on his brow, and misery in his heart, a scorner of his kind, implacable in revenge, yet capable of deep and strong affection”. I often tell my friends that President Donald Trump is, like Pechorin, “a hero of our time”: regardless of whether one lauds him or loathes him, he is the great totem of the age, and his “Liberation Day” policies of global tariffs represent the greatest reordering of the global economic order since the end of the Second World War.
Warren Buffett, the second greatest investor of all time -after Jim Simons, of course-, famously does not incorporate political concerns into his investment thinking. For decades, he has been correct to do so. Research has shown that the U.S. president has far less sway over the economy than the typical voter believes. However, all presidents since the end of the Second World War worked within a conventional understanding of the benefits of what has come to be called the “liberal order” of which free trade was an important component. The old order is dead, the new order is in the making.
In an epoch of fear and trembling, uncertainty reigns, and, in response, investors have and will continue to invest in gold and gold miners. Though the consensus opinion is that tariffs will lead to recession and general immiseration, the White House has marshalled scholarly arguments in favour of tariffs, and some economists, such as Oren Cass, have argued that tariffs have unappreciated benefits that outweigh their costs. For investors, I do not think it matters who is right and who is wrong. Having published a review of 2,000 years of literature on money, I am well aware that sometimes history defies economic theory more often than economists like to admit. What one can say is that investors, influenced by the echoes of the Smoot-Hawley Tariff Act of 1930 and its reputed causation of the Great Depression, and U.S.-China Trade War of 2018 to 2019, know that gold did well in both periods. Indeed, gold is negatively correlated to the US dollar, and outperforms equities during periods of volatility.
Market Perceptions Are Driving a Reallocation of Capital Toward Gold and Gold Miners
What concerns investors is this: the defining feature of the present moment, until some grand bargain is achieved, if ever, or at least analytical clarity is gained, is that investors are fearful and uncertain, and the reaction to that spurs investment flows. In The Alchemy of Finance, George Soros proposed a theory of reflexivity, saying,
Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions. To speak of supply and demand as if they were determined by forces that are independent of the market participants’ expectations is quite misleading. The situation is not quite so clear-cut in the case of commodities, where supply is largely dependent on production and demand on consumption. But the price that determines the amounts produced and consumed is not necessarily the present price. On the contrary, market participants are more likely to be guided by future prices, either as expressed in futures markets or as anticipated by themselves. In either case, it is inappropriate to speak of independently given supply and demand curves because both curves incorporate the participants’ expectations about future prices.
He suggested that market dynamics are governed by the interaction of two equations:
- y = f (x),
- x = φ(y),
where f is the cognitive function in which “the participants’ perceptions depend on the situation” and φ is the manipulative function in which “the situation is influenced by the participants’ perceptions”. The interested reader is encouraged to read the Journal of Economic Methodology’s 2013 series on his theory, in which economists reacted to his ideas. The interaction of these equations leads to feedback loops that drive market trends. Applying his theory to the present moment, one sees how investor expectations of economic malaise have led to capital flowing out of stock markets and U.S. Treasuries and into perceived safe haven assets such as gold and the producers of those safe haven assets, exacerbating the perception of the riskiness of US markets and fueling more outflows to safe haven assets, in a positive feedback loop. The perception of risk, because of the manipulative function, leads to a flight into safe haven assets, creating more risk, ad infinitum. This is analogous to Hyman Minsky’s financial instability hypothesis:
The readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system’s reactions to a movement of the economy amplify the movement–inflation feeds upon inflation and debt-deflation feeds upon debt-deflation.
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Expectations of profits depend upon investment in the future, and realized profits are determined by investment: thus, whether or not liabilities are validated depends upon investment. Investment takes place now because businessmen and their bankers expect investment to take place in the future.
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The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.
In the year-to-date (YTD), the SPDR Gold Shares ETF (GLD) is up nearly 19%, and the iShares MSCI Global Gold Miners ETF (RING) is up just over 37%, compared to a decline of 8.61% for the SPDR S&P 500 ETF (SPY), and 1.5% for the iShares MSCI World ETF (URTH). It is likely that at the end of this year, gold and gold miners will outperform the S&P 500 and many other market indices. Some may respond that surely gold and gold miners are in a bubble, yet, as Soros (and I) would point out, buying into a bubble is rational if that bubble is sustainable. The investor who bought bitcoin is better off than the investor who put his money with 99% of investors across the world. The question is of the sustainability of that bubble.
It is clear that the European Union (EU), the People’s Republic of China (PRC), and other major economies will respond to the US’ protectionism, creating escalatory rounds of retaliation, even if the ultimate goal for those countries, and possibly the Trump Administration, may be to achieve a grand bargain, the so-called Mar-a-Lago Accord. In Bill Bishop’s Sinocism issue today, he writes on the PRC, whose effective tariffs now stand at 70%, that though the PRC’s “reaction is unlikely to be weak, and I doubt Xi and his team will just roll over and do nothing while trying to negotiate”, there are signs of a desire for a grand bargain in the future. He goes on to say that,
People’s Daily commentator Zhong Sheng has launched a new series – Fully Understanding the Win-Win Nature of China-US Relations 充分认识中美关系互利共赢的本质. As of April 2nd there are two installments. This first one is from March 31st and is titled “Moving Towards Each Other, Letting Investments Better Benefit the People of Both Countries.
Excerpt:
‘The logic of China-US investment cooperation is clear. While there is competition between the industries of the two countries, there is even more complementarity. By leveraging their respective advantages and strengthening investment cooperation, China and the US can fully achieve mutual benefits and win-win results.
The expected tit-for-tat response to the US’s protectionist policies will likely go on for at least a year. The Trump Administration will want tangible results by the mid-terms, and it is in the PRC’s interests to negotiate, but from a position of strength, and that means trying to get to near the mid-terms when they will be able to get a more favourable deal, especially as the PRC does not have the scope to make the fundamental reforms that the United States seeks. If a one-to-two year trade war is the bare minimum in terms of the duration of a trade war, the subsequent decline in trade volumes and build-up of economic inefficiencies will make gold and possibly gold miners, more attractive, as investors hedge against the risks of escalating trade conflicts.
Even without Trump’s revolution, it is notable that the aggregate investor’s allocation of their portfolio to equities, a measure I call, “equity preference” was at 52% at the end of Q4 2024, its highest level since the Federal Reserve started continuously collecting the component data in Q4 1951. As I explained last year, equity preference is inversely correlated with future 10-year returns, in other words, as the demand for the limited supply of future returns increases, the supply of those future returns declines. the investor who bought the S&P 500 in December and holds it for the next decade, will earn low-single digit returns. Investor portfolios, excessively allocated toward stocks, are now under forced rebalancing, and gold miners are, because of gold prices, one of the few exceptions to the gravitational pull that stocks are feeling. In many ways, this thesis is a thesis contra stock market indices, a put against the S&P 500.
Stable Supply, Supports Elevated Gold Prices
In his book, Capital Returns, Edward Chancellor told the story of Marathon Asset Management LLP, a UK firm that uses what they call a “capital cycle” framework to analyse markets. Chancellor explained,
…high returns tend to attract capital, just as low returns repel it. The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways – what we like to call the capital cycle. Our job has been to analyze the dynamics of this cycle: to see when it is working and when it is broken, and how we can profit from it on behalf of our clients.
That framework has been subsequently backed up by what economists now call the “asset growth anomaly”: in general, low asset growth stocks outperform high-asset growth stocks, and this explains stock market returns far more than any other factor such as value, size and momentum. Commodities are difficult to invest in because their production cycle follows the “cobweb model”, which means that management makes production decisions with long lead-times, long before they can observe the prices at which their products will be sold, leading to overshooting or undershooting in supply and price fluctuations. For example, according to the World gold Council, the typical time between exploration and first output is 15 years. My first job was running a small gold miner in Zimbabwe in 2007. it was, appropriately, named “Scallywag”. Many of the older gold miners had spent the majority of their careers not actually mining gold, but treating “dumps”, or the tailings from gold processing, because for decades, the price of gold was so low that gold mining was not worth it. Firms such as DRDGOLD Limited (JSE:DRD) in South Africa, who primarily engage in the treatment of tailings, have a longer history of profitability than conventional gold miners. The devastation felt by gold miners in former times was the consequence of excess supply leading to a collapse in prices that made gold mining unprofitable. The entry of capital and subsequent expansion in production portended a collapse in profitability and exit of capital. A joke told to me was, “It takes a small fortune to make a large fortune in gold mining”. A report in Reuters captures the history of the industry:
Anyone acquainted with the industry might find that hard to believe. Historically, gold miners have offered remarkably poor protection against rising prices. Over the past three decades the index of U.S. consumer prices more than doubled and the price of gold rose sixfold. Over the same period, the Philadelphia Gold and Silver Index of listed miners climbed by about 40%. The mining benchmark remains well below its peak in 2011. Since that date U.S. prices and bullion have risen by 33% and 55%, respectively.
Few industries have a more dismal record of allocating capital. After the gold price took off in the early 2000s, miners pursued growth at any cost. They borrowed freely, splurged on new developments, and pushed up costs by extracting gold from low quality mines – what’s known in the business as low-grading. Debt levels at the four senior miners – Newmont (NEM.N), Barrick Gold (ABX.TO), Agnico Eagle Mines (AEM.TO), and Kinross Gold (K.TO) – rose to an average 50% of net assets. After the gold price dropped in 2011, the miners were left stranded. Barrick, the world’s largest miner at the time, announced some $23 billion of asset writedowns between 2012 and 2015.
That era is, for now, a thing of the past. Today, gold prices are so high that gold miners can comfortably pay their all-in sustaining costs and all-in costs. Although the gold price has shot up to dizzying heights, part of a run that began around 2002, thereabouts, capex has actually fallen from its peak in 2012. In fact, capex for the top miners globally, across all commodities, has not recovered from the 2012-2013 heights, despite the temptations posed by the commodities boom. The economic result is clear: since 2010, supply has risen from 4,316.9 tonnes in 2010 to 4,974 tonnes in 2024, compounding at just 1% a year. Although demand is currently below supply, on balance, demand is more likely to rise quickly than supply is, pushing prices up. I try to avoid demand forecasts. What is essential is the realisation that the excesses of previous cycles have been avoided, supporting high gold prices.
A recent discussion in the Financial Times shows the extent to which capital allocation has improved in the industry. Not only have miners shunned capex expansion, but M&A deals are far more conservative. As prices have risen, gold miners have become free cash flow (FCF) spigots. The FT cites a report by TD Securities which shows that, at current prices, Barrick Gold Corporation (GOLD) will earn an FCF yield of 9.5% and the Newmont Corporation (NEM) will enjoy an FCF yield of 7.5%. Kinross has doubled its FCF to $1.3 billion year-over-year. Gold miners have also become better about returning capital to shareholders. Barrick Gold, on the back of doubling its FCF in Q4 2024, announced a $1 billion share buyback. AngloGold Ashanti plc (JSE:ANG) declared a final dividend of $0.91 per share, five times the previous year’s dividend, having said that its balance sheet is at its strongest in a decade. Gold Fields Limited (JSE:GFI) has also said it will initiate a share buyback this year, while Harmony Gold Mining Company Limited (JSE:HAR) has said it will be able to self-fund the construction of a new copper mine in Australia.
My own research suggests that a high-cost gold miner can make $1,000/oz more than it costs to produce, while low-cost producers can earn half of the gold price in profits. Usually, gold miners do not do as well as gold in terms of returns, but as profitability has risen, the market has started to wake up to the attractive economics of gold mining. In March, gold mining ETFs experienced their first net monthly inflows in six months. We are at a moment now where, if gold continues to do well, gold miners will benefit on the market. The capital discipline within the industry is even more remarkable when one considers that gold miners did not budget for prices in excess of $3,000. They have been built for lower prices, so that they are now earning excess FCF which, based on recent history, will be allocated in a disciplined fashion.
How High Can Gold and Gold Miners Go?
The iShares MSCI Global Gold Miners ETF trades at a price-to-equity multiple of 19.11, compared to 22.3 for the iShares MSCI World ETF (URTH) and 25.02 for the SPDR S&P 500 ETF Trust (SPY). This is, of course, a crude way to look at it if one cannot value each business on its own. If a re-rating results in the iShares MSCI Global Gold Miners ETF getting to 23.66 or thereabouts, an average of the iShares MSCI World ETF and SPDR S&P 500 ETF Trust, the share price will have risen by about 25%. I think the SPDR Gold Shares ETF can match that rise, the thesis working out over the next 2 years.